Sweet spot until tightening bites.  We expect the cyclical bull market to continue for three reasons. We believe we are at the start of an earnings growth cycle; equity valuations are still attractive vs. interest rates; and sentiment is not ultra-bullish yet. We see 9% upside to our bull case of a mid-cycle multiple on mid-cycle earnings of 15x 12% ROE. That equates to 1200 on MSCI Europe. Above that, risk-reward could deteriorate rapidly, as this is unlikely to be a normal cycle.   

We expect late cyclicals - particularly materials and energy - to outperform soon.  On average, the low in late-cyclical relative performance has been six months prior to the first Fed hike.  They generally underperform during the early stages of recovery, but as early rallies progress and we start to approach potential Fed tightening, these sectors tend to outperform. In our portfolio, we are overweight energy, metals, and industrials.

An EM-led global expansion means a commodity-intensive global expansion.  We believe the world will see, within the next 2-3 years, a historic transition: emerging economies' share of global GDP will exceed that of the developed economies.  That's good for commodity suppliers.  It may also mean that commodities - particularly energy - become a constraint sooner in this cycle than in previous cycles.  

Sweet spot until tightening bites.  We expect the cyclical bull market to continue for three reasons. We believe we are at the start of an earnings growth cycle; equity valuations are still attractive vs. interest rates; and sentiment is not ultra-bullish yet. We see 9% upside to our bull case of a mid-cycle multiple on mid-cycle earnings of 15x 12% ROE. That equates to 1200 on MSCI Europe. Above that, risk-reward could deteriorate rapidly, as this is unlikely to be a normal cycle.   

Compiling a menu of rate hedges.  We continue to believe one of the largest challenges credit investors face will be navigating through a secular rise in risk-free rates.  Thus, we have gathered together              a menu of strategies that we believe will increasingly be employed through 2010 as credit investors come to grips with the likely reality of a secular reversal in Treasury yields serving as a headwind to continued credit market healing.   

We conclude our two-part series on Sources of Competitive Advantages in EM by naming the companies with the Best Business Models in each of 26 different industry groups.  The List offers broad exposure to high-quality stocks in EM for the long run. From 1998, an equal-weighted portfolio made up of these names has outperformed the MSCI EM index ex-Financials each year, with relative outperformance of over 1,000%.  

The liquidity-driven leg of the rally in risky assets may be nearing an end, and as a result, the sensitivity of risky-asset performance to rates has increased.  For example, the tight level of credit spreads is more sensitive to rates, unless you think we will return to 2006-07 levels. The performance of equities is similarly affected. We expect rates to remain low for now but then sharply reverse higher at the start of 2010. Playing for this reversal is at the heart of our tactical view. 

While the pace of the US dollar decline is likely to slow, we anticipate no change in the trend.  In recent weeks, G20 policymakers have been more active in attempts to smooth volatility in the USD.  Officials are likely to continue engaging in verbal intervention, but we believe that coordinated FX intervention is not imminent, partly due to the fundamental explanations for USD weakness.  We continue to forecast another 5% decline in the trade-weighted USD. 

Indian equities in a sweet spot, but the pace of gains is likely to slow. We reckon that Indian equities are in a sweet spot with low institutional ownership, strong liquidity, prospects for growth, strong corporate balance sheets, and stable politics. Our Dec-2010 target for the Sensex (19,400) suggests upside of 19%, reflecting a slower pace of gains after the impressive performance we have seen over the past six months.

Subpar potential growth to take a further hit.  Like other advanced economies, Italy appears to be past the worst of the global recession.  But the damage to both labour productivity and the labour force is likely to be substantial.  We estimate that Italy's potential growth rate will be negative this year and the next, and remain at around 1% between 2011 and 2014.  Italy is likely to go through a prolonged period of disinflation, but we believe it will escape outright deflation.

Korea's third-quarter GDP beat expectations by a wide margin.  Real GDP growth came in at +0.6% year over year, showing that the economy has already climbed back to the pre-crisis level.  On a seasonally adjusted quarter-to-quarter basis, 3Q growth was +2.9%, even higher than +2.6% in 2Q.  The stronger sequential growth in 3Q is the biggest upside surprise, as it indicates that Korea's recovery has extended beyond global restocking in 2Q.

Excess reserves are elevated on central bank balance sheets.  Do they pose any risk to policy or the macroeconomy?  If central banks manage the process of draining excess reserves efficiently or set the right incentives to control their movement, then clearly even a large stock of reserves poses little risk to the macroeconomy.  However, like many of the dilemmas facing central banks today, such a balanced exit is far from a foregone conclusion.  

The pace of economic growth in 3Q09 is robust and the economic recovery is on track, but not yet overheating, calming fears of an imminent tightening of policy stance.  We continue to believe that the authorities are committed to policy stability so as to uphold private sector confidence, and we expect the growth-supportive policy stance to be maintained until mid-2010.  We believe an RRR hike, base interest rate hike, or renminbi appreciation are unlikely until 2H 2010. 

We don't see Fed officials changing policy any time soon.  But they know that effective communication is more critical than ever as they craft the exit strategy from an ultra-accommodative stance.  Market participants want the Fed to clarify its views about the outlook and about the circumstances in which the Fed will unwind its stance.  That will help reduce uncertainty about the implications of the exit process for financial markets. 

...But a long way before rate hikes becomes restrictive, in our view.  We expect a moderate rise in the weighted average policy rate in the region to 5.7% by end-December 2011 compared to an expected 4.4% at year-end 2009.  Core inflation is still at 0.8% year over year, as capacity utilization is not at level where it starts causing inflationary pressure.  We see upside risk to our growth and policy rate forecasts. 

India's central bank gave a clear indication that monetary-policy reversal is beginning, although it made no change in policy rates.  We maintain our view that the RBI will lift policy rates by 25 bp in January 2010.  By then, we believe the RBI will have adequate comfort in pace of recovery.  We don't think this potential rate hike is likely to derail recovery, however, as we see an increase in policy rates as a move toward normalization rather than tightening that hurts growth.

The outcome of tax-reform negotiations has crucial fiscal implications.  Absent firm efforts to contain spending growth, in its current form the revised tax proposal may not go far enough in reversing the deteriorating medium-term fiscal trend.  Looking beyond the immediate fiscal challenge, we believe that the best test of Mexico's success would be to keep advancing its structural reform agenda to boost competitiveness.

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