World Economic Outlook December 08

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Global

5 December 2008

World Outlook

Searching for a new source of

global demand growth

Deutsche Bank Securities Inc.

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APPENDIX 1

Economics

Editors

Peter Hooper

(+1) 212 [email protected]

Thomas Mayer


Production editors

Mark Wall

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Torsten Slok

(+1) 212 250-2155

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Contributors

Stefan Bielmeier

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Michael Biggs

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George Buckley

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Gustavo Canonero

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Binky Chadha

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John Clinkard

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Gillian Edgeworth

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Peter Garber

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Darren Gibbs


Caroline Grady


Arend Kapteyn

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Michael Lewis


Yaroslav Lissovolik

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Mikihiro Matsuoka

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Tony Meer

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Bernd Meyer

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David Naude

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Joseph LaVorgna

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Carl Riccadonna

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Torsten Slok

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Michael Spencer

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Mark Wall

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Macro

GlobalMarketsResea

rch

Economics

In mid-October we cut our forecasts to well below consensus. With financialconditions continuing to deteriorate and exact even more pain on households

and firms than expected, we see good reason to mark our views down still

further. We now expect global growth to be barely above zero in 2009 (about

1% lower than in our previous projection), with downturns in all major regions

setting records not seen in the past 50 years.

This deep recession marks the end of a long-term expansion that wascharacterised by a few key industrial countries assuming the role of the global

net consumer, and all other countries the role of the net producer.

Consumer demand in major industrial countries should be depressed forsome time to come by tremendous losses in household wealth and a severe

credit crunch. Massive fiscal stimulus, especially in the US should fill a good

deal of this gap in aggregate demand: enough to avert serious risk of

deflation, but not enough to ensure a self-sustaining expansion of global

growth for some time to come in our view.

In our view, a new engine of private demand growth will be needed, and wesee a likely candidate in the still largely untapped consumption potential of the

rapidly expanding middle classes in the large emerging market countries.

World Economy in Deep Recession

GDP growth, % CPI inflation, %

2007 2008F 2009F 2010F 2007 2008F 2009F 2010F

G7 2.2 0.9 -2.0 1.3 2.2 3.3 0.2 1.1

--US 2.0 1.2 -2.0 1.6 2.9 4.0 -0.4 1.5

--Japan 2.1 0.3 -1.7 0.7 0.0 1.5 0.0 -0.5

--Euroland 2.6 0.9 -2.5 1.0 2.1 3.3 1.2 1.4

EM Asia 9.4 7.1 4.6 5.7 4.4 7.2 3.0 2.6

--China 11.9 9.1 7.0 6.6 4.8 6.0 0.6 1.0

EMEA 6.8 5.2 1.1 3.5 10.5 13.0 7.7 6.0

Latam 5.5 4.3 1.8 3.0 7.0 9.2 7.4 5.9

Industrial

countries 2.4 0.9 -2.0 1.2 2.2 3.4 0.5 1.2EM

countries 8.1 6.1 3.3 4.7 5.7 8.2 4.1 3.6

Global 4.7 3.1 0.2 2.6 3.6 5.3 1.9 2.2

Source: DB Global Markets Research


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5 December 2008 World Outlook

Deutsche Bank Securities Inc. Page 3

Global Overview: Searching for a new driver of global demand growth

In mid-October we cut our forecasts to well belowconsensus. With financial conditions continuing

to deteriorate and exact even more pain on

households and firms than expected, we see good

reason to mark our forecasts down still further.

We now expect global growth to be barely above

zero in 2009 (about 1% lower than in our previous

projection), with downturns in all major regions

setting records not seen in the past 50 years.

This deep recession marks the end of a long-termexpansion that was characterised by a few key

industrial countries assuming the role of the

global net consumer, and all other countries the

role of the net producer.

Consumer demand in major industrial countriesshould be depressed for some time to come by

tremendous losses in household wealth and asevere credit crunch. Massive fiscal stimulus,

especially in the US should fill a good deal of this

gap in aggregate demand: enough to avert

serious risk of deflation, but not enough to ensure

a self-sustaining expansion of global growth.

In our view, a new engine of private demandgrowth will be needed, and we see a likely

candidate in the still largely untapped

consumption potential of the rapidly expanding

middle classes in the large emerging market

countries.

Even so, this restructuring of the global economyshould take some time, and the initial expansionto come after the sharp downturn now under way

looks likely to be unusually sluggish overall, with

fits and starts of growth driven primarily by policy

stimulus over the next couple years.

The growth of public debt in the fight againstrecession should push public sector debt burdens

significantly higher in many industrial countries.

With the fiscal costs associated with retiring baby

boomers drawing nearer, this increases the risk

that monetisation of the excessive government

debt will eventually fuel inflation.

The gloom thickensAs we began our Q4 review of the world outlook, it

became clear that the intensification of the global credit

crunch and asset price deflation meant that our relatively

pessimistic view of global economic prospects would

need to be adjusted down further. Our forecast of a

serious global recession as of mid-October has now been

revised to a deep and unprecedented (at least since the

Great Depression) downturn (cover table). Growth in most

major regions of the world for 2009 has been marked

down by about 1% point. Notable exceptions are EMEA,

where the markdown was substantially more than 1

percentage point and Japan and Latin America, where it

was somewhat less. We project global growth at just

above zero in 2009, nearly two percentage points below

the mild recession level of 2%.

The global GDP revisions were driven in part by a weaker

outlook for the US (decoupling is clearly dead in our view)

and in part by weaker domestic fundamentals in each

region. We now see record rates of decline in consumer

spending lasting even longer than previously, business

spending on plant and equipment falling more sharply,

and inventory runoff continuing at a rapid pace through

the first half of 2009. The deeper downturn does not

beget a stronger recoveryour outlook for a sluggish

pickup in 2010 has not changed appreciably. Nor have our

projections of aggressive fiscal policy action changed; it

now seem more likely to be realized, at least in the US.

However, we see inflation falling further and central bankpolicy rates remaining lower for longer. Indeed, we have

marked down global inflation by a full percentage point in

2009 as well, thanks in part to the lower trajectory of oil

prices that the growth forecast yields. We now see oil

prices as remaining in the neighborhood of $50 per barrel

through 2009 and rising in 2010 (see section on

commodities below). We project headline inflation to turn

slightly and temporarily negative in the US next year, but

to rise again as commodity prices stabilize at a low level.

We do not see deflation as a serious risk thanks to

aggressive monetary and fiscal policy actions being taken.

A watershed eventSome recessions are mere hick-ups in a basically intact

longer-term expansion. Others are watershed events. In

our view, the present recession now falls even more

dramatically into the second category. It marks the end of

a long-term expansion that was characterized by a few

key industrial countries assuming the role of the global net

consumer, and all other countries the role of the net

producer. This international division of labour was made

possible by trade and financial globalisation, and the

availability of cheap credit. Trade integration allowed the

shipping of goods and increasingly services through the

internet around the world, while financial integration

allowed the funding of ever larger trade imbalances. With

inflation running fairly low, central banks kept monetary

policy relatively accommodative while financial

engineering was ever reducing apparent credit risk. In this

world, the national accounting equality of savings and

investments became irrelevant at the national level. No

imbalance seemed to be too big not to be funded by the

international capital markets. However, as countless

merchants supplying customers on credit have found out

since the advent of commerce, business turns sour when

the customers cant repay their debts. The US sub-prime

crisis of 2007 was the signal that this endpoint was finally


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Page 4 Deutsche Bank Securities Inc.

being reached in the credit-driven consumption boom that

had begun twenty five years earlier.

Chart 1. An era of US domestic demand driven growth

8000

8500

9000

9500

10000

10500

11000

11500

12000

12500

1997 1999 2001 2003 2005 2007

$ bln

8000

8500

9000

9500

10000

10500

11000

11500

12000

12500

$ blnUS: real domestic demand

US: real GDP

Source: BEA, DB Global Markets Research

Chart 2. Decline of US household savings rate coming toan end

-2

0

2

4

6

8

10

12

14

1980 1984 1988 1992 1996 2000 2004 2008

%

-2

0

2

4

6

8

10

12

14

%

US savings rate

Source: BEA, DB Global Markets Research

Averting deflation

We have learned from the experience of the 1930s that

mass destruction of debt through bankruptcy will cause

deflation and depression when resolution is left to the

private sector alone. As banks and companies fall like

dominos, unemployment surges andin the absence of a

social security netincomes and demand plunge. Sayslaw is at work, albeit with a negative sign: falling supply

induces falling demand. As producers compete in cutting

prices and consumers wait for prices to fall further,

deflation kicks in. To prevent such a vicious cycle, the

public sector has to take over bad debt from the private

sector, support the incomes of the unemployed, and add

direct stimulus to aggregate demand. We have also

learned from the Japanese experience that to be

successful, the public sector has to act quickly and

forcefully.

Chart 3. The US Depression

0

20

40

60

80

100

120

1929 1930 1931 1932 1933 1934 1935

Index

0

20

40

60

80

100

120

Index

Output/man hour

Capital Outlay (Nominal)

S&P index

Industrialproduction

GNP (Real

CPI

Source: Historical Statistics of the US, DB Global Markets Research

Policy action

The good news is that US economic policy seems to

broadly meet these requirements. Banks have beenrecapitalised and the Fed is funding potentially impaired

assets. Monetary policy has been eased very aggressively

and a big fiscal policy impulse can be expected for 2009

after a more moderate programme earlier this year. The

bad news is that European economic policy has not risen

to the occasion. Bank recapitalisation programmes have

been launched, but the take-up has been slower than in

the US (in part because tough conditions have been

attached to these programmes and in part because

national implementation has led to conflicts with

European competitiveness policy). Monetary policy was

inactive or moved in the wrong direction for more than a

year until the threat of a global financial meltdown forced

European central banks into a policy U-turn in October

(Table 1). More powerful fiscal policy action is undermined

by a dithering German government. Hence, we continue

to expect that the recession will be more severe in Europe

than in the US (Table 2). Still, thanks to some spill-over

effects from the US, some home-made policy support, a

lesser sensitivity to oil price declines and a greater degree

of wage stickiness, deflation is a relatively low probability

in Europe as well. Indeed, for these reasons, we see

inflation in Europe remaining noticeably positive next year

despite a dip in to negative territory in the US.

1. European rates catching up

Central bank rate, % 10Y yields, %

Cur-

rent 3M 6M 12M

Cur-

rent 3M 6M 12M

US 1.00 0.50

0.50 0.50 2.72 2.00 2.00 2.50

Japan 0.30 0.10

0.10 0.10 1.39 1.50 1.50 1.30

Euroland 2.50 2.00

0.75 0.75 3.05 2.50 2.25 2.00Source: DB Global Markets Research, as December 5


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2. Deep recession and shallow recovery

GDP growth, % CPI inflation, %

2007 2008F 2009F 2010F 2007 2008F 2009F 2010F

G7 2.2 0.9 -2.0 1.3 2.2 3.3 0.2 1.1

--US 2.0 1.2 -2.0 1.6 2.9 4.0 -0.4 1.5

--Japan 2.1 0.3 -1.7 0.7 0.0 1.5 0.0 -0.5

--Euroland 2.6 0.9 -2.5 1.0 2.1 3.3 1.2 1.4

EM Asia 9.4 7.1 4.6 5.7 4.4 7.2 3.0 2.6

--China 11.9 9.1 7.0 6.6 4.8 6.0 0.6 1.0

--India 9.3 7.2 4.8 6.8 4.6 9.6 5.3 4.3

EMEA 6.8 5.2 1.1 3.5 10.5 13.0 7.7 6.0

--Russia 8.1 6.9 1.0 4.0 11.9 13.8 8.2 7.4

Latam 5.5 4.3 1.8 3.0 7.0 9.2 7.4 5.9

--Brazil 5.4 5.2 2.7 3.5 4.5 6.3 5.5 4.5

Industrial

countries 2.4 0.9 -2.0 1.2 2.2 3.4 0.5 1.2EM countries 8.1 6.1 3.3 4.7 5.7 8.2 4.1 3.6

Global 4.7 3.1 0.2 2.6 3.6 5.3 1.9 2.2Source: DB Global Markets Research

Growth stabilizers

In addition to policy actions, private demand downturns

have some self-limiting features that help to bring

recessions to an end. Cyclical swings in demand are

dominated by shifts in purchases of durable goods (most

importantly autos), houses, and business plant and

equipment. In the US, these components of demand

account for roughly one-third of total GDP. In a deep

recession, they fall sharply and as they reach a bottom,growth stabilizes. The good news for the US economy

this time around is that home building has fallen sharply

over the past 2-1/2 years and has already reached a record

lowit does not have room to fall much further, and is

now running at levels that are well below the

demographic growth in demand, meaning it will not be

too long before this sector begins to make a positive

contribution to growth. Likewise, while indicators of

business spending are now plunging, that spending was

relatively low to begin with going into this downturn, and

it too is unlikely to be an important drag on growth past

mid-2009. The major uncertainty is how far spending on

consumer durables and even nondurables will fall. Prior to

the current downturn, real consumer spending had never

declined more than two quarters in a row, at least since

the inception of the US National Income and Product

Accounts in 1947. This time around, we see consumer

spending declining 4 quarters in a row, through mid-2009.

More importantly, that spending will face significant

headwinds after it has bottomed as households strive to

cut debt levels and rebuild very low saving rates.

A new source of global demand growth

Although help from fiscal policy and natural spending

stabilizers is essential to averting deflation and limiting the

extent of the recession, a new self-sustaining expansion

cannot be based on fiscal expansion alone. Nor can we

depend on the US consumer to lead the charge this time

around. Efforts to translate the high national savings in

Japan and Germany into stronger consumption in these

countries have not succeeded in the past, although theremay be some hope if rapidly ageing populations begin to

consume more of their financial assets in retirement. Even

so, the industrial economies may well be too stretched

financially and in some cases too reluctant to take needed

policy actions to contribute their traditional share to global

economic expansion ahead. Fortunately, a new and

potentially powerful source of global demand may be

waiting in the wings: the so far still largely untapped

consumption potential of the growing middle classes in

the big emerging market countries. The needs and tastes

of Chinese, Indian and Brazilian middle class families may

have to take over from the US consumer and its

associates in spearheading the stimulation of global

production in the future. And those who until recently

have benefited from cheap goods produced in these

countries will in the future turn into their suppliers.


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Chart 4. Untapped consumption potential in emerging

market countries

70.3

56.3 57.3

35.4

55.5

60.9

48.5

0

10

20

30

40

50

60

70

80

US Euro Area EuropeanUnion

China India Brazil Russia

%

0

10

20

30

40

50

60

70

80

%Personal consumption expenditure as % of GDP


A reduced global saving glut means that growth in

individual countries will in the future probably be more

constrained by their ability to fund investments through

their own savings rather than from abroad. With less

capital having to be shipped around the world to fund

national saving-investment imbalances the global financial

sector can be smaller than it was in the past. Hence, while

trade globalisation (and the benefits from international

trade integration) is likely to stay, financial globalisation

will probably retreat as more investment will be financed

by savings at home.

Bridging the gap

The restructuring of the global economy will of course

take time, and until it is completed global growth may well

seesaw, with recessions trading places with short-term

rebounds on the back of fiscal policy stimuli. Modest

recovery in the second half of next year, as presently

envisaged by many forecasters, ourselves included, could

well be followed a renewed weakening several quarters

later. And the Bush fiscal stimulus programme of 2008

may be followed by more than one Obama stimulus

programme in 2009 and later years. Our forecast sees a

period of some volatility in growth that overall is fairly

sluggish by historical standards, with relatively slow

progress made in bringing down high rates of

unemployment until the new driver of the next globalexpansion is finally in place.

Chart 5. Fiscal policy aiming to revive growth

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

1999 2001 2003 2005 2007 2009

% of GDP

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

% of GDP

US

Euroland

Fiscal impulse (= change incyclically adjusted budgetbalance)

Easing

TighteningForecast

Source: OECD, DB Global Markets Research

Fiscal burden and ultimately inflation risk

Taking over bad debt from the private sector now and

incurring new debt in the fight against recession is likely

to leave the public sector with a very high debt burden in

most industrial countries. In fact, expected future tax

revenues may not be enough to cover debt service and all

other government expenses, especially when public

pension liabilities are taken into account. Fortunately,

governments suffering from an excessive debt burden

extremely rarely default. As economic history through the

centuries has shown, they usually manage to obtain

missing funds from their central banks. It is unlikely to be

different this time. An oversupply of liquidity caused by

central bank funding of government debt should lower

exchange rates against the currencies of the faster

growing emerging market economies and encourage

wage and price increases. Thus, the monetisation ofthe excessive government debt should eventually fuel

inflation. Higher inflation should erode the claims of

nominal debt holders to real values that are eventually

consistent with the debt service capacity of the

governments. But the eventual rise in inflation is likely to

be still several years off.

Conclusion

As we enter the third year of the financial crisis the

outlook has worsened further. We are likely to avoid

deflation, but a deep and potentially long recession

(through at least the middle of 2009) seems inevitable.

Thereafter, the over-indebted consumers in the industrialworld will probably have to settle for lower growth and

higher inflation than they experienced in the last two

decades. Following a possibly extended period of sluggish

global recovery, a key driver of the next self-sustaining

global expansion is likely to be increased consumer

spending by the growing middle classes in the major

emerging market countries.

Peter Hooper, (1) 212 250-7352

Thomas Mayer, (44) 20 754-72884

Torsten Slok, (1) 212 250-2155


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Geopolitics: Recession = Oil Deflation = Geopolitical Power Deflation

The financial crisis and the resulting economic crisis have

shifted attention almost entirely from geopolitical issues

toward restoring economic growth. As a result, the

urgency of resolving in the near term outstanding issuessuch as the Iran nuclear dispute has been reduced. While

the economic slowdown has not yet brought into

question the size of US military expenditure, the need to

finance the huge stimulus package just placed on the

table by the incoming Obama Administration will

ultimately lead there. In the 2008 fiscal year, military

expenditures were about $600 billion or 4 percent of GDP.

In any case, the winding down of the deployment to Iraq

will naturally reduce US expenditures. The promised surge

of forces to Afghanistan will likely amount to no more than

two additional brigades due to logistical constraints.

As a further geopolitical side effect, the sharp economiccrisis has collapsed the price of oil by two-thirds from

peak, with some prospect for a further decline. This has

cut the financial knees from under several countries that

have adopted in recent years a more forward geopolitical

program: Iran, Venezuela, and Russia. Nevertheless, the

reserves built up during the oil boom will allow these

programs to continue in the near term if from inertia

alone.

Iran

In the presumed chronology of events surrounding efforts

to derail Irans nuclear development program, the next

couple of months have always been emphasized as adangerous moment. In this chronology, the period

between the US presidential election on November 3 and

the inauguration of a dovish Democratic Party victor on

January 20 would either force a military effort by the

outgoing Bush administration or a strike by the Israeli air

force against the nuclear facilities. The former was

precluded at the end of 2007 by the release of the

remarkably benign National Intelligence Estimate on Irans

nuclear program. The document claimed that Iran had

abandoned its nuclear weapons program in 2003. A

conflict between the US and Iran right now would add the

further catastrophe of a closure of oil flows from the

Persian Gulf to the existing economic crisis and potentially

drive the world economy to the breaking point. So that

makes US action doubly unlikely. The Bush

administrations parting shots have taken the form of

missile attacks from drones aimed at al Qaida leadership

along the Pakistan-Afghanistan border.

However, the latest IAEA report of November 19 stated

that Iran has installed 3800 working centrifuges to enrich

uranium and will install an additional 3000 next year. Iran

now has 630 kg of low enriched uranium and needs 800

kg to have enough to further enrich into a weapon. This

level can be reached by early next year. However, it is

most likely that Iran will simply continue with its low

enrichment program to establish a stockpile large enough

for a much greater number of weapons before taking thenext step.

That leaves Israel. There have been numerous threats of

an Israeli strike from official sources in Israel. But Israel

lacks sufficient force to have much impact without US

acquiescence. For reasons stated above, the US appears

to be warning Israel off.

Iran is very vulnerable to the decline in oil price, with

eighty percent of it foreign exchange revenues derived

from oil. Both its internal social and external geopolitical

subsidy programs will have to be cut back soon enough,

But the investment in enrichment has already been made,so it will move to completion on its own momentum.

The most likely outcome now is an eventual global

acquiescence in a nuclear armed Iran.

Russia

Russia has been smarting from the expansion of NATO

into its sphere, the basing of US anti-missile installations

in Poland and the Czech Republic, and US responses to

the conflict in Georgia. Furthermore, the rapid growth of

the Russian economy in recent years and its importance in

the energy market have rekindled a desire to establish a

geopolitical weight commensurate with being a greatpower. As a result it has embarked on a program to

rationalize and rearm its military, and effort to gain

recognition of its pre-eminence in the near abroad states

of the former Soviet Union, and an effort to jostle the US

in its backyard by renewing its support for Cuba and

Venezuela. These initiatives are costly, except for the

Caribbean activities, which are on a commercial basis so

far. The collapses of the oil price and the global financial

crisis have hit the Russian financial system hard. The

decline in revenues from oil will inevitably force a

retrenchment of these strategic plans. However, Russia

has been relatively frugal during the oil boom,

accumulating above $500 billion in foreign exchange

reserves. Although interventions to stem the capital flight

after the Georgia war and the effects of the financial crisis

have brought reserves to $475 billion, this can still support

the implementation of military modernization in the short

term.


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Venezuela

This time around Russia is leaving the costs of subsidizing

an anti-US coalition in the Caribbean to Venezuela, making

minimal shows of military force in the form of a couple of

strategic bombers and a demonstration by a small naval

squadron. It is selling arms to Venezuela on a scale that is

relatively large for the region, but on a commercial basis.

Venezuela and Iran are similar in their large budgetary

commitments for armament programs, for subsidizing

allies, and for subsidizing social programs, all based on oil

revenues. With half of government revenues and 90

percent of exports coming from oil, Venezuela is just as

vulnerable to the sudden collapse in oil prices. With

reserves of $38 billion, there is about a year before it will

have to scale back its various programs, including the

geopolitical one, unless the time is advanced by a larger

capital flight.

A little bit on all those aircraft carriers

In its rearmament program, the government hassuggested that Russia may build up to six aircraft carriers.

This followed close on a suggestion from China that it

would build one aircraft carrier. (The UK and France are

committed to building a total of three large aircraft carriers

between them.) These plans seem strange given the ever

increasing vulnerability of these huge military assets.

Aircraft carriers are for the projection of offensive power

over long distances where basing of aircraft may be

problematic. This makes no sense for coastal defense. To

build a serious aircraft carrier costs well above $5 billion.

But then you need to build half a dozen escort vessels and

the aircraft to produce a battle unit that will requireupwards 10,000 sailors. Since it is for distant power

projection, to keep a single aircraft carrier group on

constant deployment requires at least two and more likely

three groups. This is an enormously costly strategic

decision. Since its development has been in the industrial

sector, China has the resources to build an aircraft carrier,

and a single one would provide an experimental unit to

serve as a learning platform. But even with vaster

resources than Russia now has, the Soviet Union could

not perfect an aircraft carrier. With the rapidly waning

financial clout, Russia is unlikely to implement this

program very soon.

Peter Garber, (1) 212 250-5466


9/46



US Equity Strategy

Equity markets are pricing the worst post-war

recession. The current sell-off in the S&P 500 (-51.9%),

measured peak-to-trough, exceeds all post-war sell offs. It

is now bigger than the post-tech-bubble sell off and theworst recession-related sell off in 1973-75. Like the post-

tech-bubble selloff in 2000-02, much of the 1973-75 sell-

off also represented a derating. That recession saw a

peak-to-trough decline in trailing four quarter earnings of

15%, while equities fell by 48%, indicating a significant

derating, in our view reflecting the oil supply shock that

rendered portions of the existing capital stock obsolete.

Equities are thus pricing in a deep and long recession,

worse than any in the post war period (Figure 1).

Figure 1: The worst post-war equity sell-off

-90

-80

-70

-60

-50

-40

-30

-20

-10

0

% decline for S&P 500 from peak to trough around

recessions

Source: S&P, NBER, Haver, Deutsche Bank

Historically, equities have bottomed a little more than

half way through recessions, recovering significantly

before it ends. There are several empirical regularities in

the behavior of equity markets around past recessions. (i)

On average, they lost 32% from peak to trough. (ii) They

bottomed a little more than half way through recessions,

recovering significantly before they ended, returning 27%

in 6m and 43% in 12m from the bottom. (iii) They

bottomed well before any of the macro indicators turned.

(iv) Ex post, equity bottoms coincided on average with

GDP growth bottoms, but this data only becomes

available with a lag and is often revised. Waiting for a turn

in the macro indicators before going long equities thus

risks losing out 15-30% returns in equities (Figure 2).

Figure 2: Equities bottom half-way through recessions

100

120

140

160

180

200

220

-300 -250 -200 -150 -100 -50 0 50 100 150 200 250 300

100

120

140

160

180

200

220

RecessionCurrent episode (considering Nov 20, 2008 trough)Average of S&P 500 around recess ions

IndexIndex

Source: NBER, S&P, Haver, Deutsche Bank

In light of further downgrades to DBs US and global

growth outlooks in this World Outlook, we are

lowering our S&P 500 EPS estimates for 2008 to $61

($86 ex-writedowns) and for 2009 to $65 ($73 ex-

writedowns). Our top-down earnings estimates in the

face of the global recession, a higher dollar over the

medium term and lower oil and commodity prices imply

underlying earnings declines of -14.9% in 2008 and

-11.2% in 2009. NIPA profits are measured ex-balance-

sheet adjustments (underlying earnings).

Domestic profits are viewed as the product of margins

and sales, with the former driven by the cycle (operatingleverage) and costs, while the latter are proxied by GDP.

Domestic margins peaked in Q3 2006 and have fallen

significantly. With growth turning down, in spite of the

offset from declining costs, margins are expected to fall

through mid-2009 to about the trough levels of past

recessions (5.3%).

We forecast domestic profit growth to trough in Q1 2009

at -22.1% and then recover but remain negative through

Q3 09. Foreign profit growth looks set to suffer a

significant double whammy from lower foreign growth

and a higher dollar. Foreign profit growth lookss set to fall

from positive mid-teen rates in Q2 2008 to negative -

29.7% in Q1 09. We forecast total profit growth to trough

in Q1 2009 at -24.7% but remain negative through Q3

2009.

Financial sector writedowns have taken a heavy toll on

S&P 500 operating EPS. We estimate that $317 bn in (pre-

tax) writedowns during 2008 will have reduced S&P 500

operating EPS by $25, i.e., 29%. The magnitude of these

writedowns requires some assumption on them going

forward, their tax treatment and accounting practices in

projecting S&P 500 EPS. We assume that capital markets


10/46



losses continue in Q4 at their recent pace but dissipate as

GDP growth bottoms while loan loss provisioning peaks

with a lag. Our assumptions on writedowns implies that

despite declines in underlying earnings, S&P 500 EPS will

grow in 2009 (Figure 3).

Figure 3: Relative roles of domestic and foreign profit

growth to reverse

-30

-20

-10

0

10

20

30

40

Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 Dec-10

-30

-20

-10

0

10

20

30

40

Domestic profit growth yoy

Foreign profit growth yoyTotal Profits growth yoy

%%

Source: BEA, Haver, Deutsche Bank

Figure 4: Trailing multiples during recessions

5

10

15

20

25

30

35

Oct-34 Oct-44 Oct-54 Oct-64 Oct-74 Oct-84 Oct-94 Oct-04

Recession periods S&P 500 trailing PE ratio

0+- 1 s.d. band Average S&P 500 P/E

Low with S&P at 752.4


In the near term and during 2009, we expect that the

prevailing uncertainty about the depth and duration of

the recession will exact a discount on the forward

multiple that equity investors apply to estimatedearnings. Our long-run fair value PE for the S&P 500 is

16.4 (the ex-bubble average of 15.3 adjusted for the lower

interest rate environment). But trailing multiples first fall

(on average -28%) and then recover during recessions as

prices fall in anticipation of the decline in earnings, and

then rise well before the recovery, arguing in favor of

using forward multiples. Long-run average earnings

growth of 6.4% implies a fair value one-year-forward

earnings multiple of 15.4. We apply a significantly lower

multiple of 13.3 to forward earnings at end-2009, before

reverting in 2010 to the long-run multiple of 15.4. The

lower multiple is calibrated to be equivalent to an increase

of 300 bps in HG credit spreads above their average levels

(currently 535 bps above average). It embodies the view

that uncertainty and credit conditions improve in H2 09

(Figures 4-5).

Figure 5: Prices and earnings around recessions

100

105

110

115

120

125

130

-12M -9M -6M -3M 0M 3M 6M 9M 12M

100

105

110

115

120

125

130

RecessionAverage of S&P 500 around Recessions (Trough = 100)Average of S&P 500 EPS around Recessions

IndexIndex


Our top-down earnings estimates and multiples imply

an S&P 500 target of 1140 for 2009 and 1425 for 2010.

In the near term we see the S&P 500 remaining in a wide

range between 800 and 1000. Our US growth forecasts

imply a somewhat extended bottom in growth during Q4

2008- Q1 2009. We thus do not see a sustainable bottom

in equities until sometime in Q1 2009. We remain

overweight US versus world growth, both at the marketand sector level, and thus underweight the global cyclicals

(Energy and Materials). We are also underweight the US

exporters (Capital Goods in the Industrials and Tech). We

are overweight US importers (the Consumer sectors) and

the Diversified Financials (Figure 6).

Figure 6: EPS, multiples and S&P 500 targets

Y e a rS & P 5 0 0 E P S

e s t i m a t eF o r w a r d

P / ES & P

t a r g e t2008E 61.2 - 800-1000

2009E 64.5 13.3 11402010E 85.9 15.4 1425

2011E 93.0

(S&P targets for 2009 and 2010 represent forward P/E

applied to the next year EP S)

Source: Deutsche Bank

Binky Chadha, (1) 212 250-4776

Parag Thatte, (1) 212 250-6605


11/46



Pan-European Equity Strategy: In search of the bottom

European equities APPEAR cheap on nearly all

valuation measures. The current trailing P/E of 8.2x

compares with the 40-year average of 14x and is at the

lowest level since the 70s, when double-digit inflation wasweighing on equity valuations. The P/B of 1.1x compares

with a 29-year average of 1.67x, despite the ROE realized

over the last 12 months still running at a healthy 15%. The

dividend yield of around 5.3% is above the 75-year

average and above the 10-year government bond yield for

the first time since 1954 (Figure 1).

Figure 1: European dividend yield above government

bond yield!

-8

-7

-6

-5

-4

-3

-2

-10

1

2

1933 1947 1961 1975 1989 2003

Div - Bond Yield (avg. of

Germany, UK and France)

%

Source: Global Financial Data Inc, Datastream, Deutsche Bank calculations

The reason is that neither realized profits nor futureprofits expected by the consensus have meaningfully

declined so far. Nearly 40pp of the 50% decline ofEuropean equities since their peak in June 2008 are driven

by contracting multiples rather than earnings. This is true

both on trailing earnings, i.e. the profits realized over the

last 12 months, as well as on forward earnings, i.e. the

profits which the consensus of bottom-up analysts

expects to be realized over the next 12 months (Figure 2).

Three reasons have contributed to the P/E contraction: (1)

Investors demand a higher equity risk premium as

uncertainty has risen. Realised and implied equity market

volatility are at or close to record levels, credit spreads are

at 75-year highs and earnings uncertainty, measured asthe average standard deviation of analysts bottom-up

estimates in the IBES consensus system, has reached a 6-

year high in Europe and a 20-year high in the US (Figure

3). (2) Investors anticipate lower earnings and lower

earnings growth as economic growth falters. (3) Investors

had been concerned about inflation until mid-08 and are

concerned about deflation since then. Both, in a

deflationary as well as in an inflationary environment P/E

multiples tend to decline as real growth tends to be lower

and the required equity risk premium higher.

Figure 2: Equity market decline so far a multiple

contraction story

40

50

60

70

80

90

100

110

1-Jun-07 1-Oct-07 1-Feb-08 1-Jun-08 1-Oct-08

Stoxx 600

Forward P/EStoxx 600 forward ear nings

All indexed at 100 at 1 June 2007

Source: Thomson Financial IBES, Deutsche Bank Equity Strategy

Figure 3: But earnings uncertainty* is at record level

2

4

6

8

10

12

14

16

18

20

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

US Europe

%

*Average of standard deviation of bottom-up analysts earnings forecasts

for each company as percent of the consensus earnings forecast

Sources: Thomson Financial IBES, Deutsche Bank calculations

In the baseline scenario, we expect European earnings

to decline by 20% both in 2008E and 2009E.Despite

the recent acceleration of consensus earnings

downgrades, consensus earnings growth numbers still

remain far too high at -10% for 2008E and +6% for

2009E. In our view, the problem of estimates is not at thetop line, which should get a sizable boost from the dollar

appreciation. The problem is the margin assumption. We

are projecting EBITDA margins to contract by 1.2pp and

2.5pp in 2008E and 2009E, respectively, substantially

more than currently factored in by analysts. Below the

EBITDA line, we expect the rising cost of interest bearing

debt, goodwill impairment, pension funding gaps and

rising working capital to weigh on profits and/or cash

flows.


12/46



In our view the market has already priced in more

than this forthcoming profit/cash flow deterioration.

We calculate that at the current Stoxx 600 index level of

roughly 200 the market is pricing in a roughly 50% peak to

trough decline in earnings and a 6pp peak to trough drop

in ROE, both more than in the cycles in the last 40 years

and more than we forecast in the baseline scenario. So

while the market looks clearly more expensive on ourbottom-up numbers, it still offers 15-30% upside until

end-09 (Figure 4). Also supported by our other models,

our Stoxx 600 end-09 target is 250 in the baseline case

(see final table for index targets).

Figure 4: and profits will likely come down

substantially2000 2001 2002 2003 2004 2005 2006 2007 2008E 2009E 2010E

Bottom-up

consensus

earnings 14.8 10.6 8.0 11.8 19.3 22.8 25.7 27.5 24.7 26.1 28.6

Growth 3% -29% -24% 47% 64% 18% 13% 5% -10% 6% 10%

Stoxx index at YE 360 299 202 229 251 310 365 365 200 200 200

Trailing P/E at YE 24.3 28.3 25.1 19.5 13.0 13.6 14.2 13.4 8.1 7.7 7.0

Top-down Deutsche Bank earnings 21.7 17.4 20.8

Growth -20% -20% 20%

Required revision of bottom-up consensus earnings -12% -33% -27%

Stoxx index at YE 200 200 200

Trailing P/E at YE 9.2 11.5 9.6

YE level on 38Y average trailing P/E of 14.0 304 243 292

YE level on 38Y average trough P/E of 13.6 295 236 283

YE level on 38Y average trough earnings P/E of 15.2 330 264 317

Source: Thomson Financial IBES, Deutsche Bank estimates

We believe for equity markets it will be crucial whether

global growth stabilises in 2009 or not. However deep the

recession will be in 2009, equity markets should performpositively, if global growth looks like heading towards

some acceleration in 2010. We believe this is even the

case if growth remains sluggish thereafter, as expected in

the baseline scenario. The risk scenario is that global

growth does not trough in 2009, e.g. if neither aggressive

monetary easing nor aggressive fiscal stimulus trigger a

rebound. In this case we see another 20% downside risk

in 2009 (Stoxx 600 target of 160).

Sustainable upswing not likely before end of Q4 08

reporting. For the market to start a lasting rebound we

see the following pre-requisites: (1) Slowing pace of

earnings estimates downgrades (Figure 5); (2)Improvement in lending conditions; (3) Improvement in

consumer confidence; And, (4) improvement of our

proprietary Macro Support Ratio. We do not expect a

lasting rebound before the end of the Q4 reporting. Near

term risks include re-financing needs, higher debt

financing costs, goodwill write downs and pension

funding gaps.

Figure 5: Market moves are related to pace of

earnings revisions

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

0

50

100

150

200

250

300

350

400

450Earnings revision ratio (3 month avg.) (lhs)

Stoxx 600 (rhs)

Latest observation not

averaged

IndexRatio

The earnings revision ratio looks at the number of companies with

consensus

forward earnings upgrades and downgrades over the last month. It is

calculated as (# upgrades - # downgrades) / # of companies in the universe.

Source: Thomson Financial IBES, Deutsche Bank calculations

Growth, large caps and defensives are still the way

forward for now. With regard to investment themes,

we continue to favour large caps over small caps. We also

believe that Growth will continue to outperform Value.

Growth does not look expensive and we find that Growth

has always outperformed Value in years in which global

GDP growth declined by more than 1pp. Cyclicals vs

Defensives is a closer call. Defensives now look more

expensive and are over-owned. Yet, as the backdrop

clearly remains in favour of Defensives we have

maintained a defensive bias with Overweight positions in

Health Care, Telecoms and Oil & Gas. In the last twomonths though we have started to gradually scale back

these O/w positions and, at the same time, added weight

to Basic Materials and Consumer Cyclicals where we are

now slightly O/w and, respectively, less U/w.

Figure 6: End-2009 index targets for European equity

marketsTarget index level for

end 2009

Upside from current

level

Base scenario (60% probability)

Stoxx 600 250 29.5%

Stoxx 50 2650 29.8%

Euro Stoxx 270 27.4%

Euro Stoxx 50 3000 29.4%

FTSE 100 5300 29.4%Dax 5900 31.8%

CAC 40 4000 28.7%

SMI 7000 27.0%

IBEX 35 10700 23.4%

MIB 30 25000 32.4%

Best scenario (15% probability)

Stoxx 600 300 55.4%

Risk scenario (25% probability)

Stoxx 600 160 -17.1%

Source: Deutsche Bank estimates, prices for upside as at 1 Dec 2008 cob

Bernd Meyer, CFA, (44) 20 7547 1533


13/46



Commodities: OPEC action & global growth

We find that OPEC has a good track record ofdefending oil prices via production cuts. However,

their success rate dissolves when global growth is

under attack. We would view events today as reminiscent of

1998 and 2001 when world growth and crude oil

prices collapsed. At those times, the cartel

announced cumulative production cuts of

approximately 5mmb/d, which occurred over a 12

month period.

We believe OPEC will cut quotas throughout mostof next year. However, we believe production cuts

will not immediately rescue the oil price and

consequently we target WTI crude oil prices

hitting USD40/bbl next year.

In fact we find that it is only two to three monthsafter the last quota reduction does the oil pricebegin to stabilise. This would imply a stabilisation

in oil prices around the first quarter of Q1 2010.

History would suggest that crude oil prices canrally between 35-80% when world growth starts

to recover and for this rally to occur within a six

month period. This would imply crude oil prices

back up at USD75-85 by the second half of 2010.

We expect the industrial metals will continue tostruggle in an environment where global equity

markets remain under pressure.

Since 1993, OPEC has taken action twelve times to cut

production to defend the crude oil price. In Figure 1 wetrack the performance of the crude oil price in the two

weeks before a quota reduction and in the subsequent 2-3

month period. We find that since 1993 OPEC has a 75%

success rate of defending the oil price when it takes

action and cuts quotas.

However, on two occasions, 1998 and 2001, successive

rounds of quota reductions were unsuccessful in

supporting the oil price. On a cumulative basis production

cuts amounted to 4.5mmb/d in 1998-99 and 5.0mmb/d in

2001-02. In our view, this reflected the inability of OPEC

to cut production as fast as global oil demand growth was

slowing. In 1998, oil demand was under pressure from

the unfolding Asia crisis while in 2001 oil demand was hit

by a mild US recession. In both years, world GDP growth

slowed to 2.5% or below.

Figure 2 tracks the performance of the crude oil price in

the one, three and six months following a cut in OPEC

production quotas since 1993. We find that on average

quota reductions are effective in pushing oil prices higher.

However, their effectiveness evaporated in 1998 and

2001 with oil prices falling over a one month, three month

and six month horizon despite OPEC action.

Figure 1: Tracking the performance of the crude oil

price following OPEC production cuts

60

70

80

90

100

110

120

130

140

150

-14 -7 0 7 14 21 28 35 42 49 56 63 70

Mar-93 Apr-98 Jul-98

Apr-99 Feb-01 Apr-01

Sep-01 Jan-02 Nov-03

Apr-04 Nov-06 Feb-07

Number of trading days before and after OPEC quota reduction

1998

2001

WTIoilprice=100inthedaybeforequota

reduction

Source: OPEC, DB Global Markets Research

Figure 2: OPEC quota cuts & the WTI crude oil price

Production % change in WTI crude oil pr ice:

cut (mmb/d) 1M later 3M later 6M later

Mar-93 -0.99 -0.8 -2.8 -11.2

Apr-98 -1.76 -1.4 -9.2 3.4

Jul-98 -1.36 -6.7 -12.2 -26.2

Apr-99 -1.41 36.6 37.2 80.2

Feb-01 -1.50 -4.4 -0.7 -8.1

Apr-01 -1.00 8.3 -0.2 -10.9

Sep-01 -1.00 3.2 -19.6 -26.1Jan-02 -1.50 -1.8 32.6 35.4

Nov-03 -0.90 4.5 13.5 28.4

Apr-04 -1.00 4.5 3.6 38.8

Nov-06 -1.70 7.5 -1.0 11.9

Feb-07 -0.50 -3.3 -2.1 1.4

Average -1.22 3.9 3.3 9.8

1998 -4.52 -4.1 -10.7 -11.4

2001 -5.00 -2.4 -6.8 -15.0

Source: OPEC, DB Global Markets Research

These results would imply that the current OPEC quota

reduction cycle will continue until the fourth quarter of

next year. Moreover, that oil prices will stabilise

approximately three months after the last reduction in

quotas has been announced. In other words, crude oil

prices should not hit rock bottom until the very end of

next year/early 2010. We believe at that point a sustained

move higher in crude oil prices will start to become more

compelling. Indeed in the 1998 and 2001 quota reduction

cycles as soon as the last production cut had occurred in

April 1999 and January 2002 within six months crude oil

prices had rallied by 80% and 35% respectively, in line

with the recovery in the world economy at that time.


14/46



How low can oil prices go?

In March 2008, following a doubling in oil prices in the

previous 12 month period, we examined at what point oil

prices could be considered extreme. We presented a

variety of indicators such as oil prices relative to income,

the US dollar and as a share of global GDP and found that

the oil price would need to surpass USD150/barrel for it to

represent levels of valuation which had never beenreached in recorded history. Last month we reversed this

analysis to assess how low oil prices can fall. We selected

a variety of indicators, which are presented in Figure 3. It

reveals that budgetary positions of certain oil producers

starts to become increasingly strained when the oil price

falls below USD55/bbl (Saudi Arabia) or USD95/bbl (Iran

and Venezuela). In terms of marginal cost of production

we set this close to USD80/bbl as the point for trimming

new capital expenditures.

Figure 3: How low can oil prices go?

Indicator Oil price level

Budget balance USD55-95

Marginal cost of production USD80

Based on f utures forecasting error USD80

As a share of S&P500 USD60-90

As a percent of US disposable income USD60-85

As a percent of global GDP USD40-75

Relative to G7 per capita income USD45

Versus US dollar USD30-60

In real terms (PPI) USD35

Average USD61


While we believe these two indicators are the most

important in setting the long term fair value of crude oil,

the last few months have demonstrated the ability of oil

prices to overshoot to the upside as well as to the

downside. On the indicators we examined, we believe the

extreme low point in crude oil is between USD30-35/bbl.

Indeed we find that oil prices would need to fall to

USD35/bbl in order to bring prices in real terms back to

their long run historical averages.

Industrial metals & the S&P500

The fortunes of the industrial metals complex havehistorically been closely tied to the performance of the

S&P500. We expect the industrial metals will continue to

struggle in an environment where global equity markets

remain under pressure, demand side risks are skewed to

the downside and inventories continue to rise. We would

view aluminium and copper as the most exposed in this

environment. We would view stability to global equity

markets as a necessary condition to avert further

downside in industrial metal prices. Since the S&P500

only tends to stabilise 3-6 months before the end of a US

recession, we believe prospects for the sector will remain

hostile into 2009. Indeed the typical trigger for higher

industrial metal prices has historically been a new

monetary tightening cycle from the Fed, Figure 4.

Figure 4: The performance of industrial metals in the

year after the Fed starts a new tightening cycle

-40

-20

0

20

40

60

80

100

120

140

Nickel Aluminium Zinc

1987 1994 1999 2004

% change in price in the 12 months after the

first tightening move by the US Federal Reserve

58%

42%

30%5% 14%

-4%

Average price rise

in the last four

tightening cycles

Copper Lead Tin

Source: Bloomberg, DB Global Markets Research

Figure 5: DB Oil & Natural Gas Price Forecasts

WTI

(USD/bbl)

Brent

(USD/bbl)

US Gas

(USD/mmBtu)

Q4 2008E 62.00 60.00 6.90

2008E 100.39 98.99 9.00

Q1 2009E 55.00 55.00 8.00Q2 2009E 50.00 50.00 7.50

Q3 2009E 45.00 45.00 7.50

Q4 2009E 40.00 40.00 8.00

2009E 47.50 47.50 7.75

Q1 2010E 50.00 50.00 8.00

Q2 2010E 55.00 55.00 8.00

Q3 2010E 55.00 55.00 8.50

Q4 2010E 60.00 60.00 8.50

2010E 55.00 55.00 8.25

2011E 80.00 80.00 9.00 Source: DB Global Markets Research

Michael Lewis, (44) 20 7545-2166

Adam Sieminski, (1) 202 250 2928


15/46



US: Marking activity down further

Macro-economic activity & inflation forecastsEconomic activity 2008F 2009F 2010F

(% qoq, saar) Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F % yoy % yoy % yoy

GDP 0.9 2.8 -0.5 -4.5 -3.7 -2.8 1.0 1.5 1.2 -2.0 1.6

Private consumption 0.9 1.2 -3.7 -2.4 -2.0 -1.7 0.0 1.0 0.4 -1.6 1.0

Investment -5.8 -11.5 0.4 -20.2 -18.7 -14.0 4.2 4.1 -6.5 -11.5 4.3

Govt consumption 1.9 3.9 5.3 2.0 -0.1 -0.1 1.9 2.4 2.9 1.6 2.8

Exports 5.1 12.3 3.4 -10.0 -15.0 -10.0 -5.0 -5.0 7.3 -7.5 -2.3

Imports -0.8 -7.3 -3.2 -10.0 -15.0 -10.0 -5.0 -3.0 -2.9 -9.3 -0.8

Contribution (pp): Stocks -0.1 -1.4 0.7 -0.5 0.0 0.5 1.8 0.7 0.2 0.3 0.5

Net trade 0.8 2.8 1.0 0.3 0.5 0.3 0.1 -0.2 -0.9 0.5 -0.2

Industrial production -0.3 -6.1 0.5

Unemployment rate, % 4.9 5.3 6.0 6.8 7.4 8.1 8.4 8.6 5.8 8.1 8.2

Prices & wag es (% yoy)

CPI 4.2 4.3 5.3 2.1 0.5 -0.5 -1.8 0.4 4.0 -0.4 1.5

Core CPI 2.4 2.3 2.5 2.0 1.7 1.5 1.0 1.1 2.3 1.3 1.2

Producer prices 7.1 7.6 9.4 2.3 -1.8 -4.5 -6.4 -1.8 6.6 -3.7 0.3

Compensation per empl. 3.3 4.0 4.0 3.4 3.2 2.9 2.6 2.4 3.7 2.8 2.7

Productivity 3.3 3.2 2.3 1.2 0.1 -1.1 -1.5 -0.4 2.5 -0.7 1.2

2008 2009

Sources: National authorities, DB Global Markets Research

1. Financial conditions have tightened dramatically

further over the last two months

-4

-2

0

2

4

6

8

10

81 84 87 90 93 96 99 02 05 08

-4

-2

0

2

4

6

8

10

Real GDP Domestic financia l condit ions index*

* Includes M2, bank loans & leases, consumer credit, yield curve,

credit spreads and cyclical stocks.

November

estimate

% yoy% yoy

Sources: BEA, DB Global Markets Research

2. Troubled asset prices made new lows following

abandonment of the original TARP plan

0

500

1000

1500

2000

Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08

0

500

1000

1500

2000

5Y CMBS cash AAA spread to Libor

bpsbps

In our view, the abandonment of the Treasurys original

intention to purchase troubled assets has weighed on

market sentiment and investor risk-taking, potentially

leading to another wave of credit write-downs and loan

losses. This has adversely affected investor confidence,

which should in turn prolong the credit crunch and hencethe economic downturn. This is apparent in financial

conditions, which have become even more restrictive

toward future economic activity. Consequently, we now

expect the economic downturn to be even deeper and more

protracted than we initially assumed. As a result, we are

further lowering our forecasts of growth and inflation.

We expect the Fed to cut rates another 50 bps to 0.5% and

then hold rates at that level indefinitely. We do not projec

the economy to return to trend growth until mid-2010,

which means the unemployment rate will continue to trend

higher as the capacity utilization rate trends lower. As labor

and product market slack open up further, both headline andcore inflation are likely to move down substantially. With

official interest rates steady at 0.5%, the Fed is likely to

pursue more overt measures of quantitative easing, eviden

by the planned upcoming purchases of debt issued by

government-sponsored agencies as well as highly-rated

mortgages. This should help lower borrowing costs and

possibly lead to a mini-refinancing wave, but until the non-

agency mortgage market improves, policy initiatives to date

are likely to have only a muted positive effect on the

broader financial markets. In light of these adverse

economic developments, we now expect substantial fiscal

stimulus in the first half of 2009. Additionally, the sharp

decline in energy prices over the past several monthsshould provide a substantial benefit to cash-strapped

consumers. Sources: Bloomberg, DB Global Markets Research


16/46

5 December 2008 WorldOutlook



3. Banks are unwilling to provide credit to consumers

-80

-40

0

40

80

66 69 72 75 78 81 84 87 90 93 96 99 02 05 08

-80

-40

0

40

80

Fed's Sr Loan Officer Survey: banks willingness

to lend to consumers

%%

Sources: FRB, DB Global Markets Research

4. The consumer spending share of GDP is bound toslow in the future

60

62

64

66

68

70

72

74

60 64 68 72 76 80 84 88 92 96 00 04 08

60

62

64

66

68

70

72

74Ratio of PCE to GDP %%

Sources: BEA, DB Global Markets Research

5. Low savings and high debt service put US

households in a precarious financial situation

13

14

15

16

17

18

19

80 84 89 93 98 02 07

-4

-2

0

2

4

6

810

12

14

Homeowner financial obligation ratio (lhs)Personal saving rate (rhs)

%%

The credit crunch intensifies. According to the National

Bureau of Economic Research, the cyclical peak in

economic activity occurred in December 2007. At that time

the economy entered a recession, which continues at

present. The economic outlook is likely to continue to

deterioratealthough we believe the sharpest outputdecline will occur in the current quarter. There are few, if

any, parallel periods in the post-WWII era which compare to

the current environment. Arguably, the closest example is

the introduction of credit controls by President Carter in

1980.

In March 1980, President Carter announced the adoption of

credit controls under the Credit Control Act of 1969. These

controls, which were administered through the Fed, were to

be in effect for an indefinite period of time until the

President chose to remove them. The intention of the

controls was to put a brake on excessive money and credit

creation, which was helping inflation move toward 15%.Consumer credit, which had grown 14% in 1979, slowed to

5% growth in Q1 1980 and produced an outright decline of

7% in Q2. With the economy in recession, the controls

were fully lifted by July 1980.

As we have noted on numerous occasions, todays

economic environment bears little resemblance to the 1980

landscapeinflation and interest rates were substantially

higher at that time. Moreover, the 1980 credit crunch was

short and voluntary, lasting just one quarter. The current

credit crisis began in Q3 of last year and has intensified in

force as of late, despite repeated Fed, Treasury and, more

recently, international attempts to thaw frozen credit

markets and restore global financial order.Households are leveraged. Especially troubling to us is thefact the current credit crunch is occurring in an environment

of an extremely cash-strapped consumer. Household

savings are near their all-time record lows, while total debt

service is near its all-time high. The recent hiccup in the

savings rate and modest decline in the debt service burden

are both a function of temporarily higher income resulting

mostly from the tax rebateswhich were primarily saved.

With the labor market poised to weaken further, thereby

putting downward pressure on income creation, consumer

spending is likely to decline substantially. Without easy

access to credit, households will be forced to limit

consumption to the flow of earnings, predominantly fromwages and salaries.

In addition to the credit crunch, households have to contend

with a massive negative adjustment to net wealth. This

should further dampen consumer spending and hence GDP

growth. Indeed, our forecast assumes the economy

experiences the longest and deepest pullback in consumer

spending in the post-WWII period. We project an

unprecedented four quarter decline in consumer spending

in prior instances, consumption has never declined for more

than two consecutive quarters.Sources: BEA, FRB, DB Global Markets Research


17/46




0

1

2

3

4

5

6

97 98 99 00 01 02 03 04 05 06 07 08

-15

-10

-5

0

5

10

15

20Real GDP (lhs)

Real household net wealth (rhs)

Q4 estimate

% yoy% yoy

6. If sustained, the decline in household net wealth

could offset most of the benefit from lower energy costs

Sources: BEA, BLS, FRB, DB Global Markets Research

7. The credit crunch can be seen across all major

product areas

-25

0

25

50

75

100

90 92 94 96 98 00 02 04 06 08

-25

0

25

50

75

100

Tightening standards for commercial real estateResidential mortgages: net share, banks tighteningBanks tightening standards: consumer credit cardsBanks tightening standards: other consumer loans

FRB Senior Loan Officer Survey

%%

Sources: FRB, DB Global Markets Research

8. An economic trough will not be in sight until the

index of leading economic indicators stabilizes

-10

-5

0

5

10

15

76 79 82 85 88 91 94 97 00 03 06 09

-10

-5

0

5

10

15

Real GDPIndex of leading economic indicators (2Q lead)

% yoy% yoy

How does the current recession compare? In terms ofthe peak to trough decline in consumption, we forecast a

2.5% drop, slightly worse than the two quarter drop which

occurred during the 1980 episode. One of the reasons we

believe consumers will not pull back to an even greater

degree is due to declining energy costs, which should helpUS households. According to our analysis, a $1 decline in

retail gasoline prices creates approximately $100 billion in

added household cash flow. Gasoline prices are down $2

from their peak. Eventually, this should help steady

consumer spending.

Another reason we expect consumer spending to stabilize

is fiscal stimulus. At the moment, we expect the incoming

Obama Administration to enact a fiscal stimulus plan which

will include middle class tax cuts, financial aid to states and

federal infrastructure spending. The total size of the

stimulus package is likely to be around $500 billion. While

the President-elect has not put out a formal stimulus plan,

as he only recently put his economics team in place, we canbe assured from his political mandate that a viable program

will be put forth soon.

In terms of our forecast, we project a peak-to-trough decline

in real GDP of -2.9%. This compares to an average post-

WWII peak-to-trough decline in real output of -2.1%. Our

forecast puts the current projected decline in output on a

par with the 1981-1982 recession. In addition to what we

previously discussed, there are several factors that support

an eventualalbeit anemic in historical contextrecovery

late next year.

First, the projected peak-to-trough decline in GDP does not

fully capture how weak the economy is. With the recessionbeginning in December 2007, our forecast is consistent

with an 18 month recession. This is two months longer than

either the 1974-1975 or 1981-1982 recessions. More

importantly, if we factor in the amount of time in which

economic output has been below trend, illustrated by a

continually rising unemployment rate from its cyclical low,

we would be looking at a four-year period of sub-par

growth.

Second, we expect that all of the various policy initiatives,

such as aggressive Fed easing, the TARP capital injections,

the FDIC ring-fencing of troubled assetswitness the

Citibank bailoutand the most recent announcement that

the Fed will buy mortgage assets and help fund consumerasset-backed securitization, will eventually work. At

minimum, when fully implemented, these various programs

combined with sizeable fiscal stimulus and lower energy

costs should help stabilize the economy.

Three, the economy is generating some pent up demand

that we believe will eventually be unleashed once credit

starts to flow. For example, housing and motor vehicle sales

are at record lows, but these interest-sensitive sectors

should benefit from lower rates once finance companies

become less capital-constrained.

Sources: BEA, Conference Board, DB Global Markets Research


18/46




External balances & financial forecasts2008F 2009F 2010F Financial forecasts Current 3M 6M 12M

Official 1.00 0.50 0.50 0.50

Fiscal balance, % of GDP -3.2 -8.2 -3.4 3M rate 2.19 1.50 1.50 1.50

Trade balance, USD bn -453 -379 -401 10Y yield 2.58 2.00 2.00 2.50

Trade balance, % of GDP -3.2 -2.7 -2.7 USD per EUR 0.78 1.28 1.28 1.21

Current account, USD bn -677 -519 -465 JPY per USD 92 95 96 92

Current account, % of GDP -4.7 -3.5 -3.0 USD per GBP 1.47 1.41 1.38 1.30 Source: DB Global Markets Research, as of December 5

Joseph A. LaVorgna, (1) 212 250-7329

Carl J. Riccadonna, (1) 212 250-0186

9. Credit market stress must also meaningfully abate

before the economic outlook can improve

0

50

100

150

200

250

300

350

400

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09

0

50

100

150

200

250

300

350

4003m LIBOR minus 3m USD swap OIS%%

Sources: Bloomberg, DB Global Markets Research

10. Headline inflation will decline in response to rising

labor and product market slack

0.0

2.5

5.0

7.5

10.0

12.5

15.0

69 72 75 78 81 84 87 90 93 96 99 02 05 082.5

5.0

7.5

10.0

12.5

15.0

CPI (lhs)Unemployment ra te/ capacity utilization (rhs)

% yoy %

What are the risks? If the Fed is successful in jumpstarting

the securitization markets, this would help free up

consumer credit growth and therefore consumer spending.

At present, many consumers are shut out of the credit

markets, because of a lack of credit availability. Of course,

there are risks to our projections. Conceivably, the variousFed, Treasury and FDIC programs may not sufficiently

restore investor confidence and fully deal with the problem

of distressed assets remaining on financial firms balance

sheets. However, we believe the biggest risks to our

forecast in the near term stem not from the financial

markets per se, but rather from developments among the

Big Three automobile manufacturers. With the economy

already in recession, we do not believe it can handle a large

bankruptcy; and if one occurred, we would likely be looking

at a double-digit unemployment rate and a much deeper

decline in economic activity than we presently project.

According to industry estimates (Centre for Automotive

Research), 2.5 to 3 million workers could lose their jobs ifthe Big Three filed for bankruptcy. This is not an

unreasonable estimate because, similar to the Lehman

bankruptcy, there would be inevitably negative shocks

associated with any potential automobile industry

bankruptcy, not least of which could be a further collapse in

consumer confidence and thus even greater declines in

consumer spending. In terms of output, we estimate the

Big Three account for upwards of 70% of total US motor

vehicle production. At $350 billion in inflation-adjusted

terms, a 35% decline in motor vehicle output translates into

about $125 billion in lost output, which is worth about 4%

of GDP growth. As such, an automaker bankruptcy could

easily push growth next quarter down by nearly -8%afrightening prospect, to be sure.

Sources: BLS, FRB, DB Global Markets Research


19/46



Japan: Recession to continue through H1 2010

Macro-economic activity & inflation forecasts

Economic activity 2008F 2009F 2010F


GDP 2.5 -3.7 -0.4 -2.3 -2.9 0.0 -2.4 0.3 0.3 -1.7 0.7

Private consumption 2.4 -2.2 1.1 -0.6 -0.2 3.6 -3.6 0.8 0.7 0.1 0.6

Investment 2.0 -6.5 -3.5 -3.6 -4.5 -4.5 -3.3 -2.2 -2.9 -4.0 -0.6

Govt consumption -1.8 -0.4 0.3 1.6 1.6 1.6 1.6 1.6 0.3 1.3 1.6

Exports 14.5 -10.2 2.8 -12.5 -8.0 -4.5 -3.6 -2.7 4.7 -6.2 0.2

Imports 5.0 -11.5 7.9 -9.5 -4.5 0.3 -1.2 -0.4 0.0 -2.9 1.9

Contribution (pp):

Private inventory -0.8 -0.2 0.2 -0.5 -1.4 -0.7 0.4 0.4 -0.2 -0.5 0.3

Net trade 1.7 -0.4 -0.4 -1.1 -0.8 -0.7 -0.4 -0.4 0.7 -0.7 -0.2

Industrial production -2.9 -3.3 -5.1 -11.5 -7.8 -5.9 -4.7 -3.9 -1.1 -6.9 -1.5


Prices & w ages (% yoy)

CPI 0.9 1.3 2.2 1.6 1.1 0.4 -0.8 -0.8 1.5 0.0 -0.5

Core CPI 1.0 1.5 2.3 1.7 1.0 0.4 -0.8 -0.8 1.6 -0.1 -0.5

Producer prices 3.5 4.9 7.1 1.2 -3.3 -7.0 -10.2 -5.8 4.2 -6.6 -1.3

Compensation per empl. 1.3 0.7 0.3 -0.6 -1.8 -2.0 -2.2 -1.5 0.4 -1.9 -0.5

Productivity 0.5 1.8 1.3 1.8 1.0 1.1 0.0 0.3 1.3 0.6 1.5

2008 2009

Sources: National authorities, DB Global Markets Research

1. Leading index has already fallen substantially

80

85

90

95

100

105

110

90 92 94 96 98 00 02 04 06 08

85

90

95

100

105

110Leading index: DBCLI-ECONOMY (rhs )

Cabinet Of fice coincident index (lhs)

CY2005=100 Jan 1995=100

Sources: Cabinet Office, DB Global Markets Research

2. Export volumes on the decline to all destinations

40

50

60

70

80

90

100

110

120

130

93 95 97 99 01 03 05 07 09

US

Europe

Asia

All regions

CY2005=100, sa, 3mma

Japans recession is likely to continue through H1 2010,given the severity of the ongoing global recession, JPY

appreciation, and the substantial fall in the leading index

of the business cycle. We expect the depth and

duration of this recession to be almost as severe as the

one which started in February 1991. We expect real GDP to shrink for six consecutive

quarters through Q3 2009, led mainly by weakness in

exports and private capital investment where we

expect both of them to shrink QoQ throughout 2009. A

2% slower global GDP growth and 10% JPY

appreciation would lower real exports by 10% points, a

substantial drag to economic activity.

Private consumption is likely restrained by ongoinglabor market softening. Recovery in real purchasing

power from falling oil prices and JPY appreciation

should not be considered supporting factors for

consumption. Remember that in the past business

cycles, deterioration (improvement) in the terms oftrade accompanied economic expansion (recession).

Prices, as lagging indicators of the business cycle, havealready peaked in Q3 2008 and are likely to fall in Q4

2008 onward. A modest degree of deflation should

prevail again in Japan through 2009-10.

Sources: Ministry of Finance, DB Global Markets Research


20/46



Japan:Recession to continue through H1 2010

Mikihiro Matsuoka, (81) 3 5156-6768

We doubt the validity of the arguments that Japan isimmune because it is not at the epi-center of this

financial crisis; its financial system is undamaged;

inventory levels are under control; and capital

investment is entirely financed by cash flow.

This argument, does not take into account dynamicalaspects of the business cycle: 1) Japans economic

activity has clearly been affected by international trade

and currency. 2) Prolonged and severe recession would

eventually result in newly generated bad loans, which

could trigger another credit crunch. 3) A sense of

excess in inventories is determined not only by supply

but also by demand; a substantial weakness in demand

would push up inventories, which in turn leads to cuts

in production. 4) A severe and prolonged recession

eventually curtails profit so that companies would have

to borrow from banks.

Most of the fiscal stimulus packages require theapproval of the second supplementary budget by theDiet, but this may not be obtained easily in the Jan-09

session. This package includes JPY2trn coupon

payment to all households. We expect the BoJ to cut

rate by 20bp in Q1 2009, but do not expect a return to

either zero interest rate policy or quantitative monetary

easing, because of their doubt over the effectiveness of

such extreme policies.

The next economic recovery is unlikely to be V-shaped,led by exports. Stabilizing domestic demand, instead,

would slowly lead to recovery, albeit at a pace of

potential growth at best in our view.

External balances & financial forecasts2007 2008F 2009F 2010F

M2 + CD growth, % 1.6 2.2 2.2 2.1

Fiscal balance, % of GDP -0.8 -2.8 -4.2 -5.1

Public debt, % of GDP 162.8 167.6 174.0 0.0

Trade balance, USD bn 105.8 44.4 74.5 90.8

Trade balance, % of GDP 2.4 0.9 1.4 1.6

Current account, USD bn 211.3 174.0 239.2 303.2

Current account, % of GDP 4.8 3.5 4.5 5.4

Financial forecasts Current 3M 6M 12M

Official 0.30 0.10 0.10 0.10

3M rate 0.89 0.85 0.85 0.85

10Y yield 1.38 1.50 1.50 1.30

JPY per USD 92 95 96 92

JPY per EUR 118 122 122 112

5. Credit spreads have widened even in Japan

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

3/04 9/04 4/05 11/05 6/06 1/07 8/07 3/08 10/08

BBB corporate

AAA corporate

JBG 5-year

%

3. Prices likely to fall

:

94

96

98

100

102

104

106

108

110

112

114

116

00 01 02 03 04 05 06 07 08 09 10 11 12

Domestic CGPI

National CPI excl. fresh food

National CPI excl. energy and food

CY2005=100

Forecast

Sources: Ministry of Internal Affairs and Communication,, DB Global Markets

Research

4. Inverted terms of trade as coincident indicator

60

70

80

90

100

110

120

80 84 88 92 96 00 04 08

40

60

80

100

120

140

160

180

200

Terms of trade; finished goods prices/raw

material prices (rhs)Industrial production (lhs)

CY2005=100 CY2005=100

Sources: Bank of Japan, Ministry of Economy, Trade and Industry,

DB Global Markets Research

Sources: National authorities, DB Global Markets Research, as of Dec 5 Sources: Bloomberg, DB Global Markets Research


21/46



Euroland: A deep recession

Macro-economic activity & inflation forecasts

Economic activity 2008F 2009F 2010F


GDP 2.7 -0.8 -0.9 -3.2 -4.7 -3.3 0.2 0.7 0.9 -2.5 1.0

Private consumption -0.1 -0.6 0.0 -1.2 -1.2 -0.8 0.0 0.4 0.3 -0.7 0.5

Investment 6.1 -4.6 -2.4 -7.8 -11.5 -11.5 -2.0 0.0 1.1 -7.4 0.0

Govt consumption 1.2 2.2 2.8 2.0 2.8 2.8 2.8 2.8 1.7 2.6 2.6

Exports 7.3 -1.5 2.4 -2.0 -0.8 -2.8 -0.8 -0.8 3.2 -1.0 0.5

Imports 7.9 -1.6 7.0 -1.6 0.0 -0.8 0.0 0.8 3.4 0.3 0.7

Contribution (pp): Stocks 1.2 0.2 1.0 -1.0 -1.7 0.0 0.4 0.6 0.2 -0.4 0.3Net trade -0.1 0.0 -1.9 -0.2 -0.4 -0.9 -0.4 -0.7 0.0 -0.6 -0.1

Industria l production 1.4 -1.9 -2.8 -6.6 -9.0 -6.6 -0.8 -0.2 0.0 -5.4 1.0


Prices & w ages (% yoy)

HICP 3.4 3.6 3.8 2.4 1.7 1.1 0.7 1.4 3.3 1.2 1.4

Core inflation 1.8 1.7 1.8 1.9 1.9 1.9 1.7 1.6 1.8 1.8 1.1

Producer prices 5.4 7.1 8.5 4.8 2.2 -0.1 -1.8 0.3 6.5 0.2 0.2

Compensation per empl. 3.3 3.8 4.2 3.6 3.2 2.4 1.9 1.5 3.7 2.3 1.5

Productivity 0.5 0.2 -0.2 -1.0 -2.3 -2.1 -1.3 0.0 -0.1 -1.4 1.4

2008 2009

Sources: Eurostat, DB Global Markets Research

1. GDP to decline 2.5% in 2009, worst since WWII

-4

-3

-2

-1

0

1

2

3

4

5

00 01 02 03 04 05 06 07 08F 09F 10F

Consumption GovernmentInvestment StocksNet trade GDP

Contributions to annual GDP growth

Forecast

Sources: Eurostat, DB Global Markets Research

2. Peak-to-trough output destruction of 3.3%

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

Euro area GDP growth, % qoq

Forecast

Growth: The outlook has deteriorated further since our WO

Update in mid-October. We now expect the euro area to

contract by 2.5% in 2009, with a peak-to-trough decline in

output of 3%, the largest on record (since 1960).

Technical recession in Q2-Q308 has been confirmed. The

main drags were the spike in commodity prices and thedeclining housing/construction cycle. As Q3 unfolded,

discretionary spending (cars, trucks, machinery, etc) started

to roll-over, suggesting the euro area was on the verge of

slipping into self-reinforcing recessionary dynamics. The

escalation of the credit crisis in late September was a blow,

creating an inflection point into Q4. Surveys imply that

output in the final quarter will fall at the fastest rate since

1974. Despite a rapid decline in supply, stocks, which

increased sharply in Q3, have risen further. Anecdotal

evidence points to lengthy production holidays from late Q4

well into Q1. We have cut our Q4 GDP forecast from -0.5%

to -0.8% qoq and our Q1 forecast from -0.6% to -1.2%. The

credit crunch is restricting the supply for credit. Risinguncertainty is reducing the appetite for investment

(business investment is starting to contract, adding to

declining housing and construction) and consumption.

Falling demand is pushing unemployment higher quickly,

reinforcing household sector retrenchment; declining house

prices will weigh on consumption too. At the same time,

foreign demand is contracting. For the next couple of

quarters, we believe this spiral will be largely unbreakable.

However, around the middle of 2009, activity will have fallen

below minimum levels and some catch-up activity should

then occur. This process is normally supported by an easier

policy environment. Looking into 2009, policy decisions

outside the euro area maybe as important as those athome. We expect GDP to grow 1% in 2010.

Sources: OECD, Eurostat, DB Global Markets Research


22/46



Euroland: A deep recession

Mark Wall, (44) 20 7545-2087

Inflation

World Economic Outlook December 08

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Transcript of World Economic Outlook December 08