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 WorldGlobal Strategy
2 September 2009
Global Strategy
Prepare for the next leg in the Ice Age journey into deflation
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
Global asset allocation
Equities 30-806035Bonds 20-503550Cash 0-30515
Source: SG Global Strategy
Equity allocation
Very OverweightOverweightUSUKNeutral Cont EuropeUnderweightJapanEmerging mktsVery Underweight
Source: SG Global Strategy
Commentators have been perplexed by recent strength in government bond markets,especially set beside continued resilience in equities. They should not be. The bond market isresponding to two key events. First, it is clear to us the ongoing march into
deflationwill accelerate during this short-lived economic recovery. Second, post-bubble realities willforce commercial banks to aggressively step up their buying of government bonds.
Recent weeks have seen commentators either busy throwing in their towels, as theequity bull market has marched resolutely upwards and onwards (maybe that will changeafter Monday), or wrestling with their conundrums. Many have found the robustness ingovernment bond prices through August most perplexing, especially when set besidecontinued resilience in developed equity markets.
Once again, equity participants are missing the big picture. For despite clear signs fromthe business surveys of some sort of H2 recovery, firm evidence is emerging that the globaleconomy is sliding towards a full-blown deflationary episode once this recovery falters.
My former colleague Rob Parenteau pointed out something interesting to me the otherday. He noted the huge divergence between US economy-wide inflation as measured by thegross domestic product (GDP) deflator and a slight variant of GDP, the deflator for grossdomestic
(see chart below). The key definitional difference between the twomeasures is that the latter includes recent savage import deflation (as GDP includes exportsand
imports). Hence the gross domestic purchases deflator is a better measure ofwhat is going on in the US
economy. With import prices down some 19% yoy andeven a record 7.3% yoy if one excludes petroleum, no wonder the price of domesticpurchases has already fallen into deflation. If anything, domestic purchases inflation leadstrends in both GDP and core CPI, so this is significant news. ( 
For those who have never come across Rob Parenteau, I believe he is one of the best and bravest commentators out there. His printed thoughts can be found in the renowned Richebächer Letter – link .)
US GDP measure of inflation lags domestic purchases inflation…or is that deflation?
Source: Datastream
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08-1012345-1012345
gross domestic purchasesgross domestic product (GDP)
Global Strategy Weekly
2 September 20092
While there can be no doubt that survey evidence is pointing to a more robust second half,equity markets should be far more nervous than they currently are. We heartily concur withGMO
s Jeremy Grantham who remarked recently that after 20 years of more or lesspermanent overvaluation of US equities, we saw just five months of under-pricing through theMarch trough. Do bursting global equity valuation bubbles really end like this? Of course theydon
t.One of the lessons from Japan was that, in a post-bubble world, equities were subject to farmore violent swings. We expect to see an exact replica event play out in the west. The GreatModeration - where the 1980
s debt super-cycle filled in troughs of recessions
will now giveway to far more violent swings in the economic cycle more usually seen in the pre-war yearsand the 19th century. Meanwhile, as we saw in Japan, each economic downswing will sink usdeeper and deeper into the deflationary mire (see chart below).
Japan’s core CPi (ex food and energy) crashes back into deep deep deflation
Source: Datastream
Investors will continue to be shocked by the robust performance of government bonds in thecoming months as core CPI crunches lower
the economic recovery (see chart below).For it is quite clear that it is the recovery phase that takes core CPI to new lows in each cycle.
US core CPI crashes lower in the recovery phase
Source: Datastream
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08-1.50-1.00-0.5000.501.001.502.002.503.003.50-1.50-1.00-0.5000.501.001.502.002.503.003.50
VAT hike
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08354045505560651.001.502.002.503.003.504.004.505.005.506.00
headline ISM (inverted, 6mth mav)core CPI (rhscale)
Global Strategy Weekly
2 September 20093
This is because it is in the recovery phase where the lagged impact of yawning output gapsdoes its pernicious work to core CPI and companies lower prices in response to the cyclicalimpact of lower unit labour costs. Hence, while the market focuses on the recovery of volumesas signaled by survey evidence, nominal GDP and consequently nominal revenue growthcontinue to see lower highs in the recovery and lower lows in the downturn. The bond markethas already caught onto this event and yields will continue to decline on a secular basis.But what about massive supply of government bonds I hear you ask? Won
t that drive yieldshigher? Well it never did in Japan. But let
s cast our minds back to the early 1990
s US creditcrunch (which seems so minor in retrospect!). What happened then is that US commercialbanks bought US Treasuries aggressively at the same time as they contracted lending to theprivate sector (see chart below). This continued well after the end of recession in early 1991.
US commercial banks buy government bonds aggressively in 1990s credit crunch, yoy %
Source: Datastream
I note with interest that Swedish Riksbank recently took its target interest rate negative, in anattempt to force banks to remove surplus reserves and resume lending to the private sector.Of course, no such thing will happen as banks are continuing to buy government paper inunlimited quantities - I note here the recent collapse in UK 1 and 2 year yields to new lows. Inthe US and elsewhere, where commercial bank exposure to government paper is still close toall-time lows, the unwinding of grotesque over-exposure to bubble sectors like real estate (seechart below) will continue to underpin the secular bull market in government bonds.
Share of US total domestic commercial bank loans to real estate and US government, %
Source: SG Global Strategy
1989 1990 1991 1992 1993 1994 1995-4-202468101214-10-505101520
recessionbank loans (private)loans to gov (treasuries)total
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08101520253035404550101520253035404550
Govies as % of loan bookreal estate lending as % of loan book

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