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The Great Rebalancing

David WyssChief EconomistStandard & Poor’s

July 24, 2008

2.



The World Is Being Rebalanced

• World financial markets are undergoing an enormous relative shift

• Incomes in the developed world are rising slowly,

• While most of the emerging markets are growing rapidly.

• Wealth is piling up in the commodity producing countries,

• While high commodity prices are slowing growth in the U.S., Japan, and Western Europe.

• Financial problems, which started in the U.S. subprime mortgage market, have spread throughout the world.

• But the resulting imbalances are a threat to the stability of the world financial and trade system.

• The fight for control of natural resources could also lead to trade and other conflicts.

3.



The Housing Bubble

• Housing was too affordable, thanks to low mortgage rates

• But what happened when rates went up?

• Ratio of home price to income hit a record high in 2006,

• Which could not be maintained at higher interest rates

• We built too many houses at too high prices

• Starts and sales have dropped sharply

• Defaults and foreclosures have soared, cutting back on willingness to lend

• Prices are down 15% from their peak

• We expect to hit bottom on starts this summer

• But prices probably won’t hit bottom until early 2009.

4.



Home Prices Were Too High

2

2.5

3

3.5

4

4.5

1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

Existing New Quality-adjusted

(Ratio of average home price to average household disposable income)

Source: BEA, Census

5.



The Housing Market Cycle

0

500

1,000

1,500

2,000

2,500

1990 1993 1996 1999 2002 2005 2008-20

-10

0

10

20

30

Starts Home prices (%chya)

(Housing starts (1000) and 12-month % change in home prices (S&P/Case-Shiller))

Source: S&P and Census Bureau

6.



Bubbles Were Almost Everywhere

-100 -50 0 50 100 150 200 250

Hong KongNewZealan

ChinaAustralia

JapanSpain

FranceSweden

ItalyIrelandBritain

NetherlandSwitzerland

GermanyCanada

US

(Percent increase in home prices, 1997-2005)

Source: Mortgage Bankers’ Association and S&P

7.



Most Weakness Is In The Bubble Cities

Source: Standard & Poor’s, RealtyTrac

(S&P/Case-Shiller Home Price Indexes)

Apr-082002-2005

averageForeclosure rate

Top 5Charlotte -0.1 4.1 1.4Dallas -3.4 2.7 1.7Portland, OR -4.7 13.1 0.6Denver -4.7 2.6 2.6Seattle -4.9 12.2 0.5

National average -15.3 14.3 1

Bottom 5Las Vegas -26.8 17.5 4.2Miami -26.7 19.9 2.7Phoenix -25.0 20.6 1.9Los Angeles -23.1 15.8 1.4San Diego -22.4 17.2 1.8

(12-month percent change)

8.



0

2

4

6

8

10

1995 1997 1999 2001 2003 2005 2007 2009 2011

Federal Funds Rate 10-Yr Bond Yield Muni bonds

(Percent)

The Fed Is Done Cutting

Source: Federal Reserve, Bond Buyer

9.



Foreign Money Is Coming Into Private Bonds

0200000400000600000800000

100000012000001400000

2001 2002 2003 2004 2005 2006 2007

Treasury Agency Private Equity

Source: US Treasury.

(Net inflows of long-term capital, Millions of dollars)

10.



Global M&A Activity

Announced M&A Deal Volume $bn

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2002 2003 2004 2005 2006 2007 2008E

March YTD FullYear

11.



Financial Markets Are Rising Rapidly

0 100 200 300 400 500

USEurozone

JapanRussia

E. EuropeLatin America

ChinaIndia

Emerging Asia

Equity Private debt Public debt Bank deposits

(Assets as percent of GDP, 2006)

Source: McKinsey Global

12.



Enterprise Risk Management: What will S&P be looking for?

• Management deliberately intends to actively manage key their risks.

• Management has allocated sufficient resources for risk management to reasonably expect achievement of objectives.

• Decision making reflects impact of decisions on risks of the organization.

• Managers understand the firm’s risk tolerance for the risks that are within their remit.

• Board is involved in making and/or approving risk tolerances and major policies regarding risk and supports management’s risk management intentions.

• Long term planning and resource allocations reflect risk reward as well as cost benefit of alternatives.

• Stakeholders have confidence in management’s ability to manage the risks of the firm.

13.



The World Is Ignoring The U.S. Sniffles

• World growth remains solid

• Slower growth in the US and Europe is offset by stronger growth in Asia

• The train has more engines attached

• And the world is thus less dependent on US growth

• We expect a slight slowdown in world growth, to 3.9% from 4.9% in 2007

• But the big trade and capital imbalances are a risk

• And higher oil prices could still slow growth more

14.



World Growth Remains Strong

0

2

4

6

8

10

UnitedStates

WesternEurope

Japan EasternEurope

OtherAsia-Pac

LatinAmerica

Mid East& N

Africa

Sub-SaharanAfrica

2006 2007 2008 2009 2010

(Real GDP, % change)

Source: Global Insight and S&P

15.



And Comes Mostly From Asia

US20%

Eurozone15%

Japan6%

Other Adv11%

China15%

India6%

East Eur7%

Other 20%

(IMF purchasing power weights, 2006)

US12%

Eurozone9%

Japan3%

Other Adv7%

China30%

India11%

East Eur11%

Other 17%

Percent of World GDP Percent of World Growth

Source: IMF

16.



A Longer-Term View Shows The Swing

US23%

Eurozone21%

Japan8%

UK4%China

3%

India4%

Brazil3%

Other 34%

(IMF purchasing power weights, Percent of world GDP)

US20%

Eurozone16%

Japan7%UK

3%China14%

India6%

Brazil3%

Other 31%

1971-1975 2001-2005

Source: IMF

17.



Different Economic Performances

0

2

4

6

8

10

12

U.S.

Canad

a

Australia

Japan

France

Germany

Italy

U.K.

2005 Jun-05

(Unemployment rate, %)

Source: BLS

18.



European Productivity Growth Trails

Source: BLS

19.



World Imbalances Are Becoming Dangerous

• The US has been absorbing most of the world trade surplus

• Slower US growth has slowed imports

• A weaker dollar has helped exports

• But rising oil prices are keeping the deficit large

• The US trade deficit cannot be sustained at its current level

• But with large surpluses in the OPEC countries and other commodity producers

• It is hard to see how the US can get closer to balance

• Without Europe running a large deficit

• Or China and Japan moving into balance

20.



US Trade Deficit Balances Surpluses Elsewhere

-8

-6

-4

-2

0

2

4

6

8

10

US Canada Germany France Italy UK Japan Korea China India

(Trade balance percent of GDP, 2007)

Source: Global Insight

21.



8%10%12%14%16%18%20%22%

1970 1975 1980 1985 1990 1995 2000 2005

Gross saving Private saving Private investment

(Percent of GDP)

US Borrows From Abroad to Offset Weak Savings

Source: BEA

22.



-200-100

0100200300400

1990 1993 1996 1999 2002 2005

(Capital balance, $billion, 34 emerging economies)

Emerging Markets Have Become Capital Exporters

Source: McKinsey Global

23.



0

10

20

30

40

50

60

Canada

France

Germany

Italy

Japan

KoreaMexic

o UK US

25-34 45-54

(Percentage of tertiary degrees by age group, 2003)

Other Countries Are Catching Up On Education

Source: OECD

24.



Changing Industry Mix

Source: BLS

25.



Fiscal Deficits Almost Everywhere

-8

-6

-4

-2

0

2

4

US Canada France Germ. Italy UK Japan

2004 2007

(Government balance as percent of GDP)

Source: IMF

26.



The Future Looks Bleak

49101

38 57 59113

173

62 86 71

350

530

182223 220

0

100

200

300

400

500

600

US Japan UK France Germany2005 2025 2050

(Government debt as % of GDP)

Source: S&P

27.



Aging Populations Will Boost Government Spending

0

10

20

30

40

50

60

US Canada France Germany Italy UK Japan AustraliaMexico OECD

2000 2020

(Ratio of over 65 population to labor force)

Source: OECD

28.



The Stock Market Is Heading Down

• Double-digit earning gains for a record 18 quarters• But earnings are now down for three consecutive quarters

(entirely because of financials).• Profits were at a record high relative to GDP• Earnings are slowing to below GDP growth• Share prices cannot continue to outpace earnings• Especially when interest rates rise• Stocks were overdue for a correction• But this was not quite a bear market• And we think the market will improve, but slowly.

29.



Most Markets Are At New Highs

-100 -50 0 50 100 150 200 250 300 350 400

World (1200)

US (500)

Canada (60)

Lat Am (40)

Europe (350)

Japan (150)

Asia/Pacific (50)

Australia (50)

Oct-02 May-08

(Change in S&P stock indexes since March 2000 peak)

Source: S&P

30.



Most US Sectors Have Recovered From The Bear Market

-100 0 100 200 300

S&P 500Cons Discr

Cons StaplesEnergy

FinancialsHealth CareIndustrials

TechnologyMaterials

TelecommUtilities

Oct-02 May-08

(Change in S&P 500 sectors since March 24, 2000 peak)

Source: S&P

31.



High Global Equity Correlation

Source: Standard & Poor’s Equity Research, MSCI (through July 31, 2007)

S&P 500 S&P MC 400 S&P SC 600 MSCI EAFE MSCI EMS&P 500 1.00 0.88 0.79 0.84 0.70S&P MC 400 0.88 1.00 0.96 0.75 0.67S&P SC 600 0.79 0.96 1.00 0.71 0.63MSCI EAFE 0.84 0.75 0.71 1.00 0.83MSCI EM 0.70 0.67 0.63 0.83 1.00

60-Month Correlations

32.



0

10

20

30

40

50

60

1997 2006US Canada Eurozone UK Japan Other DevChina Russia Brazil India Other

Source: Goldman Sachs

(Stock market capitalization, $trillion)

World Stock Markets Are Rising

33.



Emerging Markets Are Growing Faster

0%

20%

40%

60%

80%

100%

2006 2026US Canada Eurozone UK Other EurJapan Other Asia S Amer Mid East Africa

Source: Goldman Sachs

(Stock market capitalization, % of world total)

34.



Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

the great rebalancing...the great rebalancing david wyss chief economist standard & poor’s...

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