HSBC - The Allocator by riteshbhansali


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Asset Allocation
                                                                                                    Global Research

The Allocator                                                 Our economic outlook is skewed to
                                                               below-trend growth with a deterioration
                                                               in the growth/inflation balance
Strategic thinking in a tactical world
                                                              We realign our strategic allocation from
                                                               credit into commodities and EM debt

                                                              Tactically, we shift out of credit

                                                             With the mixed data signals and oscillations in policy, it is easy
                                                             to believe that there are two or three economic cycles per week.
                                                             In this environment, it is hard not to let short-term thinking
                                                             cloud a long-term view. In this piece, we offer readers a
                                                             strategic haven away from the day-to-day turmoil.

                                                             Our strategic view is driven by a scenario-based investment
                                                             process in which we assess the likelihood of different economic
                                                             outcomes. Using this approach, we see:

                                                              Deterioration in the inflation/growth trade-off since our last
                                                               strategic update in Dec 2011 as a result of stickier
                                                               commodity prices and possible supply disruptions.

                                                              There is a 90% chance of a low-growth scenario over the
                                                               next two years. Within this, we see a 40% chance of
                                                               stagnation (up from 35% in Dec 2011) and a 35% chance
12 September 2012                                              of a recession (down from 45%).

Fredrik Nerbrand
                                                              Headline risks are increasingly contingent on each other,
Global Head of Asset Allocation                                which should lead to greater economic volatility and higher
HSBC Bank Plc
                                                               correlations. Coupled with low growth, this is likely to keep
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                                                               risk premiums at elevated levels, depressing returns across
Daniel Fenn                                                    the asset spectrum.
HSBC Bank Plc                                                We therefore reweight our strategic portfolio by:
+44 20 7991 3025
                                                              Reducing our allocation to credit where valuations are
                                                               stretched and there is less scope for returns;

                                                              Increasing our allocation to EM debt as we are likely to see
                                                               sustained demand for the stronger EM sovereigns because
                                                               of the scarcity of alternative safe assets; and
View HSBC Global Research at:
                                                              Increasing our allocation to TIPS and commodities, which
                                                               should outperform in a world of loose monetary policy and
Issuer of report:   HSBC Bank plc
                                                               possible supply shocks.
Disclaimer & Disclosures                                     Readers can amend our assumptions and test the impact on their
This report must be read with the                            asset allocation using the linked spreadsheet.
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it
      Asset Allocation                                                                                                                                      abc
      12 September 2012

Asset Allocation
Asset Allocation overview
                                                 Strategic Portfolio Weight     Tactical Portfolio Weight
                                                 ______ (3-year view) ________ ______(6-month view) ______
                                                    New Change from last           New Change from last                      Last move in Tactical          Added to     Performance
                                                  weight      publication        weight      publication                           Portfolio (date)       portfolio on   since added
Cash                                               0.0%                     -                     5.0%     -                        (18 May 2012)     12 October 2010         0.2%
US Treasuries
UST 5Y                                            10.0%                     -                    13.0%     -                     (21 August 2012)     12 October 2010         9.3%
UST 10Y                                           10.0%                     -                    12.0%     -                        (18 May 2012)     12 October 2010        13.1%
TIPS                                              13.0%                   0.5%                   13.0%   2.0%                (12 September 2012)          8 June 2011        13.7%
Corporate Credit
Investment Grade Credit                            8.0%                   -4.5%                  12.0%      -                  (14 February 2012)     12 October 2010        13.7%
High Yield Credit                                  7.0%                   -3.0%                   7.0%   -4.0%               (12 September 2012)      12 October 2010        17.3%
Emerging Market Debt
Local Currency FX                                  6.0%                   1.0%                    4.0%     -                        (18 May 2012)     12 October 2010        -1.0%
Hard Currency FX                                   6.0%                   4.0%                    2.0%     -                        (18 May 2012)    9 December 2011         14.6%
Global Titans                                      4.0%                     -                     6.0%   1.0%                (12 September 2012)      12 October 2010        21.4%
Global Select Dividend 100                         1.0%                     -                     2.0%   1.0%                (12 September 2012)      12 October 2010        23.1%
Emerging Markets                                  15.0%                     -                     3.0%     -                       (22 June 2012)     12 October 2010        -0.8%
Industrial Metals                                  2.0%                   1.0%                    3.0%     -                     (21 August 2012)     12 October 2010        -17.1%
Oil                                                2.0%                   1.0%                    3.0%     -                       (28 April 2012)    12 October 2010          0.0%
Agriculture                                        1.0%                     -                     0.0%     -                     (21 August 2012)     12 October 2010         18.5%
Gold                                              15.0%                     -                    15.0%     -                        (18 May 2012)     12 October 2010         28.6%
                                                   100%                                          100%
Estimated Portfolio Risk                          7.46%                                          5.89%
Current Portfolio Yield                           2.08%                                          1.83%
Source: HSBC

    Portfolio allocation

    40%                                                                                          40%
                                                                                                           Investment process
                                                                                                           The strategic asset allocation is the function of a
    30%                                                                                          30%
                                                                                                           scenario-based investment process with a tactical risk
    20%                                                                                          20%
                                                                                                           overlay to achieve a return target of three-month USD
    10%                                                                                          10%       LIBOR + 4% (in line with the historical equity risk
      0%                                                                                         0%        premium) and a volatility limit of 10-year US Treasury



                                                   EM debt


                                                                                                           We use three main drivers of our tactical views:
                                                                                                            Economic activity
                                         Strategic           Tactical
                                                                                                            Relative valuations
                                                                                                            Financial conditions
    Source: HSBC

  Asset Allocation                                                                                                                                    abc
  12 September 2012

Key Indicator snapshot

                                                                                          We see that economic activity has fallen away, with
                                              Negative risk         Positive risk
                                                                                          our Global Leading Economic Indicators (GLEI)
Economic activity                                                                         showing negative momentum and weakening
                 GLEI - Headline Strength
                                                                                          strength. This is in line with the recent PMI releases
               GLEI - Headline Momentum                                                   that showed a gloomy picture for the global
               GLEI - Industrial Momentum                                                 economy, particularly in developed markets.

           GLEI - Consumer Momentum                                                       However, from a valuation perspective, we do see
         HSBC IP Surprise (30d change)                                                    reasons not to reduce riskentirely. Our proprietary
                                                                                          bottom-up CDS/12m forward Earnings Yield model
  HSBC G7 PMI Surprise (30d change)
                                                                                          favours equities, while our discounted cash flow
        HSBC US Consumer Composite
                                                                                          analysis shows strong valuations for equities.
                                                                                          Our US consumer composite continues to increase,
      Equity/Credit Preference (CDS/DY)
                                                                                          although this is from a very low level, while our
      Equity/Credit Preference (CDS/EY)                                                   global bank lending indicators show strength again,
                                Nerbrand z                                                driven by strong lending growth in emerging
Financial conditions
            Global Bank Lending - Slope                                                   In summary, we see mixed signals with regards to
                                                                                          our risk appetite but believe that the negative macro
          Global Bank Lending - Impulse
                                                                                          outlook is likely to dominate the valuation strengths.
                        HSBC Clog Index
                                                                                          Please see page 21 for a definition of the different
                        Current level                 Change from last month              models.
Source: HSBC

Portfolio Allocation                                                                Portfolio performance statistics
115                                                                        115      Returns                                            Strategic      Tactical   Benchmark*
                                                                                    1 month                                                   1.39%     1.91%         0.38%
110                                                                        110      3 month                                                   5.37%     5.46%         1.11%
                                                                                    6 month                                                   2.54%     2.32%         2.24%
105                                                                        105      12 month                                                  5.53%     5.76%         4.50%
                                                                                    Year to date                                              8.25%     7.81%         3.06%
100                                                                        100      Since Inception                                          13.71%   12.84%          8.54%

 95                                                                        95
                                                                                    Annualised volatility                                     7.22%     6.04%        14.77%
  Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12
                                                                                    * Benchmark return target: 3m USD LIBOR + 4%.
                  Tactical              Strategic          Benchmark                  Volatility benchmark: 10 Year US Treasury volatility
                                                                                      Inception: 12 October 2010

Source: HSBC                                                                        Source: HSBC

    Asset Allocation                                                                                                       abc
    12 September 2012

Conditional Love
 While the risk of recession has decreased a little, the economic
    outlook still looks decidedly poor
 The conditionality of headline risks increase the severity of
    downside scenarios
 We decrease our credit position and increase our allocation to EM
    debt and commodities

Introduction                                            It’s the distribution of events
The foundation of our asset allocation process is
                                                        not base cases that matter
deciding which assets to own based on their risk-       The outlook for the global economy is never
return profiles in different economic                   certain. It should, however, be possible to make
environments. For example, the reason to own a          reasonable forecasts for the distribution of events
bond is essentially a desire to have a low volatility   because of the constraints on possible outcomes.
asset with a high return of capital. On the other       That is, the underlying constraints on potential
hand, the ownership of an equity is a participation     economic activity and realistic policy options
in an economic upswing. Our strategic asset             increase future predictability. This is the
allocation is thus predominantly a function of the      underlying rationale for our scenario-driven
probability distribution of future                      strategic investment process.
economic scenarios.
                                                        1. Economic scenario matrix

This process alleviates the problems associated
with traditional asset allocation models that
                                                                                  Above trend    Trend       Below trend
assume normally distributed returns and a
                                                                    Above trend                        Goldilocks
constant correlation matrix. Neither of these                                     Inflationary

assumptions is true in the current environment (or                      Trend                    Trend

any other environment for that matter).                             Below trend                        Stagnation
Ultimately, global economic risks are increasingly                     Negative                        Recession
contingent on one another, which implies a higher
degree of economic correlation and greater              Source: HSBC

volatility in the economic cycle.
                                                        It is virtually impossible to come up with an
                                                        allocation among a large group of assets by
                                                        considering every state of the world

    Asset Allocation                                                                                                                                      abc
    12 September 2012

Table 1. Scenario descriptions
                    Inflationary growth        Goldilocks            Trend               Stagnation             Stagflation            Recession
Real GDP range              >4%                   3-4%                2-3%                  1-2%                    0-1%                  <0%
Inflation range             >4%                 1.0-1.5%            2.0-2.5%                0-1%                    >4%                   <0%
Brief description   Overly aggressive      EZ structural issues Similar to           Postponement of        Overly leveraged       Highly contingent
                    monetary policy in     are solved, but      Goldilocks but       resolving structural   governments and        top-line risks spark
                    combination with       labour markets take without the boom in   EZ and US issues.      an investment-         a severe decline in
                    wage growth and a      a long time to       capex. Some          Monetary policy        averse private         sentiment. Policy
                    demand-led shock       recover. This should progress in the EZ   stays loose but        sector limit growth.   paralysis deepens
                    in commodity           limit wage growth and US, but not         without traction. A    Loose monetary         the contraction and
                    markets lead to a      but improve capex necessarily long-       delay in creative      policy (or a “debt     prevents a rebound.
                    deterioration in the   and productivity     term structural      destruction also       jubilee”) and a
                    growth/inflationary    outlooks.            remedies.            limits long-term       supply-led
                    relationship.                                                    growth prospects.      commodity shock.
Source: HSBC

simultaneously. Instead, the task can be made                                In the following sections, we go through each of
manageable and better results achieved by                                    the five steps in turn and explain how we reach
splitting up the decision into smaller parts and                             our new strategic allocation.
then aggregating. This is why we split up our
                                                                             Step 1: Scenario definitions
allocation decision by first considering a set of
scenarios (Chart 1). We then make forecasts of the                           To define our economic scenarios, we focus on
expected returns and optimal allocation for                                  the outlook for developed markets. This does not
different asset classes under each scenario.                                 mean that emerging markets are any less
                                                                             important, rather we believe that less-developed
Ask yourself this question: What is easier to
                                                                             economies follow a similar business cycle to the
predict, the price of the S&P500 at year-end or
                                                                             OECD. In addition, we believe that, in general,
whether the S&P500 will outperform US
                                                                             emerging markets will fare relatively better in
Treasuries given a best-case “Goldilocks”
                                                                             most of the growth-oriented scenarios and worse
scenario? In our mind, your ability to predict an
                                                                             in a recessionary outlook.
outcome given constraints is significantly higher
than a more general forecast.                                                We have identified six scenarios that differ in
                                                                             terms of the levels of growth and inflation.
This leads to a five-step asset allocation process:
                                                                            Inflationary growth
1     Define the scenario matrix and the catalysts
      that would lead to each outcome.                                      Goldilocks

2     Define the expected returns for each asset                            Trend
      class for every scenario.
                                                                            Stagnation
3     Construct scenario portfolios; ie, the optimal
                                                                            Stagflation
      allocation under each scenario.
                                                                            Recession
4     Define the probability that each scenario will
      occur.                                                                 We give a brief description of each scenario in
                                                                             Table 1 and a more detailed explanation in the
5     Construct an overall portfolio by weighting
                                                                             appendix on page 18. We explain the probabilities
      each individual scenario portfolio by the
                                                                             that we assign to each scenario on page 11. To get a
      probability that that scenario happens.

      Asset Allocation                                                                                                                                abc
      12 September 2012

    2. Scenario history
     6%                                                                                                                                         120
     0%                                                                                                                                         80
     -6%                                                                                                                                        40
        Aug-84 Aug-86 Aug-88 Aug-90 Aug-92 Aug-94 Aug-96 Aug-98 Aug-00 Aug-02 Aug-04 Aug-06 Aug-08 Aug-10
                   Inflationary Growth                          Goldilocks                                           Trend
                   Stagnation                                   Stagflation                                          Recession
                   G7 Inflation (LHS)                           G7 Industrial Production (RHS)
    Source: Thomson Reuters Datastream, HSBC

better feel for what the scenarios actually mean, in                          has some level of operational gearing, a negative
Chart 2 we show a timeline of when the economy                                growth outlook has an outsized impact on earnings.
has been in each state. During the past 20 years, we                          Given that, economic volatility rather than trend
have spent 30% of the time in the best-case                                   should be the largest driver of risk premiums.
goldilocks scenario and 14% of the time in
                                                                              Table 2. Risk premiums’ dependence on growth and volatility
recession (Chart 3).
                                                                                                                       Economic volatility
                                                                                                                     Low                High
    3. Distribution of time in each scenario over the past 20 yrs
                     Recession                 Inflationary
                       14%                       Growth                                                                           Medium-risk
                                                                                                       High   Low-risk premium
                                                                               Economic trend growth

                                                   15%                                                                            premium
                                                                                                       Low                        High-risk premium
           Stagnation                                       30%               Source: HSBC

                          12%                                                 With closer economic linkages and the increased
    Source: Thomson Reuters Datastream, HSBC                                  interdependence of risks, we would argue that
                                                                              heightened economic volatility is here to stay. As
Step 2: Expected returns                                                      a result, risk premiums should remain high for the
The next step in our allocation process is defining                           foreseeable future. In addition, while our core
the expected return for the different asset classes                           scenario remains continued economic stagnation
under each scenario. An important consideration in                            (see page 11 for details), we believe that this is
                                                                              different from Japanese stagnation because of the
setting our return expectations is the risk premium.
In our view, this depends primarily on two                                    difference in economic volatility. Over the past
                                                                              few decades, the volatility of the business cycle has
variables: economic trend growth and economic
volatility (Table 2). This dependence is basically                            remained fairly subdued. This changed though
                                                                              when reality hit in 2008 and since then volatility has
the result of expectations about the possibility of
negative growth. Since most of the equity market                              been much higher. Up to 2008, monetary policy

   Asset Allocation                                                                                                                          abc
   12 September 2012

 4. Risk premium should be elevated given underlying economic volatility
  6%                                                                                                                                  20%
  3%                                                                                                                                  10%
  1%                                                                                                                                  5%

  -2%                                                                                                                                 -5%
     Oct-79       Oct-82        Oct-85      Oct-88   Oct-91   Oct-94    Oct-97      Oct-00      Oct-03   Oct-06       Oct-09

                       24m avg OECD IP growth                     24m OECD IP volatility                   Risk premium (RHS)
 Source: Thomson Reuters Datastream, HSBC

also appeared to be working. Since then, however, it                     Given the high volatility of the business cycle, we
has had a fairly marginal impact on growth                               expect that risk premiums will remain at an
expectations. Furthermore, the structural shifts in                      elevated level, which impacts our return
the inventory cycle have also served to make the                         expectations and helps to inform our allocation
economic cycle more volatile as a result of more                         decisions. At the same time, the volatility of the
integrated production models and just-in-time                            cycle will also shift underlying assumptions for
delivery.                                                                each scenario in a material manner.

Defining the risk premium                                                  5. Risk premium is likely to stay elevated as long as
                                                                           economic volatility is high
The notion of risk premium is slippery, with                              10%                                                          10%
multiple alternative definitions. Here, we define it                       8%                                                          8%
as the earnings yield of MSCI world less the real                          6%                                                          6%
bond yield (US yield and inflation) – see Chart 4.                         4%                                                          4%
On this measure, the risk premium in equity
                                                                           2%                                                          2%
markets was remarkably low from 1982 to 2000.
                                                                           0%                                                          0%
Since then, the risk premium has increased and at
                                                                           -2%                                                         -2%
the moment we are stuck in the worst of all worlds:
                                                                           -4%                                                         -4%
high volatility and low trend growth.                                        01-Oct-79       01-Oct-89    01-Oct-99       01-Oct-09
                                                                                             model         Risk premium (RHS)
Needless to say, this type of modelling is never
                                                                           Source: HSBC
perfect; however, the increase in economic
volatility will ultimately depress expected returns
across the asset class spectrum. If we overlay a
model of economic volatility and growth to
delivered risk premium, we get a fairly decent fit.
This is not aimed to be a tactical fit of the risk
premium, instead we use it as a strategic tool to
define the equilibrium level. In Chart 5, we
illustrate this type of modelling.

      Asset Allocation                                                                                                                                                                                                             abc
      12 September 2012

From inputs to returns                                                                                        correlated with GDP, and we see significantly
Keeping this in mind, we can calculate returns for                                                            lower sales growth in stagflation and
each asset class and economic scenario using the                                                              recessionary scenarios – while stagnation has the
asset inputsshown in Table 11 in the Appendix on                                                              same downward pressure on incomes, but
page 21. Taking the example of equities, we apply                                                             equally less of a drag from inflation compared
forecasts for margins, sales growth and PE ratios to                                                          with stagflation.
leave us with earnings and an implied price and                                                                  7. Variation of equity inputs across scenarios
return over a two-year time horizon (Chart 6). The                                                              15%                                                                                                       15%
method by which we arrive at an overall return is                                                               10%                                                                                                       10%
shown in Table 3.                                                                                                 5%                                                                                                      5%

    6. DM equity earnings expectations to 2014                                                                    0%                                                                                                      0%
 120                                                                                                             -5%                                                                                                      -5%
                                                                                                               -10%                                                                                                       -10%
                                                                                                                               Inflationary Growth





                                                                                                                                                      Real sales growth year 1                    Margin year 1
    60                                                                                                           Source: HSBC
     Aug-06              Aug-08               Aug-10               Aug-12               Aug-14

                   Earnings                                         Stagflation
                   Recession                                        Inflationary Growth                       Fixed income
                   Goldilocks                                       Trend                                     The same is true in fixed-income markets, where
    Source: HSBC, Thomson Reuters Datastream
                                                                                                              we expect to see 10-year US treasury yields rise in
                                                                                                              all but a stagnation or recession scenario. The
Equities                                                                                                      impact is much greater in inflationary scenarios –
Our inputs have a wide range across the different                                                             and hence we see poor, negative returns in
scenarios; with equities this is true for sales,                                                              these scenarios.
margins and PEs. We would expect margins to be
higher when growth is not followed by inflation,
                                                                                                              Credit spreads are highly correlated with growth
as commodity prices put pressure on companies’
                                                                                                              owing to the rise in risk premium in a recessionary
bottom line, and hence see the strongest margins
                                                                                                              scenario. The converse is true during periods of
in a goldilocks scenario. Sales growth is heavily
                                                                                                              strong growth with credit spreads tightening the

Table 3. Calculating returns from our inputs
                                                            Inflationary                Goldilocks                        Trend                       Stagnation                 Stagflation                      Recession
Current price                                                     1293.43                    1293.43                   1293.43                                    1293.43                  1293.43                      1293.43
Inflation in Year 1                                                4.00%                      1.50%                     2.00%                                      0.00%                    4.00%                        -0.50%
Current PE                                                          13.50                      13.50                     13.50                                      13.50                    13.50                         13.50
Current EPS                                                         95.80                      95.80                     95.80                                      95.80                    95.80                         95.80
Real Sales Growth Year 1                                            8.0%                      10.5%                      7.0%                                       4.5%                     -1.0%                        -8.5%
Margin Year 1                                                       7.0%                       9.0%                      7.5%                                       7.0%                      7.0%                         5.5%
EPS growth                                                          13.50                      13.50                     13.50                                      13.50                    13.50                         13.50
12m fwd EPS Year 1                                                  98.93                     127.19                    103.16                                      92.30                    90.98                         63.16
PE                                                                     17                         19                        17                                         12                      100                            11
Implied Price Year 1                                              1681.79                    2416.69                   1753.65                                    1107.65                   909.79                       694.71
Source: HSBC. Note: EPS growth calculated from nominal sales growth (real sales growth +inflation) and margin. Table shows example calculation for year 1, model is run on a 2 year time horizon.

    Asset Allocation                                                                                                                                                  abc
    12 September 2012

most during low inflation growth as investors                                                               some interesting trends, with the relationship
prefer fixed income relative to equity. We see a                                                            between asset classes in different scenarios
similar pattern with emerging market debt in                                                                proving a useful starting point for our asset-
which spreads tighten in high-growth scenarios as                                                           allocation decisions.
a result of increased risk.
                                                                                                            We see that emerging market outperforms
  8. While US 10y yields fall in a recession, credit spreads                                                developed market equity in every scenario, despite
                                                                                                            historically higher volatility. Our expectations
 5%                                                                                                    5%
 4%                                                                                                    4%
                                                                                                            within each scenario are for sales growth in
 3%                                                                                                    3%   emerging markets to far outstrip that of developed
 2%                                                                                                    2%   ones, while we expect margins to be similar –
 1%                                                                                                    1%   leading to stronger earnings growth supporting
 0%                                                                                                    0%   higher prices.
           Inflationary Growth






                                                                                                            Looking at fixed-income markets, we would expect
                                                                                                            both treasuries and corporate credit to perform badly
                                         10Y UST yield in 1 year
                                         Investment grade credit spread 1yr                                 in any inflationary scenario, and with very mixed
  Source: HSBC                                                                                              outcomes in the other four scenarios. Owing to the
                                                                                                            current low-yield environment, returns are limited in
                                                                                                            every scenario.
We expect gold to perform well in stagflation and
recessionary scenarios because of a flight to safety                                                        Gold remains a good portfolio hedge with strong
and to hard assets. However, we accept that                                                                 return expectations in scenarios where risk assets
current prices already factor in much of this                                                               underperform.
perceived misery and so believe that should we
experience a return to strong growth then gold
will falter.

Returns across asset classes
Using the different inputs and calculations for
each asset class, we arrive at a matrix of returns
under each scenario (Table 4). This table contains

Table 4. Asset returns by scenario
                                                Inflationary                          Goldilocks            Trend       Stagnation      Stagflation     Recession
Cash                                                      0.9%                             0.3%               0.3%           0.3%             0.4%             0.3%
UST                                                     -10.9%                            -4.4%              -1.3%           1.4%            -7.6%             1.7%
TIPS                                                      4.8%                             2.7%               2.9%           1.1%             5.4%             0.5%
IGC                                                      -7.7%                            -0.1%               1.6%           1.5%           -12.4%            -3.3%
HYC                                                       1.9%                             7.9%               9.5%           3.4%            -4.4%            -4.8%
EM Debt (hard)                                           -0.4%                             3.3%               4.8%           3.2%            -5.0%             0.7%
EM Debt (local)                                          10.3%                             8.7%               6.7%           2.2%             2.3%            -2.4%
DM Equities                                              16.3%                            44.7%              22.4%          -5.4%           -14.9%           -22.7%
EM Equities                                              26.1%                            54.9%              39.3%           9.0%            -5.1%           -18.4%
Commodities                                              30.0%                            20.0%              10.0%           0.0%            10.0%           -25.0%
Gold                                                      3.0%                           -22.4%             -16.4%         -19.4%            25.4%            31.4%
FX Carry                                                  7.0%                             5.0%               2.0%          -1.5%            -0.1%            -6.0%
Source: HSBC

     Asset Allocation                                                                                                                                                                                                                                                                                 abc
     12 September 2012

Table 5. Asset class return rankings
Rank                                  Inflationary                                                             Goldilocks                           Trend             Stagnation                                   Stagflation                                                         Recession
1                                   Commodities                                                   EM Equities                                   EM Equities         EM Equities                             Gold                                                                          Gold
2                                    EM Equities                                                  DM Equities                                   DM Equities    High Yield Credit                    Commodities                                                                 US Treasuries
3                                    DM Equities                                                 Commodities                                   Commodities      EM Debt (hard)                              TIPS                                                               EM Debt (hard)
4                                EM Debt (local)                                              EM Debt (local)                             High Yield Credit     EM Debt (local)                  EM Debt (local)                                                                          TIPS
5                                      FX Carry                                             High Yield Credit                               EM Debt (local)   Inv. Grade Credit                            Cash                                                                          Cash
6                                          TIPS                                                     FX Carry                                EM Debt (hard)       US Treasuries                         FX Carry                                                                EM Debt (local)
7                                          Gold                                               EM Debt (hard)                                          TIPS                 TIPS                 High Yield Credit                                                            Inv. Grade Credit
8                              High Yield Credit                                                        TIPS                                      FX Carry                Cash                   EM Debt (hard)                                                               High Yield Credit
9                                         Cash                                                         Cash                               Inv. Grade Credit        Commodities                       EM Equities                                                                     FX Carry
10                               EM Debt (hard)                                             Inv. Grade Credit                                        Cash             FX Carry                    US Treasuries                                                                    EM Equities
11                             Inv. Grade Credit                                               US Treasuries                                 US Treasuries          DM Equities                Inv. Grade Credit                                                                   DM Equities
12                                US Treasuries                                                         Gold                                          Gold                 Gold                      DM Equities                                                                  Commodities
Source: HSBC

Returns across scenarios                                                                                                                            Some assets, such as equities and commodities,
The key driver of our portfolio allocation using                                                                                                    are clearly a function of growth – which can be
this approach is the ranking of different asset                                                                                                     seen by comparing the expected returns in
classes in each scenario. We see from Table 5 that                                                                                                  inflationary growth and stagflation (Chart 10) –
while some assets are very strong in some                                                                                                           where despite similar inflation outlooks, return
scenarios, they may be weak in others. This is                                                                                                      prospects are vastly different.
why we use the scenario approach as the world is
not black and white, and we must be prepared for                                                                                                      10. …and other by growth
                                                                                                                                                       30%                                                                                                                                     30%
the chance that the world does not align perfectly
                                                                                                                                                       20%                                                                                                                                     20%
with our estimates.
                                                                                                                                                       10%                                                                                                                                     10%
The same can be said for the clear effect that                                                                                                          0%                                                                                                                                     0%

inflation expectations have on expected returns                                                                                                        -10%                                                                                                                                    -10%

(Chart 9), primarily in fixed-income markets                                                                                                           -20%                                                                                                                                    -20%
                                                                                                                                                                                                                                  DM Equities
                                                                                                                                                                                                                                                EM Equities

                                                                                                                                                                                                                                                                                    FX Carry

                                                                                                                                                                                                                EM Debt (local)
                                                                                                                                                                                               EM Debt (hard)


where we see returns shift either side of zero
depending on inflation, when, in terms of growth,
the two scenarios are very similar.
                                                                                                                                                                       Inflationary Growth                                                                    Stagflation

  9. Some assets are driven by inflation…                                                                                                             Source: HSBC

 25%                                                                                                                                     25%
 15%                                                                                                                                     15%
     5%                                                                                                                                  5%
  -5%                                                                                                                                    -5%
-15%                                                                                                                                     -15%
-25%                                                                                                                                     -25%
                                                                             DM Equities
                                                                                           EM Equities

                                                                                                                              FX Carry

                                          EM Debt (hard)
                                                           EM Debt (local)


                       Stagnation                                                          Stagflation

  Source: HSBC

     Asset Allocation                                                                                                                                        abc
     12 September 2012

Step 3: Scenario portfolios                                                                         Step 4: Scenario probabilities
The next step in the process is to create an optimal                                                The penultimate step in the allocation process is
portfolio for each scenario based on the expected                                                   assigning probabilities to each scenario. In doing
returns and holding limits that we impose for each                                                  this, we assess the likelihood that the various
case (Table 6).                                                                                     policy and economic outcomes that are necessary
                                                                                                    to put us in that state of the world actually happen.
Table 6. Limits for each scenario portfolio
                                                                                                    Of course, such judgements are necessarily
                                             Min                         Max
                                                                                                    subjective. It is, however, possible to make some
Cash                                         0%                         100%
UST                                          0%                          50%                        assessment of the chances of particular scenarios
TIPS                                         0%                          50%                        based on the strength of the forces driving the
IGC                                          0%                          40%
HYC                                          0%                          25%                        world in that direction and the constraints that
EM Debt (hard)                               0%                          15%
EM Debt (local)                              0%                          15%                        limit the chances of alternative outcomes.
DM Equities                                  0%                          40%
EM Equities                                  0%                          30%                        In our view, the most likely scenario for the next
Commodities                                  0%                          25%
Gold                                         0%                          25%                        few years is stagnation in the developed world,
FX Carry                                     0%                          20%                        which we assign a probability of 40% (Chart 11).
Source: HSBC
                                                                                                    This is closely followed by recession with a
                                                                                                    probability of 35%. We consider the likelihood of
These created scenario portfolios reflect the                                                       both scenarios to be high because of the continued
optimum portfolio if we knew that the specified                                                     high levels of government leverage. This debt
scenario would occur.                                                                               overhang limits the willingness of the private sector
                                                                                                    to commit capital, and in the absence of investment
                                                                                                    growth will continue to be muted. In the case of
                                                                                                    capital expenditure, some austerity programmes are
                                                                                                    proving counter-productive as new taxes can reduce
                                                                                                    the incentive to invest in new projects. This then
                                                                                                    leads to a vicious cycle in which lower growth leads
                                                                                                    to greater austerity and a further reduction in
                                                                                                    investment incentives.

Table 7. Scenario Portfolios
Scenario               Inflationary Growth                      Goldilocks                        Trend        Stagnation      Stagflation      Recession
Cash                                           -                           -                           -                -               -                -
UST                                            -                           -                           -                -               -           50.0%
TIPS                                           -                           -                           -                -          50.0%            10.0%
IGC                                            -                           -                           -           15.0%                -                -
HYC                                            -                           -                       5.0%            25.0%                -                -
EM Debt (hard)                                 -                           -                           -           15.0%                -           15.0%
EM Debt (local)                            5.0%                        5.0%                            -           15.0%                -                -
DM Equities                               40.0%                       40.0%                       40.0%                 -               -                -
EM Equities                               30.0%                       30.0%                       30.0%            30.0%                -                -
Commodities                               25.0%                       25.0%                       25.0%                 -          25.0%                 -
Gold                                           -                           -                           -                -          25.0%            25.0%
FX Carry                                       -                           -                           -                -               -                -
                                         100.0%                      100.0%                      100.0%           100.0%          100.0%           100.0%
Source: HSBC, note: maximum weights for stagnation halved to account for similar return expectations.

      Asset Allocation                                                                                                                 abc
      12 September 2012

11. Economic scenario matrix                                         We see the three scenarios in which growth returns
                                                                     to, or exceeds, trend as much less likely. We assign
                                                                     inflationary growth and goldilocks a higher
                            Above trend    Trend       Below trend
                                                                     probability than trend because in order to achieve a
              Above trend   Inflationary         Goldilocks
                              growth                                 strong growth environment we would need decisive

                Trend            5%                       5%         policy action. If we do have such a response, we
              Below trend
                                                Stagnation           believe it is more likely that growth will exceed
                            Stagflation            40%
                               15%              Recession            rather than merely return to trend.
                                                                     Risks remain high for several events that could
Source: HSBC                                                         drive us back into recession. These include a Greek
                                                                     exit from the eurozone; contagion in the currency
Adding to this is the continued uncertainty in the                   union that leads other major nations to request
eurozone and the political stalemate in the US                       bailouts; the US fiscal cliff; and heightened tensions
over tackling its mounting debt. We believe that                     in the Middle East. Although any one of these
we are still a long way from a long-term,                            events could spark a recession, they are closely
sustainable solution to both problems, and this                      intertwined and if one takes place it increases the
policy inertia and the absence of a clear plan to a                  chance of the others; some of these work one way
resolution will act as a drag on growth. While we                    but not the other (Table 9).
believe that the ECB will continue to provide
short-term, piecemeal policy action, we do not                       Scenario distribution
believe that this will be sufficient to put us back                  Table 8 illustrates the changes we have made to our
on a path to growth.                                                 expectations. We shift from recession to stagflation.

These event uncertainties are compounded by the                      Table 8. Our scenario expectations are still bearish

fact that they feed on each other (Table 9). For                                           Current Dec 2011 June 2011       Oct 2010
example, if the US fell off the fiscal cliff this would              Inflationary growth        5%         5%          5%        5%
                                                                     Goldilocks                 5%         5%         15%       15%
further exacerbate problems in the eurozone, and                     Trend                      0%         0%          5%       15%
both events would increase the likelihood of a hard                  Stagnation                40%        35%         40%       45%
                                                                     Stagflation               15%        10%         15%        5%
landing in China. There are also additional, less                    Recession                 35%        45%         20%       15%
predictable, risk factors, such as the possibility of a              Source: HSBC

confrontation in the Middle East over Iran’s nuclear
ambitions, which could potentially drive us back
into recession.

We see the next most likely scenario as stagflation.
In terms of growth, the same arguments that we
outlined for stagnation and recession apply.
However, in this scenario, the ultra-loose monetary
policy that has been undertaken to drive growth
passes through into prices and drives inflation. At the
extreme, an additional inflationary risk is that
heavily indebted nations try to lower their debt
burdens through debt monetisation.

     Table 9. Conditional probabilities

                                                                                                                                                                                                                                                                   12 September 2012
                                                                                                                                                                                                                                                                   Asset Allocation
                                                                                                                                             Effect on event likelihood
                                           US Fiscal Cliff                     Grexit                                    Israel / Iran conflict                China hard landing              ECB QE                             Fed QE
                      US Fiscal Cliff                                           A US fiscal cliff is likely to           Tensions in the Middle East       A US fiscal cliff would push      Any additional                    Similar to the ECB, the
                                                                                    increase the likelihood of a             appear independent of the           the US into a recession.          recessionary pressures             Fed is likely to react to
                                                                                    severe eurozone recession,               economic outlook.                   Couple this with the direct       are likely to increase             any deterioration of the
                                                                                    which in turn would worsen the                                               impact on the eurozone and        the pressure on the                growth/inflationary
                                                                                    situation in Greece, which                                                   the likelihood of a Chinese       ECB to expand its                  outlook. That said, the
                                                                                    could reduce the political will to                                           hard landing increases            balance sheet.                     Fed is hamstrung until the
                                                                                    continue bailouts in the core.                                               substantially.                                                       presidential and
                                                                                                                                                                                                                                      congressional elections.
                      Grexit                Any material deterioration                                                                                     Similar to above, a Grexit        In this instance, the            

                                                in the economic or                                                                                               would still cause                 ECB is likely to flood

                                                geopolitical picture outside                                                                                     immeasurable damage to            the system with liquidity

                                                the US should increase                                                                                           the eurozone economy and          in order to avoid further

                                                the probability of                                                                                               thereby increase the              contagion to Spain and

                                                compromise in                                                                                                    probability of a globally         Italy.

                                                Washington as policy                                                                                             coordinated recession.

                      Israel / Iran conflict  makers are unlikely to           Similar to the US fiscal cliff,                                             The impact from higher oil        While growth would take 
                                                worsen the economic                 any geopolitical risks in the                                                prices would hurt the             a severe hit, inflationary
                                                outlook.                            Middle East would result in a                                                Chinese economy in a              pressures would rise.
                                                                                    severe supply-side-led energy                                                disproportionally large           Faced with this dilemma,
                                                                                    shock, which would increase                                                  manner given underlying           ECB action is
                                                                                    the probability of a recession                                               growth dynamics.                  questionable given its
                                                                                    across the eurozone.                                                                                           hard inflation target.

                      China hard landing                                       While not a direct impact on                                                                                  Similar to a US fiscal cliff, 
                                                                                    the eurozone, a scenario when                                                                                  the growth outlook for the
                                                                                    China slows materially would                                                                                   eurozone under an
                                                                                    highlight an otherwise very                                                                                    environment with a
                                                                                    poor growth outlook for the                                                                                    Chinese hard landing is
                                                                                    region. A slight increase in                                                                                   dreadful. Consequently,

                                                                                    probability but not material.                                                                                  the ECB would look to
                                                                                                                                                                                                   stabilise the price outlook.

     Source: HSBC
     Note: :        Increased probability, : Decreased probability, : No material impact
     Asset Allocation                                                                                                                                                                                      abc
     12 September 2012

Step 5: Final Portfolio                                                                                                                        Cutting credit
                                                                                                                                               We realign our allocation by cutting the weight
Using our scenario probabilities, we weight our
                                                                                                                                               from assets in the ‘middle ground’, which we do
scenario portfolios in Table 7 to produce a
                                                                                                                                               not expect to give high returns in any scenario.
portfolio weighted for returns and economic
                                                                                                                                               We reduce our strategic allocation to investment
expectations (Chart 11).
                                                                                                                                               grade credit by 4.5% and high yield by 3%. From
We could simply realign our allocation by                                                                                                      a pure valuation point of view, we think that
maximising our expected return under our base-                                                                                                 spreads have gone too far and valuations are now
case scenario, ie, the scenario to which we assign                                                                                             stretched (see ‘The illusion of choice, European
the highest probability. This would prove the best                                                                                             Credit Strategy’, 11 September 2012).
decision if our scenario pans out; however, it
                                                                                                                                               Increasing EM debt, commodities and TIPS
would probably underperform if there was any
                                                                                                                                               We see no reason to alter our equity or US
deviation from this base case, which is a distinct
                                                                                                                                               treasury positions, but increase our allocations to
possibility in today’s uncertain economic climate.
                                                                                                                                               TIPS, EM debt and commodities while
Given this, in creating our portfolio we therefore                                                                                             maintaining our already large position in gold
account for the possibility that our central                                                                                                   (Table 10). We believe that TIPS, commodities
scenario does not play out. We do this by                                                                                                      and gold should all perform well in the current
incorporating into our asset allocation decision the                                                                                           world in which central banks continue to use
expected returns (Chart 12) under all possible                                                                                                 unconventional monetary tools to try to stimulate
scenarios, which means that we are diversified                                                                                                 growth and inflation risks remain high.
across different economic outcomes.
                                                                                                                                               Our biggest portfolio increase is into emerging
Owing to the high weight we place on low-growth                                                                                                market debt, particularly into hard currency. This is
outcomes (Chart 11), the expected return for                                                                                                   in line with the bullish forecasts of our emerging
equities and commodities is low or negative, but                                                                                               market team (see ‘Fond of Bonds’, Emerging
we still require a holding in these assets, should                                                                                             Market Strategist, 5 August 2012). Despite yields
the global economy be more favourable than                                                                                                     on EM bonds reaching record lows, a global
expected.                                                                                                                                      scarcity of safe assets is likely to result in continued
                                                                                                                                               demand for the debt of stronger EM sovereign;
 12. Expected returns of different assets
  8%                                                                                                                                    8%     hence, we expect further spread tightening.
  6%                                                                                                                                    6%
  4%                                                                                                                                    4%     Table 10. New Portfolio
  2%                                                                                                                                    2%
  0%                                                                                                                                    0%                               Previous   Probability     New
 -2%                                                                                                                                    -2%                                          Weighted
 -4%                                                                                                                                    -4%
 -6%                                                                                                                                    -6%    Cash                         0.0%         0.0%       0.0%
 -8%                                                                                                                                    -8%    US Treasuries               20.0%        17.5%      20.0%
-10%                                                                                                                                    -10%   TIPS                        12.5%        11.0%      13.0%
                                         EM Debt (hard)
                                                          EM Debt (local)


                                                                            DM Equities
                                                                                          EM Equities

                                                                                                                             FX Carry



                                                                                                                                               Investment grade credit     12.5%         6.0%       8.0%
                                                                                                                                               High yield credit           10.0%        10.0%       7.0%
                                                                                                                                               EM Debt (hard FX)            2.0%        11.3%       7.0%
                                                                                                                                               EM Debt (local FX)           5.0%         6.5%       6.0%
                                                                                                                                               DM Equities                  5.0%         4.0%       5.0%
                                    Expected Return                                                                                            EM Equities                 15.0%        15.0%      15.0%
                                                                                                                                               Commodities                  3.0%         6.3%       5.0%
 Source: HSBC
                                                                                                                                               Gold                        15.0%        12.5%      15.0%
                                                                                                                                               FX Carry                     0.0%         0.0%       0.0%
                                                                                                                                                                          100.0%       100.0%     100.0%
                                                                                                                                               Source: HSBC

     Asset Allocation                                                                                                                                     abc
     12 September 2012

Tactical overlay                                                             strategists who have recently recommended
                                                                             reducing risk in high yield as we head into Q4
In addition to the adjustments in our strategic
                                                                             following strong performance in Q3 (see
portfolio, we also make some changes to our
                                                                             ‘Positioning for Q4 – reining back risk’,
tactical allocation. We reduce our tactical high-
                                                                             European High Yield Strategy, 6 September
yield credit weight from 11% to 7%, which brings
                                                                             2012). It therefore seems like a good time to take
it into line with the new high-yield weight in our
                                                                             some profit on this position.
strategic view. We reassign 2% of this weight to
TIPS, increasing our tactical allocation from 11%                            Overall, these changes have only a marginal effect
to 13%, which also brings our tactical TIPS                                  on the risk of our portfolio with volatility
weight in line with our strategic TIPS position.                             increasing by 0.07% from 5.82% to 5.89% – ie,
This change is motivated by our concern over                                 this is essentially a risk-neutral change.
inflation risks stemming from new rounds of
                                                                             Cause for concern
monetary easing and potential supply shocks.
                                                                             We finish with a few charts highlighting the
We marginally increase our allocation to Global                              continued uncertainty in the economic outlook.
Titans (up from 5% to 6%) and the Global Select                              The first worry is the level of iron ore import
Dividend 100 (up from 1% to 2%). This change is                              prices to China (Chart 15). Iron ore prices are an
motivated by our bottom-up credit-equity model,                              important indicator of fundamental commodity
which is now showing a preference for equity over                            demand and global growth. In the past three years,
credit both from a dividends and an earnings                                 iron ore has gone through a transition from a
perspective (Charts 13 and 14). We do not make a                             largely annual-contract-based commodity, with
larger reallocation because of the continued                                 prices agreed once per year directly between
instability of the macro environment. With the                               producers and steelmakers, to a much more spot-
mixed data signals and continued policy oscillations,                        based market. Therefore, the amount of material
we do not believe that the current economic climate                          traded from week to week has increased very
suggests a bigger shift to risk. We discuss some of                          significantly, increasing the validity and depth of
these concerns in more detail below.                                         the spot market.

The reduction in our high-yield position is                                  In recent weeks, spot markets have weakened
consistent with the view of our high-yield credit                            considerably, with prices delivered to China

 13. Our bottom-up CDS-DY model shows equity preference...                    14. does our CDS-Earnings Yield model
65                                                                    2.5    65                                                                    2.5
                                    credit attractive                                                           credit attractive
55                                                                    1.5    55                                                                    1.5
45                                                                    0.5    45                                                                    0.5
35                                                                    -0.5   35                                                                    -0.5
           equities attractive                                                           equities attractive                                       -1
25                                                                    -1.5   25                                                                    -1.5
 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11                                    Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11
             Credit preference                                                            Credit preference
             Investment Grade Credit / MSCI World Relative Return (LHS)                   Investment Grade Credit / MSCI World Relative Return (LHS)
             Global CDS/DY Z-Score (RHS)                                                  Global CDS/EY Z-Score (RHS)

 Source: HSBC, Thomson Reuters Datastream                                     Source: HSBC, Thomson Reuters Datastream

     Asset Allocation                                                                                                                              abc
     12 September 2012

falling from USD130-150/t to under USD86.7/t                               the 50 expansion/contraction line at 49.6. The
for a period (although prices are now recovering                           details of the report were also worrying with new
above this level). The conventional wisdom (and                            orders and production both falling. The level of new
analysis by our Metals and Mining analysts agrees                          orders minus inventories tends to move in line with
with this) is that there is a significant amount of                        the headline ISM number; however, recently the
iron ore (150mt, or ~7% of global supply)                                  two have decoupled following the sharp fall in new
produced in China with a cost in the order of                              orders less inventories (Chart 16). This suggests that
USD120/t. Therefore, the recent weakness in spot                           there are further downside risks for the US
prices may indicate a period of weak demand for                            manufacturing sector.
iron ore – the length of time that prices remain at
                                                                            16. ISM New Orders less Inventories suggests downside risks
current levels will indicate whether this is a
                                                                            35                                                               65
transitory de-stocking (which should last one to                            30
two months, a period we are halfway through), or                            25
                                                                            20                                                               55
a more structural problem with end-use demand.                              15
                                                                            10                                                               50
Taken in conjunction with the weakness in                                    5                                                               45
Chinese PMI data, this drop only serves to feed                                                                                              40
the narrative about continued headwinds for                                -10
China. The HSBC China manufacturing PMI of                                 -15
                                                                           -20                                                               30
47.6 for August was the lowest reading since                                 Sep-92 Feb-96            Jul-99   Dec-02 May-06 Oct-09
March 2009 and was mainly driven by a                                              New Orders - Inventories (LHS)        ISM Manufacturing (RHS)
contraction in new orders. In addition, the                                 Source: Thomson Reuters Datastream, HSBC

contraction in employment conditions, low
domestic demand and weak industrial production                             The final chart that we highlight is the ratio of
all signal further difficulties ahead and, in the                          upgrade to downgrade revisions in the European
view of HSBC’s China economists, mean that                                 corporate sector (Chart 17). This ratio continues
Beijing must provide additional policy easing                              to drop with downgrades outnumbering upgrades
soon to stabilise growth and the job market.                               as a result of the continued uncertainty and
                                                                           economic weakness in the eurozone. Under these
 15. China iron ore import price has fallen sharply
200                                                                  200   conditions, it is difficult to see businesses making
                                                                           the sorts of capital investments that will be needed
170                                                                  170
                                                                           to help put us back on the path to growth.
140                                                                  140
                                                                            17. European credit revisions have also weakened
110                                                                  110   80                                                              100%
                                                                           70                                                              90%
 80                                                                  80                                                                    80%
                                                                           50                                                              60%
 50                                                                  50
  Sep-09      Apr-10       Nov-10     Jun-11       Jan-12   Aug-12         40                                                              50%
                             China iron ore import price                   30                                                              40%
 Source: Bloomberg, HSBC                                                   20
                                                                           10                                                              10%
Purchasing manager surveys in the US provide a                              0                                                              0%
                                                                            Mar-02     Mar-04 Mar-06 Mar-08            Mar-10 Mar-12
similarly bleak picture. Although the headline ISM
                                                                                      Downgrades    Upgrades             Revisions ratio
Manufacturing Index was close to unchanged for
                                                                            Source: Bloomberg, HSBC
the third month in a row, the index remained below

   Asset Allocation                                                                                             abc
   12 September 2012

Scenario descriptions                                    potentially broader banking union including a
                                                         shared bank recapitalisation mechanism and a
Inflationary growth
                                                         shared bank deposit guarantee. To achieve a
In order to achieve this scenario, resolutions to the
                                                         goldilocks environment, we also believe that it is
eurozone crisis and the US fiscal position are
                                                         important that the US Congress reach an
necessary. How this could be achieved is
                                                         agreement on a sustainable solution to the US
questionable. However, a sustainable fiscal
                                                         debt problem. Depending on the election result, a
position on both sides of the Atlantic would
                                                         positive outcome in the US may well require
release some of the pent-up demand for capex in
                                                         compromise between Democrats and Republicans,
developed markets. In conjunction with this, an
                                                         and is likely to involve both revenue increases and
overly aggressive monetary policy (or at least
                                                         spending cuts. Clearly, at the moment neither
lagging in its removal of the ZIRP) would spark a
                                                         event is on the immediate horizon. In our view, it
demand-led commodity shock.
                                                         is conceivable that we could reach goldilocks
It should also be noted that this scenario can only be   levels of growth and inflation without a solution
sustainable if unemployment in developed markets         to the US debt impasse, but not without a
were to come down below NAIRU. That is, before           resolution in the eurozone.
inflation could become a real structural problem,
                                                         In addition to this rather rosy policy backdrop, we
wage growth would have to come back. Otherwise
                                                         also need to see a clear boost through an
external inflationary pressures would soon scuttle
                                                         investment-led recovery, but an increase in
any domestic demand and thereby growth.
                                                         productivity and a delay in wage growth. While
This scenario is heavily policy driven; hence, any       this recovery takes place, a softer demand outlook
hint of achieving this scenario is predominantly         from emerging markets needs to materialise
going to come from the policy front. Fiscal              somehow in order to avoid a commodity-driven
reforms need to be swift and vast, while monetary        inflation spike.
policy lags.
Goldilocks                                               To return to pre-crisis growth and inflationary
In this best of all possible worlds, growth returns      trend levels, a full resolution in the eurozone or a
to, or exceeds, its previous long-run trend, while       clear path to controlling US debt may not be
inflation either hits trend or stays below it. In        necessary. However, there does need to be some
order for this to happen, we believe there must be       progress, such as stabilisation in Spanish and
a resolution in the eurozone involving some, or          Italian spreads. Additionally, these policy changes
all, of the following: structural reforms, such as       need to stabilise the deposit rot that is currently
labour market changes, in the peripheral eurozone        underway in the periphery (including Spain). In
countries that increase competitiveness and in           order for global consumption demand, we also
conjunction with austerity enable them to meet           need to see some pick-up in the US labour market.
deficit-reduction targets; large-scale common            To achieve trend growth without solving any of
bond issuance; a common bank regulator and a             the structural problems, the Fed and the ECB will

     Asset Allocation                                                                                           abc
     12 September 2012

likely have to introduce new and effective             inflation. In recent months, we have seen that the
unconventional policy measures that do not feed        relationship between growth and inflation has
through into higher prices.                            worsened. That is, inflationary pressures are
                                                       building relative to growth. Partly, this is because
                                                       of pricing power in emerging markets and a
There are a myriad of arguments for why
                                                       continuation of capital flows into these
developed market economies are stuck in a
                                                       economies. This divergence of capital flows is
stagnation environment. The most obvious one is
                                                       likely to ease wage pressures in emerging
overly leveraged governments that limit the
                                                       markets. In addition, further quantitative easing
private sector’s willingness to commit capital to
                                                       may skew this relationship further as could any
these economies. This leads to a balance sheet
                                                       added disruption in commodity supply.
recession where monetary policy has little impact
as it does not deal with the underlying problems –     Furthermore, if current monetary policy is deemed
it merely kicks the proverbial can down the road.      as ineffective in its ability to generate inflation, a
Couple this with a severe case of policy inertia       shift in policy towards a ‘debt jubilee’, ie,
and the growth outlook looks anything but dreary.      monetisation of debt, could take place. Such a
Subsequently, cyclical stabilisers such as             move would no doubt release the inflationary
unemployment benefits, which were designed in          genie and cause a cascading effect on sentiment
an environment of higher trend growth, only serve      and perception of fiat currencies. While such a
to worsen the underlying issues.                       policy could have a short-term impact on growth
                                                       as government debt would no longer be a source
The inflationary outlook in this scenario is much
                                                       of concern, it would erode the underlying
of the same: low. Rather, we would expect the
                                                       credibility of policy makers and cause severe
Fed and ECB to continue to provide short-term
                                                       currency fluctuations. This would, in turn, lead to
piecemeal responses that prevent output from
                                                       a further deterioration of real growth, while
falling and allow markets to muddle through, but
                                                       keeping inflationary expectations high.
that don’t tackle structural issues. In this
environment, we believe that continued policy          Recession
easing will affect the cost of borrowing for           Risks remain high for several events that could
sovereigns but will not lower the cost of credit for   drive us back into recession (see Table 9 on
businesses and consumers. Inflation will remain        page 13). These include a Greek exit from the
muted despite loose monetary conditions as a           eurozone; contagion in the currency union that
result of continued high unemployment and              leads other major nations to request bailouts; the
under-utilised industrial capacity.                    US fiscal cliff; and heightened tensions in the
                                                       Middle East. Although any one of these events
It should be noted that this scenario of ‘muddle
                                                       could spark a recession, they are closely
through’ is not a solution to any of our structural
                                                       intertwined and if one takes place it increases the
problems. Rather, it is likely that it will lead to
                                                       chance of the others. This intertwined nature of
even greater problems in the future.
                                                       catalysts and potential impact on the other
Stagflation                                            headline risks. Some of these work one way but
Growth follows a similar path to that outlined in      not the other. We have highlighted these
“Stagnation”; however, monetary expansion as a         interdependencies in Table 9. The main take-away
result of central bank action results in high          from this is the increased likelihood of not just

   Asset Allocation                                     abc
   12 September 2012

one catalyst occurring but the probability that it
will spark another downside event.

It is not, however, necessary for a major event to
occur in order for us to fall into recession; it is
plausible that we have a similar scenario to that
outlined for “Stagnation” but which leads to
recession. In this instance, rather than central bank
action allowing the market to muddle through, the
efficacy of policy action is drawn into question and
thus fails to stimulate activity and output declines.
In the case of a major event in the eurozone, trade
ties of other EU members will lead to contagion;
although the emerging world is less exposed, it is
not immune and there is likely to be a global
slowdown. In this state of the world, there is more
interest in capital preservation than returns, so
investors will hunt for safety and sit in government
bonds despite rising budget deficits resulting from
the lack of growth.

     Asset Allocation                                                                                                 abc
     12 September 2012

Table 11. Scenario Inputs
                                                                 Inflationary   Goldilocks    Trend    Stagnation   Stagflation   Recession
  Developed                           Real sales growth year 1        8.00%        10.50%     7.00%        4.50%        -1.00%       -8.50%
                                      Real sales growth year 2        7.00%        10.00%     8.00%        3.50%        -2.00%        2.00%
                                                 Margin year 1        7.00%         9.00%     7.50%        7.00%         7.00%        5.50%
                                                 Margin year 2        6.50%         9.00%     7.50%        7.00%         7.00%        6.00%
                                                           PE             17            19        17           12            10           11

                                      Real sales growth year 1       14.00%        20.00%    13.00%        8.00%         3.00%        0.00%
                                      Real sales growth year 2       11.00%        18.00%    15.00%        7.00%         0.00%       -4.00%
                                                 Margin year 1        7.50%         9.00%     8.50%        7.00%         7.00%        4.50%
                                                 Margin year 2        7.00%         9.00%     8.50%        7.00%         7.00%        5.00%
                                                           PE             13            14        13           11            9          10.5

Fixed Income
   Fed Funds Rate
                                           Fed funds in 1 year        0.25%         0.25%     0.25%        0.25%         0.25%        0.25%
                                           Fed funds in 2 year        2.25%         0.25%     0.25%        0.25%         0.75%        0.25%

     US 10yr Treasuries
                                       10Y UST yield in 1 year          3.0%         2.5%      2.0%         1.5%          2.8%         1.3%
                                       10Y UST yield in 2 year          4.5%         3.0%      2.3%         1.6%          3.8%         1.5%

     Investment Grade Credit
                                Investment grade credit spread        1.50%         0.75%     1.00%        1.00%         4.00%        4.00%
                                Investment grade credit spread        1.50%         0.75%     1.00%        1.50%         3.50%        3.00%
                                                  Default rate        0.50%         0.25%     0.25%        1.00%         1.00%        2.00%
                                                Recovery rate           40%           40%       40%          30%           30%          30%
     High Yield Credit
                                        HY credit spread 1yr          4.57%         3.30%     5.00%        5.00%       13.50%       12.00%
                                        HY credit spread 2yr          4.56%         3.00%     3.00%        6.00%        8.00%       10.00%
                                                Default rate          2.73%         1.46%     3.19%        5.00%        0.47%        7.00%
                                              Recovery rate             40%           40%       40%          30%          30%          30%
     Emerging Market Debt (hard currency)
                                        EM credit spread 1yr          1.80%         2.10%     2.60%        3.50%         3.70%        4.00%
                                        EM credit spread 2yr          1.50%         2.00%     2.50%        3.30%         3.70%        4.00%
                                                Default rate          1.50%         1.00%     0.00%        2.00%         2.00%        3.00%

     Emerging Market Debt (local currency)
                                         EM credit spread 1yr         4.25%         3.05%     3.60%        3.25%         3.80%        4.10%
                                         EM credit spread 2yr         3.50%         2.80%     3.20%        3.25%         3.80%        4.10%
                                                 Default rate         1.00%         1.00%     1.00%        1.00%         1.00%        1.00%

     TIPS                                   10Y Real yield 1yr        0.50%         0.40%    -0.10%       -0.30%         0.50%       -0.15%
                                            10Y Real yield 2yr        2.00%         0.90%     0.15%       -0.20%         1.50%        0.10%

Gold                                                     Price          1725         1300      1400         1350          2100         2200

Commodities                                 Price appreciation        30.0%         20.0%     10.0%         0.0%         10.0%       -25.0%

Cash                                                   Return         0.69%         0.19%     0.19%        0.19%         0.31%        0.19%
FX                                      FX carry return year 1         7.0%          5.0%      2.0%         0.0%          5.0%        -5.0%
                                        FX carry return year 2         7.0%          5.0%      2.0%        -3.0%         -5.0%        -7.0%
                                      Real GDP growth year 1          4.00%         4.00%     3.00%        1.50%         1.00%       -3.00%
                                      Real GDP growth year 2          4.00%         4.00%     3.50%        1.50%         1.00%        1.00%
                                                 Inflation 1yr        4.00%         1.50%     2.00%        0.00%         4.00%       -0.50%
                                                 Inflation 2yr        5.00%         2.00%     2.50%        1.00%         5.00%        0.00%
Source: HSBC

    Asset Allocation                                                                                                                         abc
    12 September 2012

Key indicator definitions
As every model is measured on a different scale, we normalise each indicator based on the available
historical data. The axis measures from -3 to +3 standard deviations, with a positive score suggesting a
greater appetite for risk, and vice versa. We plot the range over the last three years, and overlay the last
two months data. The latest month is represented by the black diamond, and the black line shows the
change from the previous month (if any). Please see the chart on page 3.

  Indicator                             Definition

  GLEI (Global Leading Indicators) –    Our proprietary indicators to assess the general state of the global economy. We divide our 120
  Headline Strength                     components into six categories: Employment, Industrials, Consumer and Trade. Our headline
                                        strength indicator is an aggregate all components. We take the strength score as a 24-month
                                        rolling z-score, which is calculated as the difference between the current value and the 24-month
                                        average, all divided by the 24-month standard deviation. These individual component scores are
                                        then aggregated on a GDP-weighted basis to provide the headline strength score.
  GLEI (Global Leading Indicators) –    On a similar basis, we take the exact same components as above and calculate the month-on-
  Headline Momentum                     month change in each component. We then define the components as moving significantly if this
                                        month’s change is greater (or less) than half a standard deviation of the previous 24-month-on
                                        month changes. We then calculate a momentum score as the number of significantly rising
                                        components divided by the number of all significantly moving components.

  GLEI (Global Leading Indicators) –    Similar to above, except only for the 60 industrial components.
  Industrial Momentum
  GLEI (Global Leading Indicators) –    Similar to above, except only for the 25 consumer components.
  Consumer Momentum
  Global Bank Lending - Slope           We take the aggregated, GDP-weighted, magnitude-adjusted slope of all the underlying bank
                                        lending data from various national sources.
  Global Bank Lending - Impulse         For each country’s bank lending data, we calculate the adjusted z-score. This is the z-score based
                                        around a de-trended 24-month period before each value. Each impulse score is then aggregated
                                        as a GDP total.
  Equity / Credit Preference (CDS/DY)   Our main relative-value model between equities and credit. We take the 12-month forward
                                        dividend yield and 5-year credit default swap data for major equities across the US, EU, Japan
                                        and the UK. We calculate the ratio of CDS/DY for each company, and then take a z-score of this
                                        ratio over the previous 12 months of data. These individual company z-scores are then
                                        aggregated by total market value to provide a relative value score between equities and credit. We
                                        consider a score suggesting value in equities to be a positive risk signal.
  Equity / Credit Preference (CDS/EY)   The same process as above, except we use the 12-month forward earnings yield for each
                                        company in place of the dividend yield.
  HSBC IP Surprise (30d change)         The surprise indices quantify the extent to which economic data are above or below market
                                        expectations. Each industrial production data release is compared with its survey median and the
                                        forecast “surprise” measured with respect to past forecast errors in terms of the number of
                                        standard deviations.
  HSBC PMI Surprise (30d change)        Similar to above, but for purchasing manager index releases.
  Nerbrand z                            Given that investments are subject to revisions of future expectations the Nerbrand Z utilises
                                        uncertainty of consensus estimates to assess how much earnings forecasts can be revised in
                                        standard deviation terms before PE ratios return to normalised levels.
  HSBC US Consumer Composite            A weighted 24m rolling z-score of US unemployment, change in unemployment, % of unemployed
                                        for more than 27 weeks, house prices and real wages. The composite tends to lead US consumer
                                        confidence surveys.
  HSBC Clog Index                       The HSBC Financial Clog index measures the level of stress in the US financial system. It
                                        includes inter-bank stress, financial institution default risk, mortgage agency credit spreads and
                                        equity volatility.
Source: HSBC

     Asset Allocation                                                                                          abc
     12 September 2012

Disclosure appendix
Analyst Certification
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personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Fredrik Nerbrand and Daniel Fenn

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   Asset Allocation                                                                                                                         abc
   12 September 2012

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Global Asset Allocation
Fredrik Nerbrand
Global Head of Asset Allocation
+44 20 7991 6771
Daniel Fenn
+44 20 7991 3025

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