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Global Strategy

2 September 2009

Global Strategy Weekly

Prepare for the next leg in the Ice Age journey into deflation

Albert Edwards Commentators have been perplexed by recent strength in government bond markets,
(44) 20 7762 5890
albert.edwards@sgcib.com especially set beside continued resilience in equities. They should not be. The bond market is
responding to two key events. First, it is clear to us the ongoing march into outright deflation
will accelerate during this short-lived economic recovery. Second, post-bubble realities will
force commercial banks to aggressively step up their buying of government bonds.

Q Recent weeks have seen commentators either busy throwing in their towels, as the
equity bull market has marched resolutely upwards and onwards (maybe that will change
after Monday), or wrestling with their conundrums. Many have found the robustness in
government bond prices through August most perplexing, especially when set beside
continued resilience in developed equity markets.

Q Once again, equity participants are missing the big picture. For despite clear signs from
the business surveys of some sort of H2 recovery, firm evidence is emerging that the global
Global asset allocation
economy is sliding towards a full-blown deflationary episode once this recovery falters.
Index SG
% Index
neutral Weight
Q My former colleague Rob Parenteau pointed out something interesting to me the other
Equities 30-80 60 35
Bonds 20-50 35 50
day. He noted the huge divergence between US economy-wide inflation as measured by the
Cash 0-30 5 15 gross domestic product (GDP) deflator and a slight variant of GDP, the deflator for gross
Source: SG Global Strategy domestic purchases (see chart below). The key definitional difference between the two
measures is that the latter includes recent savage import deflation (as GDP includes exports
Equity allocation and excludes imports). Hence the gross domestic purchases deflator is a better measure of
Very Overweight what is going on in the US domestic economy. With import prices down some 19% yoy and
US even a record 7.3% yoy if one excludes petroleum, no wonder the price of domestic
Overweight
UK
Neutral Cont Europe
purchases has already fallen into deflation. If anything, domestic purchases inflation leads
Japan trends in both GDP and core CPI, so this is significant news. (For those who have never
Underweight
Emerging mkts
come across Rob Parenteau, I believe he is one of the best and bravest commentators out
Very Underweight
Source: SG Global Strategy
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?

5 5

4 4

gross domestic product (GDP)

3 3

2 2

1 1
IMPORTANT: PLEASE READ
DISCLOSURES AND DISCLAIMERS 0 gross domestic purchases 0

BEGINNING ON PAGE 4
-1 -1
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

www.sgresearch.socgen.com Source: Datastream

 Global Strategy Weekly

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 with
GMO’s Jeremy Grantham who remarked recently that after 20 years of more or less
permanent overvaluation of US equities, we saw just five months of under-pricing through the
March trough. Do bursting global equity valuation bubbles really end like this? Of course they
don’t.

One of the lessons from Japan was that, in a post-bubble world, equities were subject to far
more violent swings. We expect to see an exact replica event play out in the west. The Great
Moderation - where the 1980’s debt super-cycle filled in troughs of recessions – will now give
way to far more violent swings in the economic cycle more usually seen in the pre-war years
and the 19th century. Meanwhile, as we saw in Japan, each economic downswing will sink us
deeper and deeper into the deflationary mire (see chart below).

Japan’s core CPi (ex food and energy) crashes back into deep deep deflation
3.50 3.50

3.00 3.00

2.50 2.50

VAT hike
2.00 2.00

1.50 1.50

1.00 1.00

0.50 0.50

0 0

-0.50 -0.50

-1.00 -1.00

-1.50 -1.50
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Datastream

Investors will continue to be shocked by the robust performance of government bonds in the
coming months as core CPI crunches lower despite 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

35 6.00

headline ISM (inverted, 6mth mav)

5.50

40
5.00

4.50
45

4.00

50 3.50

3.00

55
2.50

2.00
60

1.50
core CPI (rhscale)
65 1.00
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Datastream

2 2 September 2009
 Global Strategy Weekly

This is because it is in the recovery phase where the lagged impact of yawning output gaps
does its pernicious work to core CPI and companies lower prices in response to the cyclical
impact of lower unit labour costs. Hence, while the market focuses on the recovery of volumes
as signaled by survey evidence, nominal GDP and consequently nominal revenue growth
continue to see lower highs in the recovery and lower lows in the downturn. The bond market
has 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 yields
higher? Well it never did in Japan. But let’s cast our minds back to the early 1990’s US credit
crunch (which seems so minor in retrospect!). What happened then is that US commercial
banks bought US Treasuries aggressively at the same time as they contracted lending to the
private 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 %
14 20

12
loans to gov (treasuries)
15

10

8 10

5
4 total

2 0

-5
-2
recession
bank loans (private)
-4 -10
1989 1990 1991 1992 1993 1994 1995

Source: Datastream

I note with interest that Swedish Riksbank recently took its target interest rate negative, in an
attempt 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 in
unlimited quantities - I note here the recent collapse in UK 1 and 2 year yields to new lows. In
the US and elsewhere, where commercial bank exposure to government paper is still close to
all-time lows, the unwinding of grotesque over-exposure to bubble sectors like real estate (see
chart 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, %
50 50

45 45

40 40

35 35
real estate lending as % of loan book
30 30

25 25

20 20

15 15

10
Govies as % of loan book 10
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: SG Global Strategy

2 September 2009 3
 Global Strategy Weekly

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4 2 September 2009