MONTHLY INVESTMENT STRATEGY

1. MONTHLY INVESTMENT STRATEGY October 2011

2. Introduction The Euroland debt crisis continues. As the economy spirals downwards and tax revenues fall short Greece is falling ever further behind in achieving its deficit reduction targets. This is seen as a betrayal by other Eurozone countries. “Cheater in the Euro family” as Germany’s Focus magazine put it eighteen months ago. Naturally the other countries who are in a similar position [or are about to be] are less vocal in their criticism. Events increasingly force a decision between a lurch in the direction of a Federal State or a breakup of monetary union. The main issue hasn’t changed. The Federal project is at variance with the wishes of most European voters and its implementation at variance with the supposed realities of European democracy. The discussions about an extended bailout plan, guarantees, leveraging the EFSF or whatever, are the latest in a series of [sometimes successful] attempts to circumvent national democratic processes in pursuit of the greater goal. Greek debt is not the central issue. As Larry Summers said last week, if a friendly Martian were to repay all Greece’s debts the Greek economy would still be in trouble. What the Greek situation does do is illuminate the larger issues, the limits of national democracy within the union and the mechanisms for enforcing compliance. Things are seldom obvious or straightforward in Euroland. Few, arguably any, countries met the Maastricht treaty’s criteria for joining EMU and in Belgium’s case there was hardly even an attempt to maintain that it had. Greece met the overall debt/GDP criteria by announcing an ambitious estimate for the size of its “unofficial economy” [including revenues from prostitution], which swelled the whole and in the process reduced the debt/GDP ratio. The EU itself has now had its own accounts qualified by its auditors for so many years that the annual announcement is no longer even considered newsworthy. Given all that it is not surprising that it proves hard to convince Greece that “this time it’s serious". The German official who described the process of dealing with Greece as like “getting a child to tidy its room” probably unconsciously revealed a little of this aspect. According to Merkel and Sarkozy last week, Greece is an integral part of “Europe” so what exactly are the sanctions if Greece doesn’t comply? If mixed messages and the absence of effective sanctions characterise the “official” response to the Greek crisis the market response has been something different. Concerns over Greece have turned into concerns over Portugal Spain and Italy and most recently into concerns about the capital position of the European banking system. Even Christine Lagarde, now at the IMF, has become concerned about this in a way she wasn’t a few short months ago when France’s Finance Minister. In the short term this has been partially addressed by liquidity assistance by the ECB and the US Federal reserve but this postpones rather than settles the wider political questions including, of course, whether the member states and in particular Germany will sanction the ECB monetising European government debt without limit if there is not an explicit fiscal solution. The comments by Wulff, Weber and most recently Stark’s resignation all point to this becoming a more intense part of the debate. Compared to the acute nature of Euroland’s problems the successive downgrades of US economic prospects seem rather tame. Having seen growth peak at a meagre 3.5% the US economy is now annualising at 1.5%, too slow to bring unemployment down and with Global PMIs rolling over the prospect is for further weakness in the world economy. To this needs to be added a new imperative to reduce budget deficits. Nick Carn Oct 2011

3. GLOBAL MONETARY CONDITIONS

4. Global money supply has been decelerating as QE programmes have come to and end. More interesting is the current state of the monetary debate. Monetarism was almost dead before the financial crisis – the Fed had even stopped publishing M3. Since 2008 it has enjoyed a remarkable and vigorous recovery in the form of QE programmes - and the hyperinflationary fears they create in some quarters.

5. CSFB risk appetite In common with most other quantitative indicators CSFB’s risk appetite index is in the panic zone – underperformance of EMs and widening credit spreads have both contributed. Useful in the past as a contrarian indicator it’s notable that episodes of “panic” seem to be becoming more frequent and in 2008/2009 the indicator spent a considerable time in the zone.

6. ECONOMIC SNAPSHOTS

7. Eurozone PMIs The overall economic picture is one in which there hasn’t been much of a recovery in the domestic economies of developed countries but a V shaped recovery in the “international” economy; world trade, business confidence etc. The “good bit” has been slowly losing altitude since April and most PMIs are now below 50 with the US and China hovering around the 50% line. Euroland has its own special issues; until recently Euroland [dominated by Germany and France] was looking OK even as the peripheral economies sunk ever deeper. This has now changed as German data is rolling over. Germany’s headline numbers don’t look too bad but the forward looking components are now weakening a picture confirmed by Asian data.

8. China activity down but not out. Source: Markit. CEIC. The most recent data from China show an economy where growth is stabilising – albeit at a rather lower level than it is used to. China is one of the few economies which played ball with the West after the financial crisis, stimulating its economy through massive infrastructure investment. Other developing economies, perhaps cognisant of their experience in the 1990s were not so keen. As we have discussed before the level of capex in China far exceeds the previous records set by Japan in the 1980s and Korea in the 1950s. Neither episodes ended well. With the Euroland crisis in an acute phase and the battle for the soul of Big Government in the US about to be joined China is not the main focus for markets. However the recent very sharp falls in commodity prices and the collapse in the price of HK REITs suggest some preliminary sharpening of claws.

9. China Industrial production IP in China is decelerating but is still positive. The big questions, both of which still lie below the horizon, are to what extent China is a new model and to what extent it is just a vast version of the “Asian model” of the 1990s; an export miracle which morphs into crony capitalism. This time around quite few developing economies were prepared to accommodate the West’s problems by relaxing policy [once bitten twice shy]. The exception was China.

10. US consumer debt US households have now reduced their debt for 12 quarters in a row. It goes without saying that this is a reversal of trend which headed in the other direction for decades. It’s increasingly likely that the financial crisis is the point at which the process which created the “debt supercycle” went into reverse. Unfinished business in this respect is the government sector; State and local government are already launched on a programme of fiscal consolidation – “surprises” in the employment data over the last twelve months have persistently come from higher than expected job losses in this sector. The Federal government is being dragged kicking and screaming in the same direction; the debt ceiling drama and the relentless rise of the Tea party are part of this story.

11. US real incomes US median incomes have been falling since the late 1990s. No wonder consumers feel despondent now that the other door to greater prosperity – leveraged equity in real estate – has been soundly slammed.

12. US Home Sales The Fed’s operation twist is the latest attempt to get the economy going by lowering interest rates – this time further along the curve. The trouble is that lower interest rates seem no longer to stimulate demand in the way that they used to do – certainly that seems to be the case where home sales are concerned.

13. US consumer confidence Unsurprisingly US consumers remain downbeat – there’s a lot not to like including, of course, a falling stock market.

14. Euroland growth revised down In common with everywhere else growth expectations in Euroland have been revised down. The ostensible reason is the debt crisis – in reality the debt crisis is more a consequence of low growth than a cause. For economies such as Greece there is now a self reinforcing process where a weak economy results in higher interest rates and further falls in consumption.

15. Federal Spain Progress on deficit reduction in Euroland is patchy with Greece most obviously struggling. The choice of numbers is important – debt/gdp ratios look quite different for all countries if future liabilities are properly accounted for. For Spain, which is effectively a federation if you look at its fiscal structure, the situation is much more serious if you include regional finances.

16. Export values as % GDP Ireland recently reported strong growth of 3.5% in H1 in spite of ongoing government austerity. While this might seem to give hope to other stressed economies this should be restrained. Ireland has seen a 20% fall in incomes [far more than in southern Euroland] and is a much more open economy.

17. Productivity growth in Euroland In a stagnant economy a debt crisis pits creditors against debtors – a recipe for political conflict. The answer is growth. Growth comes either from more people or from higher living standards [the rough C20 mix for industrialised economies was about 50/50]. For the democratically challenged all the heavy lifting has to be done by rising productivity. This is one of the reasons why Italy’s poor performance in this area is so worrying.

18. Effective tax rates in Euroland The reasons for Italy’s low productivity growth include the small scale of many businesses and low levels investment particularly in technology. A very high tax burden is probably also responsible but this is an intensely ideological debate at a time when government needs more revenue.

19. UK average earnings UK consumers have seen falling real wages for the longest extended period since the 1930s. China’s entry into the world economy would have resulted in a very large rise in Western unemployment and falling prices had not something intervened. By accident or design that something was the bubble economy. The remorseless logic of an inflation targeting regime made that inevitable. The consequence was that final demand was pushed above its sustainable trend and capacity was built to meet that artificially elevated level. Falling real wages, now widespread across the post bubble economies, exacerbate the problem of a capital overhang.

20. UK retail sales For a long time consumer spending rose faster than employment and incomes – achieved by the alchemy of rising consumer leverage, itself encouraged by falling interest rates and rising asset values. This came to a juddering halt with the end of the bubble economies’ housing booms. The mini [if more narrowly focussed] version of the same, the QE induced rise in stock prices, has now also ground to a halt.

21. MARKETS

22. Deja vu all over again It might feel as if it’s 2008 all over again but, so far, it’s only Treasuries which are in new territory.

23. Copper Source: LME It’s been a long wait but finally, along with other very economically sensitive prices copper has plunged . While acknowledging the circularity of the argument the good doctor is delivering a disturbing prognosis.

24. Silver We have featured silver several times since the Financial Crisis Part One as the poster child of the new environment. It had done well in the old cycle but went parabolic after QE1. It had something for everyone, part industrial metal [China supercycle!] and part precious metal [QE is hyperinflationary!]. The recent collapse probably confirms that we just entered a new asset phase.

25. GEMs FX index Source: Bloomberg Moderating interest rate expectations in EM have rapidly translated into currency weakness. Like commodities the moves have been both big and sudden. BRL has fallen 15% in 10 days. Korea has been intervening to support its currency. Even the NDF curve for the RMB has flattened.

26. USD The USD has seen its safe haven status sharply increase during this phase of risk aversion and has performed better than the “fundamental” safe havens such as NOK and SEK. If Euroland tips into recession next year, which is increasingly likely, and the US achieves modest growth DXY can rise a lot further.

27. Equity implied volatilities Equity volatility has spiked. In the past it has seldom remained so elevated for much longer than this - suggesting scope for a rally in equity markets. The same proviso which applies to other risk measures should be born in mind; periods of high risk seem to be becoming both more frequent and more extended.

28. Global REITs vs equity indices There’s no shortage of lurid tales from asset markets since the crash but it’s interesting to see REITS outperforming in the West and underperforming in the East – the 29% fall in Hong Kong REITs gets the attention of a Chian overcapacity bear.

29. Shiller P/E Source: Yale University Economics department Are stocks cheap or expensive? If you think earnings hold up they are cheap [the issue here is the high level of margins] and if you compare them with interest rates and consider the relationship that has entailed over the last thirty years or so then you come to the same conclusion. If you think that margins are mean reverting and that equities will yield more than bonds [as they did for decades in the US and UK and do today in Japan] then you come to the opposite conclusion – the one I favour.

30. Corporate earnings revised down Source; IBES. In familiar fashion a slump in equity prices has been followed by a wholesale revision in earnings estimates [the most infamous example was after the 1987 crash when earnings expectations for 1988 were cut so much that the stock market was on the same P/E ratio after it had fallen 20% as it had been before]. With corporate margins at very high levels it is easy to see where further downgrades come from.

31. Stock market valuations Source: Datastream The recent fall in markets has brought P/B ratios close to 1 in Euroland and Japan. The problem is that in Europe it is the banks, many of which [deservedly?] trade at huge discounts to book [e.g. RBS at 20%] which bring the average down.

32. Dividend yield and 10yr real yield Stocks are either cheap by the standards of the last 50 years or expensive by the standards of the last 140.

33. Japanese P/Es CPI core inflation and inverted bond yield For obvious reasons, lessons from Japan get an increasingly attentive audience. As Japan crossed the shadow line [part demographic and part disinflationary – related of course] bond/equity relationships inverted.

34. BONDS

35. German and French bond yields “Europe is France and Germany the rest is just trimmings” said De Gaulle. What “should” happen in Euroland is that Germany should leave and re denominate but this is impossible for France. To revalue upwards with Germany would be economic suicide for a country which already runs large external deficits, to remain part of a Mediterranean Monetary Union is unthinkable.

36. Probability of default from CDS spreads Assuming 40% recovery. Source: Bloomberg Default risk has carried on rising in Euroland. It seems that monetary union has not led to the “elimination of risk premia” as Trichet predicted. Thanks to Bernard Connolly for keeping this historic utterance ever young.

37. Credit spreads Spreads have widened as stock markets have sold off and correlations between risk assets have veered towards one. Sovereign CDS spreads have been part of the story and even gold has succumbed. What next? Bullish short term and bearish medium term sentiment towards “core” government bond markets has been a bearish signal in the past. Is the 30yr next?.