2012 Outlook: Australian Equity Strategy

Company
Australasia Australia Strategy Update
24 January 2012
Australian Equity Strategy

Global Markets Research
2012 Outlook
We expect 2012 to be a better year for equities - While persistent earnings downgrades over the past 18 months have attracted much attention, it is worth noting that actual earnings have grown. The market has failed to rise in tandem because of a steady fall in price-earnings ratios (both trailing & forward). Absent the 2011 de-rate the ASX200 would be ~5000. - The global environment remains uncertain, but a lot is priced in. Over 2011, the trailing PE de-rated by 20%, and the earnings yield-bond yield gap has risen by 3ppt, to around record highs. Other episodes like this in the past 40 years have seen the market rise 15-20% over the following year. - Economic surprise indices have improved markedly, and earnings revision ratios are off their lows. Both have historically been good for equities. Further, investor positioning is defensive and should be unwound at some point. - We forecast the ASX200 to reach 4700 by year end. This is predicated on earnings being downgraded as much as 10%, and the PE re-rating to ~12x. This scenario essentially envisions 2012 making up the losses of 2011. We expect resource stocks to outperform, buoyed by Chinese growth Commodity prices have corrected substantially relative to the slowing in global growth, taking resource stocks with them. With Chinese growth close to bottoming, we are comfortable being O/W resources now. In the last cycle commodities & resource stocks bottomed as Chinese growth did not after. With inflation pressures in China quickly easing, we see scope for policy easing. Amongst industrials, cyclicals look cheapest but need to be selective - Cyclicals appear to be trading cheaply compared to defensives but we advise being selective given a range of sectors have ongoing challenges. Consumer spending is growing at normal rates, so it is not a reluctance to spend that is hurting retail & related sectors, it is a preference for services (+7% on pcp) over goods (0%). We see this as a structural trend, and thus prefer the services exposure on offer in air travel & gaming. - We continue to favour resource capex exposure - while the pipeline of work has been evident for some time, it is only recently that projects have begun to ramp up. We also see opportunities in offshore cyclicals (solid US growth, though tempered by AUD strength) and stocks with financial market leverage. Banks look okay low earnings risk, high dividend yield Credit growth is likely to remain moderate, but with solid cost control banks should be able to hit consensus forecasts of ~5% earnings growth. Funding costs have clearly risen, but can be passed on to borrowers in time. And given we see a solid, if uneven, domestic economy going forward, bad debts look more likely to fall than rise as the consensus expects. Tim Baker
Strategist (+61) 2 8258-1376 tim.baker@db.com
DB forecasts
24-Jan Jun-12 Dec-12 ASX200 index RBA cash rate 10-year bond yield AUD/USD 4224 4.25 3.89 1.05 4350 3.75 4.00 1.00 4700 3.75 4.50 1.00
David Jennings, CFA

Strategist (+61) 2 8258-1630 david.jennings@db.com
Deutsche Bank AG/Sydney All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.
24 January 2012
Strategy Australian Equity Strategy
Model portfolio
Figure 1
P'folio Wgt % Index Wgt % P'folio Wgt % Index Wgt % P'folio Wgt % Index Wgt %
Stocks
Santos OilSearch WorleyParsons BHP Billiton Rio Tinto Newcrest Adelaide Brighton Amcor Virgin Blue Boart Longyear NRW Holdings Seek Crown News Corp Woolworths Primary ANZ CBA Westpac Suncorp AMP Goodman Group Stockland Challenger Telstra
Industry
Energy
Sector
Energy
4.0 3.5 2.0 15.0 7.0 3.5 1.5 2.0 1.5 2.0 2.0 2.0 2.5 2.5 5.5 2.0 9.0 9.0 9.0 2.5 2.5 2.0 2.5 1.5 3.5
1.2 0.7 0.6 11.6 2.9 2.4 0.1 0.8 0.0 0.2 0.1 0.2 0.3 0.9 2.9 0.1 5.4 7.6 6.1 1.0 1.2 0.4 0.8 0.2 4.0
9.5
7.4
9.5
7.4
Mining Gold Steel Building materials Chemicals Paper & packaging Transport Infrastructure Contractors Commercial services Gaming Media Discretionary retailing Food retailing Food & beverages Healthcare Banks
22.0 3.5 0.0 1.5 0.0 2.0 1.5 0.0 4.0 2.0 2.5 2.5 0.0 5.5 0.0 2.0 27.0
18.8 3.6 0.5 1.0 1.6 0.9 1.9 1.3 2.3 1.2 1.5 1.4 0.8 6.8 1.1 3.4 25.3
Materials
29.0
26.1
Industrials
7.5
7.0
Cons. discretionary
5.0
3.7
Consumer staples Healthcare Financials
5.5 2.0 38.0
7.9 3.4 38.1
General insurance Wealth managers Property Diversified financials Info. technology Telecom services Utilities
2.5 2.5 4.5 1.5 0.0 3.5 0.0
2.9 1.2 6.7 2.0 0.6 4.3 1.6 Info. technology Telecom services Utilities 0.0 3.5 0.0 0.6 4.3 1.6
100.0
1 month Portfolio performance: ASX200 performance: Relative performance
Source: IRESS, Datastream, Deutsche Bank
100.0 100.0
3 months 1.3% 0.2% 1.1% 6 months -4.0% -5.9% 1.8% Since inception -2.6% -1.4% -1.2%
100.0 100.0
3.0% 2.0% 0.9%
Page 2
Deutsche Bank AG/Sydney
24 January 2012
Sector tilts and market forecast

Figure 2
Portfolio Weightings vs Benchmark

Energy Mining Gold Steel Chemicals Building Materials Contractors Transport Packaging Infrastructure Comm. serv. Media Gaming Discretionary retailing Food retailing Food & Beverages Utilities Telecoms Healthcare Banks General Insurance Wealth managers Div. financials Property
% pt
-3 -2 -1
Defensive ind.
1
Banks
Resources
Source: IRESS, Deutsche Bank
Cyclical ind.
Non-bank financials
The matrix below shows where the ASX200 index would end up given various assumptions about the forward price-earnings ratio, and the extent of downgrades to consensus earnings forecasts. Our forecast of 4700 is based on earnings downgrades of ~10% (largely the impact of spot commodity prices on mining earnings, but also further downgrades for industrials), and an expected PE re-rating to ~12x. Figure 3: Even with substantial downgrades, the market can move higher in 2012 End 2012 - ASX200 scenarios
20% d'grades for both yrs PE multiple 10x 11x 12x 13x 14x 3542 3896 4251 4605 4959 3764 4140 4516 4893 5269 3985 4383 4782 5180 5579 4206 4627 5048 5468 5889 4428 4870 5313 5756 6199 FY13F and FY14F EPS 15% d'grades 10% d'grades 5% d'grades for both yrs for both yrs for both yrs Current forecasts
Source: Datastream, IRESS, IBES, Deutsche Bank
Page 3
24 January 2012
The price-earnings ratio fell markedly through 2011

A large part of the reason for the lack of performance over the past two years has been the de-rating of the market PE multiple. While earnings were downgraded over the past 18 months, earnings have still risen over the period, whether we look at trailing or forward earnings. Caught between rising earnings and a falling PE ratio, the market could not manage to make gains. Interestingly, if the price-earnings multiple did not de-rate through 2011, and instead stayed at its December 2010 level, the ASX200 would currently be close to 5000. Figure 4: Over 2010 and 2011, earnings (both actual and forecast) have risen, but the PE ratio has steadily fallen
ASX200 forward PE and forward earnings 5100 4900 4700 4500 4300 4100 12m forward earnings (lhs) 12m forward PE (rhs) Index Earnings go up, PE ratio goes down
15 14 13 12 11 10 9
5000 4800 4600 4400 4200
ASX200 trailing PE and trailing earnings Index Earnings go up, PE ratio goes down
19
17
15
13 4000 Trailing earnings (lhs) Trailing PE (rhs)
3900 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12

Source: IBES, Datastream, Deutsche Bank
3800 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12
11
Figure 5: If there was no PE de-rating through 2011, the ASX200 would be ~5000
5500 5000 4500 4000 3500 3000

Jan-09
Index
ASX200 performance 5500 5000 4500 4000 ASX200 ASX200 if Dec 2010 fwd PE continued ASX200 if Dec 2010 trailing PE continued 3500 3000
Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
Source: Datastream, IBES, Deutsche Bank
Page 4
24 January 2012
Falling PEs have more than offset rising earnings over the past 2 years, leaving the market lower
The charts below show the annual performance of the ASX200, and the contributions from earnings growth and PE re-rating/de-rating. Through the bull market of 2003-2007, earnings drove the market higher, with the PE doing little. In 2008, earnings fell as the financial crisis took hold, and the price investors were willing to pay for actual and forecast earnings fell sharply. In 2009, risk sentiment improved and the PE re-rated even though earnings continued to fall. And then we have the past 2 years, with rising earnings offset by a falling PE ratio. Figure 6: The forward PE de-rated a lot in 2010 and 2011, dragging down the market
60 45 30 15 0 -15 -30 -45
ASX200 performance - contribution of forward earnings & PE multiple

%, pcp
60 45 30 15 0 -15 -30 -45
Forward earnings contribution Forward PE ratio contribution ASX200 performance
03
04
05
06
07
08
09
10
11
Figure 7: While earnings have been persistently downgraded, there has been growth
60 45 30 15 0 -15 -30 -45
ASX200 performance - contribution of trailing earnings & PE multiple

%, pcp
60 45 30 15 0 -15 -30 -45
Trailing earnings contribution Trailing PE ratio contribution ASX200 performance
03
04
05
06
07
08
09
10
11
Source: Datastream, Deutsche Bank
Page 5
24 January 2012
The de-rating has been quite sizeable by historical standards

This de-rating has been very large, with the trailing PE falling by almost 3 points over the past year. At 12x , the trailing PE is now at its lowest level since 1991, with the exception of the financial crisis. It could be argued that a trailing PE at this level is still quite high relative to the 1970s and 1980s. However we do not find this an appropriate comparison, as those decades were associated with high inflation and high bond yields. High interest rates lower equity valuations through higher discount rates and decrease the attractiveness of equities given bonds are an alternative asset. Simply, with a higher bond yield, the earnings yield tends to be higher, and thus the PE is lower (being the inverse of the earnings yield). Figure 8: Excluding the financial crisis, the trailing PE is at its lowest level in 20 years
25 x Australia PE ratio on last reported earnings 25
20
20
15
15
10
Big de-ratings shaded
10
5 71 74 77 80 83 86 89 92 95 98 01 04 07 10
In contrast, the current period is characterised by low inflation and rates, and thus we have tended to see a higher PE than in the 1970s and 1980s. Compared to bond yields, the equity earnings yield is currently very high, and has moved up substantially in the past 6 months. Figure 9: Bond yields have fallen recently, leading to a widening of the earnings yield-bond yield gap to high levels
18 15 12 9 6 3 0 71 74 77 80 83 86 89 92 95 98 01 04 07 10
* The difference between the trailing earnings yield and the 10yr govt bond yield
Australian equity and bond yields % Earnings yield 10 year govt bond yield
18 15 12 9 6 3 0
9 6 3 0 -3 -6 -9
ppts
Australian equity yield-bond yield gap* Equities cheap
9 6 3 0 -3
Large increases in yield gap shaded 71 74 77 80 83 86 89 92 95 98 01 04 07 10
-6 -9
Source: IRESS, Datastream, Deutsche Bank
Page 6
24 January 2012
Markets have tended to perform very well in the year following a sizeable de-rating
Over the past four decades, we find 9 episodes with such a large de-rating. During these episodes, the market has on average tended to rise by 7%in the year after this de-rating. And if we exclude the September 1973 episode, which was arguably part of the broader de-rating that continued into 1974, the market on average is up 15% a year after. So the market typically experiences a solid rally after such a de-rate. There have also been six episodes over the past four decades where the gap between the equities earnings yield and the bond yield has risen by 3ppts over a 6-month period. During these episodes, the market has on average tended to rise by 20% in the year following a large rise in the equity yield gap. Figure 10: The market usually performs well after a sizeable de-rating and a rise in the equity-bond yield gap
150 Market performance after 20% de-rating of trailing PE over previous 6m Index 150
150 140 Market performance after 3ppt rise in equity-bond yield gap over previous 6m 150 140 130 120 110 100 Jul-74 Feb-82 Jan-88 Average Nov-77 Aug-84 Nov-08 months 90 80 70
Index
125
125
130 120
100 Sep-73 Sep-77 May-84 Nov-88 Nov-08
100 110 Jul-74 75 Sep-81 Dec-87 Jul-94 Average months 50 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12

100 90 80 70
75
50
-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12
Note: zero refers to the month in which the trailing PE is 20% lower than it was 6 months previous, and the month in which the earnings yield-bond yield gap is 3ppt higher than it was 6 months previous Source: Datastream, IRESS, Deutsche Bank
Figure 11: Equties tend to perform well in the year after large de-ratings
Market performance after large PE de-ratings/move in yield gap 130 Index 3ppt rise in equity-bond yield gap over previous 6 mths 20% trailing PE de-rate over previous 6 mths 20% trailing PE de-rate ex Sep-73 outlier Current 130
120
120
110
110
100 months -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12
100
90
Source: Datastream, IRESS, Deutsche Bank
90
Page 7
24 January 2012
Overall, global economic data is taking on a better tone

Global economic data has been more positive of late, after disappointing expectations heavily through the middle of the year. The dataflow from the US has been particularly solid, with jobless claims falling, consumer sentiment edging up, and good growth in retail sales and durable goods. Figure 12: Economic data is not surprising negatively as it did a few months ago
100 75 50 25 0 -25 -50 -75 -100
Index
Economic surprise indices 5 months ago 2 months ago 4 months ago 1 month ago 3 months ago Current
Reading below zero indicates data has been below expectations
US
Euro area
UK
Canada
China
Japan
Australia
Source: Bloomberg Finance LP, Deutsche Bank
Of course some of the reduction in negative economic surprises has to do with economic forecasts being cut, rather than incoming data beating reasonable expectations. Europe falls into this category, where the incoming data remains weak, but not as unexpectedly weak as it was a few months ago. Regardless, markets do not tend to like negative surprises, so a pick-up in the economic surprise index is positive. The chart below shows a good correlation between economic surprises and equity market performance. Going ahead, this seems likely to continue, with good momentum in the US, and low expectations for Europe. Figure 13: The lack of negative data surprises has supported equity mkt performance
80 Index 40 0 -40 -80
Global economic surprise index and S&P500 Data surprise index (lhs) S&P500 (rhs)
4m% change
30 15 0 -15 -30 -45
-120 Jan-07 Aug-07 Mar-08 Oct-08 May-09 Jan-10 Aug-10 Mar-11 Oct-11
Page 8
24 January 2012
Earnings downgrades have abated quite a bit

The softer global outlook has prompted analysts to downgrade earnings forecasts. In the US, downgrades outnumbered upgrades by around three to one throughout September/October, following net upgrades in previous years. More recently, net downgrades in the US have slowed markedly, resulting in the earnings revision ratio turning up. Net downgrades have also abated a little in Asia and Europe. Figure 14: The pace of net earnings downgrades in the US has lessened substantially
0.6 0.3 0.0 -0.3 -0.6 -0.9
Ratio
Earnings revision ratios US Europe Asia ex Japan Australia
0.6 0.3 0.0 -0.3
Earnings revision ratios are off their lows
-0.6 -0.9
07
08
09
10
11
12
Note: Earnings revision ratio is number of stocks with earnings forecasts being upgraded minus number being downgraded, divided by the total Source: IBES, Datastream, Deutsche Bank
Over the past 15 years, equity markets have only typically started to recover after the worst of the earnings downgrades have been seen (i.e. earnings downgrades can still persist in upswings, but at a slower pace than before). As downgrades have started to abate, markets may continue to move higher in the next few months. Figure 15: The market has usually recovered after the worst of the downgrades
25 20 15 10 5 0 -5 -10 -15 -20 -25 -30 94 96 98 00 02 04 06 08 10 12
Note: Earnings revision ratio is number of stocks with earnings forecasts being upgraded minus number being downgraded, divided by the total Source: IBES, Datastream, Deutsche Bank
3 month%
S&P500 & earnings revisions S&P500 (lhs) Earnings revision ratio (rhs)
Ratio
0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8
Page 9
24 January 2012
Short positioning is high, and investors have cut risk exposure

Our US equity strategists see the demand-supply balance for US equities as being very favorable absent any new negative shocks. If the US manages to avoid a double-dip recession, demand for equities could increase significantly given the extent of short positions and the cutting of equities exposure by investors. Short interest across stocks, ETFs and futures still remains quite elevated, and hedge fund investors have low exposure to equities. Figure 16: Short interest in the US equity market remains quite elevated
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Source: Bloomberg Finance LP, Factset, Deutsche Bank
Futures, cash equities and ETF shorts as % of S&P500 market cap %
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Figure 17: . and hedge fund investors exposure to equities is at low levels
Hedge funds: 1-month rolling beta to the S&P500 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 06 07 08 09 10 11 Beta Macro hedge fund beta Equity long-short beta 0.8 1.10 0.6 1.05 0.4 1.00 0.2 0.95 0.0 0.90 -0.2 0.85 -0.4 0.80
06 07 08 09 10 11
Large cap mutual funds: 1-month rolling beta to the S&P500
Beta
1.10 1.05 1.00 0.95 0.90 0.85 0.80
Page 10
24 January 2012
Super funds and households remain conservatively positioned

Super finds continue to be fairly conservative in their investment decisions. They still hold a relatively high proportion of their assets as cash and deposits. Between solid additions to cash holdings and cash outperforming equities, cash holdings are now at record highs. This should provide some firepower for equities at some point, once super funds have more confidence in the outlook for global growth and market conditions. Figure 18: Super funds still hold a high proportion of their assets as cash and deposits
Superannuation Fund Financial Assets 60 50 40 30 20 10 0 89 92 95 98 01 04 07 10 90 93 96 99 02 05 08 11 % of total
Domestic equities Foreign equities Cash Fixed interest
60 50 40 30 20 10 0
Source: ABS, Deutsche Bank
Households continue to opt for the safety of deposits over buying shares. As a result, households exposure to cash and deposits are around levels seen during the early 90s recession and their exposure to shares is at a record low. It may be that the events of the past few years will continue to affect households for a while, and though they continue to get exposure through super, strong buying of shares outside of super may take some time. Indeed, following the 1987 crash, interest in shares remained depressed for several years. Figure 19: Households cash & deposit holdings are at elevated levels
60 50 40 30 20 10 0 89
Household Financial Assets, share of total

Cash and deposits Domestic equities Superannuation
60 50 40 30 20 10 0
91
93
95
97
99
01
03
05
07
09
11
Page 11
24 January 2012
2012 could see a re-rating of the market multiple

The PE has averaged close to 15x over the low inflation era, and was consistently around this level between 2002 and 2007. At present the multiple is around 11x, so at a sizeable discount to history. We dont believe the historic average is achievable, given it is based on resources trading above 16x from 1993-2003, and then banks trading at 13x from 2004-2007, neither of which seems achievable in a world with elevated commodity prices and lower credit growth. Nevertheless, 11x seems quite low (compared to bond yields for example), and we expect a gradual re-rate over 2012 to close to 12x. Figure 20: The Australian market is trading on a PE ratio of 10.2x
22
Australia PE on IBES 12 mths ahead expected earnings x

Low inflation era average
22
18
18
14
14
10
10.8x
10
6 88 90 92 94 96 98 00 02 04 06 08 10 12
Source: IBES, Datastream, MSCI, Deutsche Bank
Consensus expects solid earnings growth in FY12 and FY13, but with continual net downgrades since early 2010, these numbers are likely to be lowered. Still, we see FY13 earnings as being more achievable than FY12, based on our view of a firming in China and ongoing growth in the US. Figure 21: EPS growth in 2012-13 is expected to be fairly solid
Australia EPS growth 50 40 30 20 10 0 -10 -20 -30 -40 88 90 92 94 96 98 00 02 04 06 08 10 12

11 13
%, pcp
50
Cons. f'c
40 30 20 10 0 -10 -20 -30 -40
Source: IBES, MSCI, Datastream, Deutsche Bank
Page 12
24 January 2012
2012 outlook from our DB network of economists and strategists

Our global economists expect 2012 to see a turning point in the European sovereign crisis. Overall, they forecast world growth of 3.2% in 2012, rebounding to 4% in 2013. This is based on the house expectation that progress on the European sovereign issues will continue to be made and that confidence in the economy and markets will gradually return. By 2H12, we expect to see the completion of the new EMU ratification process and a change in market perceptions on the peripherals. Our European economists see the break-up of the euro area as unlikely, but think that resolution requires a stability architecture for the EMU and EU willingness to finance itself through the ECB. Arrangements will need to be made for EMU members to meet the real economy criteria for a common currency area. Following the adoption of the euro, the EMU was supported by cheap private credit in the boom years, and now by central bank credit. The ECB is expected to continue buying peripheral bonds, albeit at a measured pace. The euro area economies are anticipated to go into recession, with GDP to contract % in 2012. The next market crunch might appear in early 2012 when the sovereign issuance calendar picks up speed and there are elections in Greece and France. Other events include Greek PSI discussions and negotiations over a second bailout package, discussions on the fiscal compact, and progress on structural reforms. The US economy has seen a clear improvement in the data in the past couple of months, with the labour market gathering steam and early signs of a pickup in housing activity. Our US economists now expect the US economy to expand by 2% in 2012 and 3% in 2013. Still, although direct linkages with the euro area are modest, linkages through financial and confidence channels are important and represent a risk to the outlook for the US economy. Our US equity strategists see the S&P500 reaching 1500 by end 2012. This is based on the view that healthy corporate fundamentals, cheap valuations, dividend growth and a strong demand-supply balance will outweigh concerns about the risks. Our US strategist is constructive on the PE multiple in 2012 given that the current episode of risk aversion is one of the longest on record and given that the divergence between the multiple and its fair value is at an extreme. In China, growth has eased due to weaker exports and tight monetary policy. This deceleration should continue initially in 2012, but will be followed by a recovery as policy is eased. Inflation has fallen sharply and is expected to fall to 2% in 2Q12. In response, the PBoC is anticipated to cut the RRR 3-4 times this year. In annual terms, GDP growth is expected to come in at 8% in 2012 and 8% in 2013. The property sector is a concern, but sales should rebound due to improved affordability and policy easing. Incentives for first home buyers could include a reduction in the stamp duty, a reduction in the down-payment ratio or a discount to mortgage interest rates. Fiscal easing will probably be modest. Figure 22: 2012 should see firm growth in China and the US and recession in Europe
10 8 6 4 2 0 -2
% pcp
Real GDP forecasts 2011 2012 2013
World
Source: Deutsche Bank
China
US
Japan
Euro area
Page 13
24 January 2012
US macro data has been quite impressive in recent months

There has been a clear improvement in the US dataflow in recent months. Private payrolls have averaged ~150k since September, the unemployment rate has fallen to its lowest level since the start of 2009 and initial jobless claims are well below 400k. Meanwhile, the manufacturing ISM has stayed in expansionary territory, core durable goods orders have continued to grow solidly, and retail sales growth is quite strong. Despite the better-thanexpected data, our global economists have pointed to downside risks to the US economy emanating from imbalances in the housing market. Downward pressure on house prices means that the deleveraging process in the household and banking sectors will continue. Meanwhile, government deleveraging will weigh on growth for years to come. Figure 23: US jobs growth has been decent
500 400 300 200 100 0 -100 -200 -300 -400 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 000's, diff
Figure 24: The ISM surveys are comfortably above 50

500 400 300 200 100 0 -100 -200 -300 -400
US payrolls employment
Total Private
65 60 55 50 45 40 35 30 00
US ISM surveys
Index
65 60 55 50 45
Non-manufacturing Manufacturing
40 35 30 08 10 12
02
04
06
Figure 25: Business capex continues to expand

Core durable goods orders 000's
Figure 26: and consumer spending is solid

12 9 6 3 0 -3 -6 % yoy Retail sales values Total Retail sales ex autos 12 9 6 3 0 -3 -6 -9 -12 01 02 03 04 05 06 07 08 09 10 11 12
70 65 60 55 50 45 40
70 65 60 55 50 45 40
-9 -12
00 01 02 03 04 05 06 07 08 09 10 11 12
Page 14
24 January 2012
We expect conditions in China to improve as policy is eased

The Chinese economy has continued to decelerate in recent months owing to tighter monetary policy and weaker external demand. Year-ended GDP growth is expected to bottom at 7% in the June quarter, before rebounding in the second half of 2012. At DBs recent Access China conference, some of the speakers commented that the deceleration was structural in nature due to worsening income distribution. In contrast, other speakers noted that migration of technology-intensive production from OECD countries to China would lead to Chinese growth surprising to the upside this year. On inflation, feedback suggests that the surge in pork prices in 2011 was due to the mismanagement of the pork production cycle and that this would not be repeated due to increased subsidies for pork production. Easing inflation will give the PBoC scope to ease policy, potentially as early as coming weeks. Figure 27: GDP should rebound from 2Q12 Figure 28: PMIs show a reasonable pace of growth
70 65
12
14
yoy%
China GDP
DB f/c
14
Index
China PMI Non-manufacturing PMI Weighted avg PMI Manufacturing PMI
70 65 60 55 50 45 40 35
12
60 55
10
10
50 45 40
6 01 02 03 04 05 06 07 08 09 10 11 12 13
35 07 08 09 10 11 12
Source: Datastream, Bloomberg Finance LP, Deutsche Bank
Figure 29: Inflation is easing quickly

20 15 10 5 0 -5 -10 03 04 05 06 3 month annualised change 6 month annualised change Year-ended change 07 08 09 10 11 12 % China Consumer Price Index 20 15 10 5 0 -5 -10
Figure 30: which will provide room for policy easing

25
Reserve requirement ratio
25
20
20
15
15
10
10
0 87 89 91 93 95 97 99 01 03 05 07 09 11
Page 15
24 January 2012
Macro momentum in Europe suggests the region is in recession

The recent data flow out of Europe has been somewhat encouraging. The Euro PMIs have stabilised and are no longer suggestive of a free-fall in sentiment. This, combined with the depreciation of the euro, supports our European economists view that we will see a mild recession in the euro area, as opposed to a significant contraction in activity. However, we still need to see more progress in terms of government finances in the peripheral economies. Figure 31: PMIs have stabilized recently
Europe Manufacturing Purchasing Managers Indices UK 65 Index France 60 Germany 55 50 45 40 35 30 05 06 07 08 09 10 11 12
Figure 32: PMIs point to a recession, but not a deep one

Euro Area PMI and GDP growth 62 59 56 53 50 47 44 41 38 35 02 03 04 05 06 07 08 09 10 11 12
65 60 55 50 45 40 35 30
Index
yoy%
5 4 3 2 1 0 -1 -2 -3 -4 -5 -6
Composite PMI (lhs, adv 3 months) Euro area GDP (rhs)
Figure 33: Unemployment is drifting higher in GRE, ESP

25 20 15 10 5 0 05 06 07 08 09 10 11 12 Euro area unemployment rates Greece Portugal Total Spain Ireland 25 20 15 10 5
Figure 34: Competiveness issues remain

Euro area harmonised competitiveness indicator 140 iIndex Greece Spain 130 120 110 100 Germany France Ireland Italy
140 130 120 110 100 90
90 00 01 02 03 04 05 06 07 08 09 10 11 12
Page 16
24 January 2012
The sovereign bond crisis should remain a key theme of 2012

Our European economics team thinks that markets are unlikely to give the benefit of the doubt just yet, as the crisis of confidence has run very deep. Vulnerabilities remain, but our economists suggest that markets have underestimated the efforts of euro area governments. They remain constructive on the euro, do not think the euro area is likely to break up and think that reforms are underappreciated. Indeed, structural reforms could be a positive legacy of the crisis and have the potential to noticeably lift medium-term growth. Positive developments in recent months include positive discussions on the new fiscal compact, the ECBs 3 year LTRO operation and progress on structural adjustments. On the sovereign issuance calendar. The EFSF/IMF/ECB now have a combined firepower of EUR 685b, compared with ~EUR 510bn needed to fund Italy and Spain for all of 2012 & 2013. Figure 35: Heavy redemptions in 1Q12
Sovereign redemptions and coupon payments in 2012 EUR bn Italy and Spain Other EMU
Figure 36: The ECB has been supportive

250 200 150 100 50 0 May-10 ECB government bond purchases Weekly purchases (rhs) Cumulative (lhs) 25 20 15 10 5 0 Sep-10 Jan-11 May-11 Sep-11 Jan-12
200 160 120 80 40 0
EUR bn
EUR bn
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Figure 37: Bond spreads remain fairly elevated

3,500 3,000 2,500 2,000 1,500 1,000 500 0 Sep09 May10 Jan11 Sep11 Dec09 Sep10 May11 Jan12 European 10yr Bond Spreads to German Bunds Greece Ireland bps Portugal Italy Spain France 600 500 400 300 200 100 0
Figure 38: The Italian private sector is in good shape

45 40 35 30 25 20 15 10 5 0 Canada UK France Germany US Japan Italy
Household indebtedness, 2009 Liabilities as % of financial assets Liabilities as % of total assets
Source: OECD, Deutsche Bank
Page 17
24 January 2012
Growth in Australia should be supported by the mining boom

Growth in the Australian economy was slightly below-trend in 2011, with a sharp pick-up in business capex offsetting declines in government and housing investment. Looking ahead, GDP growth is expected to be 4% in 2012 and 3% in 2013. Although real GDP growth is anticipated to be above-trend, we will see softer nominal growth. Indeed, terms of trade shocks are nominal in nature. The falls seen in bulk commodity prices mean that the terms of trade will fall in the first half of 2012, flowing through to lower corporate profits and employment growth. The unemployment rate is expected to end the year around 5%. Figure 39: GDP growth is expected to be solid
12 Australia real and nominal GDP Real Nominal 12
Figure 40: Momentum in capex is particularly strong

25 20 Australia real GDP components Business capex Govt spend Household spending Housing investment 25 20 15 10 5 0 -5 -10 04 05 06 07 08 09 10 11
DB f/c
yoy%
15 10
5 0
-5 -10
-4 00 02 04 06 08 10 12
-4
Figure 41: The unemployment rate is low

7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 00 02 04 06 08 10 12 % Unemployment rate 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5
Figure 42: Confidence measures are around average

Business and consumer sentiment Index Deviation from avg
30 20 10 0 -10 -20 -30 -40
130 120 110 100 90
Business conditions (lhs) Business confidence (lhs) Consumer confidence (rhs) 89 91 93 95 97 99 01 03 05 07 09 11
80 70 60
Page 18
24 January 2012
An ongoing adjustment in household balance sheets continues

Solid income growth has allowed trend consumption growth at the same time has maintaining the saving rate at a high level. Our economists expect this situation to largely continue, as households delever their balance sheets. Debt to income is still quite high, so the process may take some time. We are less concerned about the high interest burden the rise has offset the simultaneous fall in the tax burden (due to years of tax cuts), and so household financial obligations are not far from average levels. House prices have fallen slightly over the past year, and a gradual adjustment as occurred in the first half of the 1990s seems the most likely course. Figure 43: Both incomes & spending are growing solidly
14 12 10 8 6 4 2 0 90 92 94 96 98 00 02 04 06 08 10 Household income and spending 14 12 10 8 6 4 2 0
Figure 44: A high saving rate is being maintained

20 16 12 8 4 0 -4 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
yoy%
Consumer spending Disposable income
Household saving rate
20 16 12 8 4 0 -4
Figure 45: Household debt has begun to edge down

Household Debt & Interest Share of household disposable income Debt Interest paid
Figure 46: House prices are likely to continue adjusting

ABS House Price Index Level % yoy
175 150 125 100 75 50 25
16 14 12 10 8 6 4
160 140 120 100 80 60 40 20
Index
% yoy
40 30 20 10 0 -10
83 88 93 98 03 08 84 89 94 99 04 09
Source: RBA, Deutsche Bank
0 87 90 93 96 99 02 05 08 11 88 91 94 97 00 03 06 09 12
Page 19
24 January 2012
Sector strategy
Page 20
24 January 2012
Resources still seem to offer the best earnings growth

All of the major sectors represent good value from a PE perspective, compared to historical averages. However, while the resources PE is well below average levels, this may reflect anticipation of earnings downgrades given where commodity prices are. Banks seem to be trading fairly cheaply also and are priced for flattish earnings, but we think this too downbeat. Turning to industrials, we think it is likely that there will be further earnings downgrades, given the structural challenges faced. Figure 47: Valuations are low across the board
30 25 20 15 10 5
Major sectors PE ratios on 12m forward earnings Industrials ex banks Banks Resources
30 25 20 15 10
11.4x 9.7x 10.0x
5 93 97 01 05 09 93 97 01 05 09 93 97 01 05 09
Resource sector earnings growth is expected to be strong, though this is predicated on a pick-up in commodity prices from here. Banks are expected to grow earnings only modestly over the next two years in line with a fairly subdued credit growth environment. Meanwhile, earnings forecasts for industrials remain fairly solid despite downgrades in recent months. Figure 48: Earnings growth is expected to be driven by resources once again
Major sectors EPS growth 30 20 10 0 -10 -20 95 99 03 07 11 95 99 03 07 11 95 99 03 07 11

%, pcp
Industrials (lhs)
Consensus f'casts 12 10
Banks (lhs)
Resources (rhs)
75 50
22
13
25 0 -25 -50
Page 21
24 January 2012
China housing is weak, but steel is used in other sectors also

Figure 49: Housing construction accounts for 1/3 of Chinese steel use
Housing construction is an important driver of steel demand in China, representing ~1/3 of Chinese steel use. However, there are other key sources of demand, such as manufacturing, infrastructure and nonresidential building.
50 45 40 35 30 25 20 15
Chinese steel consumption by use Infrastructure & non-res bldg Manufacturing etc Housing construction
Forecasts
50 45
37 34 30
40 35 30 25 20 15
05
06
07
08
09
10
11
Note: Commodity residential housing is housing sold at market prices
Source: Datastream, MySteel, CISA, CEK, Deutsche Bank
Figure 50: Our economists expect real estate FAI to bottom in 1Q12
Property sales have eased, which will lower real estate FAI. Our China economists see FAI bottoming in early 2012.
50 40 30 20 10 0 06 07
Real estate FAI vs residential property sales Real estate FAI (lhs) Sales volumes + 6mths (rhs)
100 80 60 40 20 0 -20 -40
08
09
10
11
12
Figure 51: Elsewhere, leading indicators point to a solid pace of growth

Overall, the Chinese economy still looks likely to experience a soft landing. The OECDs leading indicator points to ongoing solid growth in Chinese industrial production.
30 25 20 15 10 5 0
%, yoy
China Industrial Production Industrial production OECD leading indicator + 4m
30 25 20 15 10 5 0
91
93
95
97
99
01
03
05
07
09
11
Page 22
24 January 2012
Commodity prices have corrected more than global IP

Figure 52: Metal prices remain most closely correlated to industrial production
While there is some relationship to real estate FAI, industrial production has historically provided the best guide to commodity price movements.
24 20 16 12 8 4
%yoy
China industrial production and metal prices IP (lhs) Metal prices (rhs)
%yoy
120 80 40 0 -40 -80
01
02
03
04
05
06
07
08
09
10
11
12
Figure 53: Metal prices have weakened more than global industrial production
Over the past 80 years, there has been a solid relationship between industrial production and metal prices. At present, metal prices have corrected substantially more than global IP.
5 4 3 2 1 0 -1 -2 -3 -4
SD of growth from 10yr avg
World industrial production and metal prices

Metal prices Industrial production
5 4 3 2 1 0 -1 -2 -3 -4 -5
-5 1930
1940
1950
1960
1970
1980
1990
2000
2010
Note: Industrial production data is world back to 1990, then G7 from 1960 to 1990. From 1948 to 1960 world is proxied by the US and UK, and prior to 1948 is proxied by the US. Metal price data is the MG series back to 1950, and the Grilli-Yang seris prior to that. Data are presented as the year-on-year growth rate as a standard deviation from the growth rate of the past 10 years. This accounts for the different levels of volatility in the series over time IP was much more volatile in the early part of the history than in the latter part, while the opposite holds for metal prices Source: Grilli-Yang, US BEA, Deutsche Bank
Figure 54: Metal prices have also weakened more than Asian industrial production
Another way of looking at this relationship is focusing on IP growth in Emerging Asia. Metal prices have overreacted relative to Asian demand also.
25 20 15 10 5 0 -5 -10 -15 93
Emerging Asia industrial production and metal prices

3m/3m, annual.
3m/3m, annual.
150 100 50 0 -50
IP (lhs) Metal prices (rhs) 95 97 99 01 03 05 07 09 11
-100 -150 -200
Page 23
24 January 2012
With China growth bottoming, resources should start to perform

Figure 55: GDP, PMI and steel production all bottomed in the December quarter 2008
Looking at the last cycle, a range of indicators point to Chinese growth bottoming in the December quarter of 2008, as trade finance dried up following the intensification of the financial crisis.
16 14 12 10 8 6 4 2
China GDP, PMI & steel production, June 2007 to June 2010 Index GDP qoq% annual. (lhs) Steel production (rhs) PMI (rhs)
62 58 54 50 46
Chinese growth bottomed in Nov 08 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09
42 38 Jun-10
0 Jun-07
Figure 56: Resource stocks & commodities bottomed as China did, not after
Resource stocks (in relative terms) and commodity prices also bottomed in the December quarter. By the time the economic data had been released, and stronger growth had ensued, outperformance had already begun.
16 14 12 10 8 6 4
China GDP & mining share prices, June 2007 to June 2010 Index GDP qoq% annual. (lhs) AUS mining sector rel. to market (rhs)
140
130
120
110
Mining sector rel. performance bottomed in Oct 08
2 Jun-07
Dec-07
Jun-08
Dec-08
Jun-09
Dec-09
100 Jun-10
Figure 57: Our economists expect Chinese growth to bottom in 1Q12

Our economists expect Chinese GDP growth to bottom in 1Q12. Given resource stocks and commodity prices have already staged a substantial correction, we see now as a good time to get set.
12 11 10 9 8 7
China GDP & resource sector performance Index GDP qoq% annual. (lhs) Resource sector rel. performance (rhs)
140 135 130 125 120 115
DB f'casts
6 Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Page 24
24 January 2012
Oil should be supported by geopolitical tensions

Figure 58: Oil demand has eased over the past year, though EM have provided support
On the demand side, growth from the developed world has fallen over the past year, but this has been offset by ongoing solid demand from emerging markets.
9 6 3 0 -3 -6 96
yoy%
Non-OECD
Oil and Gas Consumption

OECD
World
9 6 3 0 -3 -6
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
Source: IEA, Deutsche Bank
Figure 59: Oil should be supported by geopolitical tensions and low spare capacity
Low OPEC spare capacity may be tested with geopolitical tensions in Iran, Nigeria, Libya and Venezuela.
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 07
mmb/d
OPEC excess capacity Saudi Arabia Other
08
09
10
11
12
Source: US DOE, EIA, Deutsche Bank
Figure 60: Gold is likely to benefit from low interest rates and quantitative easing
The persistence of negative real interest rates will sustain the appeal of holding gold, as will central bank gold buying in response to Euro debt concerns.
100 80 60 40 20 0 -20 -40 -60 71
% yoy
US real interest rates and the gold price Gold spot return (lhs) US real interest rate (rhs) %
-9 -6 -3 0 3 6 9
76
81
86
91
96
01
06
11
Page 25
24 January 2012
Cyclicals appear cheap, particularly those with domestic focus

Figure 61: Cyclicals are trading at a sizeable discount to defensives
With the poor market performance and concerns over further downgrades to company earnings, cyclicals are now trading at a large discount to defensives. With our more positive market view, we are inclined to be overweight cyclicals. The question is which cyclicals?
20 18 16 14 12 10 8 03
Industrials PE ratios on 12m forward earnings* Cyclicals - median Defensives - median
20 18 16 14 12 10 8
04
05
06
07
08
09
10
11
12
*Industrials comprise the market excl. resources and banks. Cyclicals comprise non-mining materials, industrials (GICS), consumer discretionary, wealth managers & diversified financials. Defensives comprise consumer staples, healthcare, telecoms, utilities, general insurance & property Source: Datastream, Deutsche Bank
Figure 62: Cyclicals PEs are low across the board, with domestic cyclicals the cheapest
Most cyclicals look quite cheap relative to history, though domestic cyclicals stand out as offering the most value. However, accounting for lower forecast growth in FY13 (see fig 63), and a worse earnings track record, we are cautious.
22
Cyclical industrials - PE ratios on 12m forward consensus earnings*
22
18
18
14 Domestic cyclicals Financial mkt related Mining related Offshore cyclicals 03 04 05 06 07 08 09 10 11 12
14
10
10
*Offshore cyclicals is the median of AMC, BBG, BXB, JHX, NWS. Financial mkt-related is the median of AMP, ASX, CGF, CPU, MQG, PPT. Resource-related is the median of AIO, BLY, BSL, CPB, DOW, IPL, LEI, MND, ORI, OST, QRN, SGM, TSE, UGL, WOR. Domestic cyclicals is the median of stocks in non-mining materials, industrials (GICS), and consumer discretionary that are not already in other categories. Source: Datastream, IBES, Deutsche Bank
Figure 63: EPS growth is expected to be strong for cyclicals

Rather than broad-based buying of cyclicals, we advise being quite selective. Resource-related stocks are our preferred exposure, but other selected cyclicals also look interesting.
30 20 10 0 -10 -20 -30
ASX100 industrials EPS growth

Resources-related 16 13 Market-related 15 4
30 20 10 0
Domestic cyclicals Offshore cyclicals 19 18 12 0
Consensus f/c
-10 -20 -30
08
10
12
09
11
13
08
10
12
09
11
13
*Offshore cyclicals is the median of AMC, BBG, BXB, JHX, NWS. Financial mkt-related is the median of AMP, ASX, CGF, CPU, MQG, PPT. Resource-related is the median of AIO, BLY, BSL, CPB, DOW, IPL, LEI, MND, ORI, OST, QRN, SGM, TSE, UGL, WOR. Domestic cyclicals is the median of stocks in non-mining materials, industrials (GICS), and consumer discretionary that are not already in other categories Source: IBES, Deutsche Bank
Page 26
24 January 2012
The composition of GDP growth is challenging some sectors

Figure 64: Excluding trade and govt spend, the Australian economy has been solid
While real GDP growth has been below trend, this is due to trade disruptions and slowing government spend. Growth elsewhere has been actually solid, suggesting that companies that are finding conditions difficult are more likely to be facing structural challenges.
9 6 3 0 -3 89
% yoy
GDP GDP ex trade & govt (private final demand)
Australia GDP
9 6 3 0 -3
91
93
95
97
99
01
03
05
07
09
11
Figure 65: Capex is the key driver of growth, with support from household spend
The biggest contributor to growth has been business capex. Consumer spending has been quite solid, while government spending and housing investment have fallen over the past year.
25 20 15 10 5 0 -5 -10 04
yoy%
Australia real GDP components Business capex Govt spend Household spending Housing investment
25 20 15 10 5 0 -5 -10
05
06
07
08
09
10
11
Figure 66: The pipeline remains very large, underpinning work for the next few years
Elevated commodity prices continue to support massive investment plans in the resources sector. There is still a very large pipeline of projects, particularly in oil & gas, and this should underpin work for the next few years.
80 60 40
$b
Engineering construction Resources

Yet to be done Completed
Infrastructure
$b
50 40 30 20
20 0 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11
10 0
Page 27
24 January 2012
Non-discretionary spending it outpacing discretionary spending

Figure 67: Consumer spend is solid, but the composition is different to history
Contrary to some reports, household spending growth is running around long-run averages. Thus, the main challenge for companies hasnt been a lack of consumer spending, but where the spending is going.
10 9 8 7 6 5 4 3 2 1 0
% yoy
Household spending - values

Year to September Long-run average
Total
Non-discretionary
Discretionary
Discretionary goods
Discretionary services
Figure 68: Non-discretionary spending is taking a rising share of household income

Non-discretionary spending (e.g. housing, food, utilities) is outpacing discretionary (+7% vs +4%), boosted by inflation in categories such as housing and utilities. This seems likely to continue.
12 10 8 6 4 2 0 -2 -4
yoy%
Non-discretionary household spending

Prices Volumes Values
12 10 8 6 4 2 0 -2 -4
90
92
94
96
98
00
02
04
06
08
10
Note: Non-discretionary spending comprises food, tobacco, alcohol, housing costs, utilities, healthcare, operation of vehicles, communications, education & financial services. Source: ABS, Deutsche Bank
Figure 69: Discretionary spend is modest, with moderate volume growth and deflation
Discretionary spending (e.g. clothing & footwear, cars, furniture) has been a bit softer than in the past, held back by deflation in a range of categories.
12 10 8 6 4 2 0 -2 -4
Discretionary household spending yoy%

Prices Volumes Values
12 10 8 6 4 2 0 -2 -4
90
92
94
96
98
00
02
04
06
08
10
Note: Discretionary spending comprises clothing & footwear, furnishings & household equipment, vehicle purchases, transport services, recreation & culture, cafes & restaurants and other. Source: ABS, Deutsche Bank
Page 28
24 January 2012
Spending on discretionary services is growing quite strongly

Figure 70: Within discretionary spending, services is growing much more than goods
Spending on discretionary goods, where listed companies have more exposure, has been quite poor. All of the strength has been concentrated in services.
15 12 9 6 3 0 -3 -6
Discretionary household spending - values yoy%
15 12 9 6 3 0
Goods
Services
-3 -6 06 08 10
90
92
94
96
98
00
02
04
Note: Discretionary spending comprises clothing & footwear, furnishings & household equipment, vehicle purchases, transport services, recreation & culture, cafes & restaurants and other Source: ABS, Deutsche Bank
Figure 71: The divergence between services and goods is broad-based

The discrepancy between goods and services is broadbased, with five of the six fastest-growing discretionary categories being services-oriented. Thus, we prefer exposure to services (air travel, gaming) over goods (retail, transport).
Discretionary household spending - September quarter 2011 Cafes & restaurants Transport Gambling Accommodation Hardware/phones Sports/entertainment/internet Furniture Total Electronics Goods Newspapers & books Services Electrical appliances Cars Clothing & footwear % pcp -6
-3
12
Figure 72: Listed retailers with exposure to consumer experiences are doing better
These trends are consistent with recent reports from listed retailers. The larger retailers who sell clothing and electrical items are struggling, but those with exposure to household activities are reporting reasonable growth.
Super Retail's outdoor Super Retail's sporting Bunnings Super Retail's auto Kathmandu Premier Kmart JB Hi-Fi Harvey Norman Target Big W Specialty Fashion Myer David Jones
Retailer comparable store sales, latest data*

7.8 6.3 3.5 2.8 0.9 0.5 -1.8 -2.8 -4.1 -4.2 -4.5 -5.1 -11.0 %, pcp
9.9
-12
-10
-8
-6
-4
-2
10
*Dec half for Super Retail & Specialty Fashion, Oct qtr for DJS & MYR, Sept qtr for Big W, Target, HVN, Kmart, Bunnings, 5 months to Nov for JBH, July half for PMV, Source: Company data, Deutsche Bank 20 weeks to 19th Dec for KMD.
Page 29
24 January 2012
Banks dont look very cheap, but dont have much earnings risk
Figure 73: Banks have outperformed, and are no longer looking as cheap
At a touch under 10x, banks look cheap relative to history. But on a relative basis the value is not as apparent, with the discount to industrials a little under 20%. Still, banks probably have less earnings risk than a range of industrials, and so are likely to perform relatively well.
22 20 18 16 14 12 10 8 6 4 88
PE on 12mth forward earnings

Banks Industrials ex banks
22 20 18 16 14 12 10 8 6 4 12
Low inflation-era average (1993-)
90
92
94
96
98
00
02
04
06
08
10
Figure 74: The market is pricing downgrades for banks, which we think unlikely
This chart suggests that the market is pricing ~5% earnings downgrades for banks. Consensus estimates of ~5% EPS growth in FY12 and FY13 seem conservative enough to us, and we think the market is too negative on the sector.
18 16 14 12 10 8
Banks PE and earnings revisions PE (lhs) Change in 12m fwd eps over next 4 months (rhs)
25 20 15 10 5 0 -5 -10 -15
00
02
04
06
08
10
Figure 75: Bank earnings forecasts have typically been more resilient than industrials
Bank earnings forecasts have been more resilient than industrials over the past couple of years, and this has been the case over the past 15 years too. Earnings forecasts for industrials are, on average, trimmed over the cycle, whereas banks do not see net downgrades.
0.6 0.3 0.0 -0.3 -0.6 -0.9
Index
Earnings Revision Ratio, 12mma Banks Industrials ex banks
0.6 0.3 0.0 -0.3
Over the cycle, industrials tend to have net earnings downgrades - banks do not
-0.6 -0.9
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Page 30
24 January 2012
Credit growth in Australia has been modest

Figure 76: Credit growth has been modest, though the majors are outperforming
Credit growth has been running a little above 3% over the past year, which is well below rates seen prior to the financial crisis. We expect this pace of credit growth to be largely maintained.
30 25 20 15 10 5 0 -5 -10 -15 95
3 month growth annualised %
Credit Growth
Total Housing Business
30 25 20 15 10 5 0 -5 -10 -15
97
99
01
03
05
07
09
11
Source: RBA, Deutsche Bank
Figure 77: No further pick-up in credit growth is required for trend economic growth
The credit impulse (the change in credit growth) is currently around zero, which supports spending growth of ~5%. Thus the economy can expand solidly even without a ramp-up of credit growth.
10 8 6 4 2 0 -2 -4 77
yoy%
Credit and real private spending growth

Private final demand (real,lhs) Credit impulse (rhs)
yoy% 10
5 0 -5 -10 -15
f/c
80
83
86
89
92
95
98
01
04
07
10
13
Source: RBA, ABS, Deutsche Bank
Figure 78: Bank margins are performing well, despite concerns about funding costs
Margin performance has been solid in recent halves, thanks to strong deposit growth. And our banking analysts think that margins will hold up well in 2012, despite concerns about rising wholesale funding costs.
4.5 4.0 3.5 3.0 2.5 2.0 1.5
Major Banks' Net Interest Margin
4.5 4.0 3.5

DB f'c
3.0 2.5 2.0 1.5
89
91
93
95
97
99
01
03
05
07
09
11
13
Source: Company data, Deutsche Bank
Page 31
24 January 2012
Dividend yields are appealing and bad debt concerns overstated

Figure 79: A further earnings boost could come up if bad debts fall
Bad debts havent dropped as much as had been expected due to the natural disasters. And now analysts generally dont expect any further improvement given concerns about the economy. But with our view that the economy overall will be solid (notwithstanding pain in certain sectors), we think bad debts are more likely to decline.
300 250 200 150 100 50 0
bps
Bad debts and GDP growth

Bad debts to non-housing gross loans (lhs) GDP +1yr, inverted (rhs)
yoy%
-3 -2 -1 0 1 2 3 4 5 6
DB f/c
89
91
93
95
97
99
01
03
05
07
09
11
13
Source: ABS, Company data, Deutsche Bank
Figure 80: Banks offer an attractive dividend yield compared to industrials

Give the recent share price softness, bank dividend yields are close to record highs. Banks offer an attractive dividend yield compared to industrials.
15%
Forward dividend yields (grossed-up) Banks Industrials ex LPTs
15%
12%
12%
9%
9%
6%
6%
3% 95 97 99 01 03 05 07 09 11
Source: Company data, Deutsche Bank
3%
Figure 81: Australian banks have held up well during times of financial stress
There is concern that a ramp-up of European financial problems could hurt Australian banks. But the banks have held up relatively well during times of financial stress. While funding costs have risen, the banks should be able to pass this onto borrowers in time.
120 110 100 90 80 70 60 50 40 30 20 07
Index
Banking sector relative performance* Australia US Europe
120 110 100
Lehman Brothers bankruptcy
Euro and US sovereign debt concerns
90 80 70 60 50
Bear Sterns
Greek funding crisis

40 30 20 11 12
*Bank return indices relative to market return indices
08
09
10
Page 32
24 January 2012
COMPANIES MENTIONED LIST

Cod e ABC AIO AMC AMP ANZ ASX BBG BHP BLY BSL BXB CBA CGF CPB CPU CWN DJS DOW GMG HVN IPL JBH JHX KMD LEI MND MQG Stock n am e Adelaide Brighton Ltd Asciano Ltd Amcor Ltd Amp Ltd Australia and New Zealand Banking Group ASX Ltd Billabong International Ltd BHP Billiton Ltd Boart Longyear Ltd Bluescope Steel Ltd Brambles Ltd Commonwealth Bank of Australia Challenger Ltd Campbell Brothers Ltd Computershare Ltd Crown Ltd David Jones Ltd Downer EDI Ltd Goodman Group Harvey Norman Holdings Ltd Incitec Pivot Ltd JB Hi-Fi Ltd James Hardie Industries Se Kathmandu Holdings Ltd Leighton Holdings Ltd Monadelphous Group Ltd Macquarie Group Ltd L ast pri ce 3.09 4.71 6.99 4.27 20.87 30.54 1.99 37.24 3.40 0.43 7.24 49.74 4.52 49.25 7.80 8.18 2.42 3.52 0.66 2.05 3.24 12.00 7.40 1.24 22.70 21.81 24.93 Co de MYR NCM NWH NWS ORI OSH OST PMV PPT PRY QRN RIO SEK SFH SGM SGP STO SUL SUN TLS TSE UGL VBA WBC WOR WOW Sto ck n am e Myer Holdings Ltd Newcrest Mining Ltd Nrw Holdings Ltd News Corporation Orica Ltd Oil Search Ltd Onesteel Ltd Premier Investments Ltd Perpetual Ltd Primary Health Care Ltd QR National Ltd Rio Tinto Ltd Seek Ltd Specialty Fashion Group Ltd Sims Metal Management Ltd Stockland Santos Ltd Super Retail Group Ltd Suncorp Group Ltd Telstra Corporation Ltd Transfield Services Ltd UGL Ltd Virgin Blue Holdings Ltd Westpac Banking Corporation WorleyParsons Ltd Woolworths Ltd L ast pri ce 2.11 32.20 2.83 18.85 25.00 6.66 0.84 4.75 20.82 2.96 3.69 67.89 5.49 0.43 14.78 3.35 13.57 5.77 8.31 3.32 2.06 13.87 0.36 20.46 27.51 24.73
Source: Deutsche Bank
Page 33
24 January 2012
Appendix 1
Important Disclosures Additional information available upon request
For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Tim Baker
Equity rating key Buy: Based on a current 12- month view of total shareholder return (TSR = percentage change in share price from current price to projected target price plus projected dividend yield ) , we recommend that investors buy the stock. Sell: Based on a current 12-month view of total shareholder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Notes: 1. Newly issued research recommendations and target prices always supersede previously published research. 2. Ratings definitions prior to 27 January, 2007 were: Buy: Expected total return (including dividends) of 10% or more over a 12-month period Hold: Expected total return (including dividends) between -10% and 10% over a 12-month period Sell: Expected total return (including dividends) of 10% or worse over a 12-month period
Equity rating dispersion and banking relationships
140 120 100 80 60 40 20 0
47 %
50 %
23 %
24 %
3% 0%
Sell
Buy
Companies Covered
Hold
Cos. w/ Banking Relationship
Australia Universe
Page 34
24 January 2012
Regulatory Disclosures 1. Important Additional Conflict Disclosures

Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.
2. Short-Term Trade Ideas

Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com.
3. Country-Specific Disclosures
Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Securities Investment Advisers Association. Commissions and risks involved in stock transactions - for stock transactions, we charge stock commissions and consumption tax by multiplying the transaction amount by the commission rate agreed with each customer. Stock transactions can lead to losses as a result of share price fluctuations and other factors. Transactions in foreign stocks can lead to additional losses stemming from foreign exchange fluctuations. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless Japan is specifically designated in the name of the entity. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation.
Page 35
Deutsche Bank AG/Sydney International locations

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The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report. Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. As a result of Deutsche Banks March 2010 acquisition of BHF-Bank AG, a security may be covered by more than one analyst within the Deutsche Bank group. Each of these analysts may use differing methodologies to value the security; as a result, the recommendations may differ and the price targets and estimates of each may vary widely. In August 2009, Deutsche Bank instituted a new policy whereby analysts may choose not to set or maintain a target price of certain issuers under coverage with a Hold rating. In particular, this will typically occur for "Hold" rated stocks having a market cap smaller than most other companies in its sector or region. We believe that such policy will allow us to make best use of our resources. Please visit our website at http://gm.db.com to determine the target price of any stock. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. 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2012 Outlook: Australian Equity Strategy

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Company

Australasia Australia Strategy Update

Australian Equity Strategy

David Jennings, CFA

Strategy Australian Equity Strategy

Consumer staples Healthcare Financials

5.5 2.0 38.0

7.9 3.4 38.1

2.5 2.5 4.5 1.5 0.0 3.5 0.0

3.0% 2.0% 0.9%

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

Sector tilts and market forecast

Portfolio Weightings vs Benchmark

Source: Datastream, IRESS, IBES, Deutsche Bank

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

The price-earnings ratio fell markedly through 2011

5000 4800 4600 4400 4200

13 4000 Trailing earnings (lhs) Trailing PE (rhs)

3900 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12

3800 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12

5500 5000 4500 4000 3500 3000

Source: Datastream, IBES, Deutsche Bank

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

60 45 30 15 0 -15 -30 -45

ASX200 performance - contribution of forward earnings & PE multiple

60 45 30 15 0 -15 -30 -45

Forward earnings contribution Forward PE ratio contribution ASX200 performance

Source: IBES, Datastream, Deutsche Bank

60 45 30 15 0 -15 -30 -45

ASX200 performance - contribution of trailing earnings & PE multiple

60 45 30 15 0 -15 -30 -45

Trailing earnings contribution Trailing PE ratio contribution ASX200 performance

Source: Datastream, Deutsche Bank

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

The de-rating has been quite sizeable by historical standards

Australian equity yield-bond yield gap* Equities cheap

Large increases in yield gap shaded 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Source: IRESS, Datastream, Deutsche Bank

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

100 Sep-73 Sep-77 May-84 Nov-88 Nov-08

100 110 Jul-74 75 Sep-81 Dec-87 Jul-94 Average months 50 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

Overall, global economic data is taking on a better tone

100 75 50 25 0 -25 -50 -75 -100

Reading below zero indicates data has been below expectations

Source: Bloomberg Finance LP, Deutsche Bank

80 Index 40 0 -40 -80

30 15 0 -15 -30 -45

Deutsche Bank AG/Sydney

Strategy Australian Equity Strategy

Earnings downgrades have abated quite a bit

0.6 0.3 0.0 -0.3 -0.6 -0.9

Earnings revision ratios US Europe Asia ex Japan Australia