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05112009_Edwards_Darkness Lies One Step Ahead

05112009_Edwards_Darkness Lies One Step Ahead

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Published by: ejlamas on Nov 12, 2009
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Macro Commodities Forex Rates Equity Credit Derivatives
5 November 2009
Global Strategy
Global Strategy
 As the Japanese say,
Darkness lies one step ahead
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
Global asset allocation
Equities 30-806035Bonds 20-503550Cash 0-30515
Source: SG Global Strategy
One can almost see the stirrings of cyclical discontent within the market. Risk trades arelooking increasingly vulnerable and correlations are beginning to break down. Investorsshould focus on the nominal quantities, which continue to wither on the vine.
OK, I know I
m getting old. Yet last weekend I managed two new life changing events.Having visited James Montier on his gardening leave a few months back, I got very excitedabout his bread-maker. In a fit of
me too
consumerism I had to have one of those and lastweekend I lovingly gave birth to my first ever home-made loaf. Bread will never be the same.That very same day I had new experience number two as my wife, Rowan, dragged me offto my very first spin class. Now that might not sound much to my finely honed, Adonis-likereaders. But I had not ever done any exercise in the 30 years since leaving school, exceptbriefly in the run-up to my wedding just over a year ago. My body was indeed a temple
butto the moob god. (For those non-English readers, the word moob has nothing to do withflabby male chests. The word was invented in 1985 meaning a sagging economy. It is
spelt backwards
Now, I have to admit that I
ve been working in finance since the very start of the long bullmarket in 1982. It
s been fun and I
ve met many very interesting people over the years. Butthere are an awful lot of puffed-up toucans in this business, strutting around and fluffingthemselves up so as to appear incredibly self-important.
We all know that Warren Buffet is not one of those. The investment guru
s foray intorailroads this week has attracted much attention. The FT
s Lex column called it
onealmighty bet on the US economic recovery
 link. Funnily enough I was looking at railroadtraffic earlier in the week. It was notable, I thought, that on a seasonally adjusted basis,there is very clear evidence that the cycle is stalling out (see chart below).
US weekly traffic of railroads (12 week mav, up to Oct 17, carloads originated)
Source: Daatastream
seasonally adjseasonally unadj
Global Strategy Weekly 
5 November 20092
While I
m on the subject of gurus, I
ve come to the very sorry conclusion that many sell-sidestrategists purport to be financial gurus, yet strangely move from job to job as their employersfind them to be empty vessels. There are very few in this business I would wrap my armsaround, kiss on both cheeks and embrace as a
guru.One of the very few is my former colleague Peter Tasker. He is one of the foremost authoritieson Japan as well as being a best-selling author of Japanese fiction
 link. Anyway a
 read is his sage like comments in the Financial Times Insight column (see
China rushestowards a Japan-style bubble
, 2 Nov). He compares the universal group-think on the Chinesesituation now, with Japan two decades ago
what you think you see is decidedly not whatyou will get
 link. If I serve no other purpose this week, flagging up Peter
s insights is a truehonour. The fact that Peter
s analysis totally concurs with my colleague Dylan Grice
s recentthoughts on China ( link ) is surely just a coincidence.
Trade-Weighted Dollar index: DXY breaking upwards?
Source: Datastream
The dollar may be breaking upwards (see chart above). If this is the start of a large upwardmove, driven in large part by huge short positions that might be forced to be unwound, thismay crush correlated risk positions. In addition, the end of the $300bn Fed program of buyingUS Treasuries last week is causing jitters. Yet amid the noise one should focus on the long-term fundamentals (see chart below). Nominal quantities matter.
US nominal bond yields are driven by nominal GDP growth
Source: Datastream
nominal GDP growth10y bond yields
Global Strategy Weekly 
5 November 20093
 Although arithmetically, bond yields are a statistical artefact of short-term interest rateexpectations, the above chart shows that trends in nominal GDP growth are the key driver. Inthe 1960s and 1970s, the continuous tendency of nominal GDP to grow well in excess ofcurrent bond yields provided an irresistible driver for higher yields. Conversely, the collapse innominal GDP growth below bond yields in the early 1980s marked the start of the long bullmarket that continues to this day. Indeed, it is notable that nominal GDP growth is once againso far below bonds that a major move down in yields may be very close indeed. The continualebbing of nominal quantities towards the deflationary Ice Age end is something we continue tobang on about in these pages. The charts below, for example, highlight what is happening towage and benefits inflation. This cycle has ground wage inflation even closer to zero. Andindeed the private sector data is even weaker than what you see below.
US Employment Cost Index (all workers, yoy%)
Source: Datastream
Now a bull would say this is all jolly good news as company profits can be increased bycontinued cost cutting and margin expansion. But as Andrew Lapthorne pointed out in arecent note, with margins already so very high, it is
for companies to cost-cut theirway to sustained profits growth -link. Hence
revenue growth will be
key driver tothe profits outlook. In targeting margins, companies are currently driving the US economy tothe very abyss of outright deflation - something we will all realise as this cycle soon stalls.
What recession?Operating profit margins (ex financial & ex-energy) - and consensus expectations (%)
        1        9        8        5        1        9        8        6        1        9        8        7        1        9        8        8        1        9        8        9        1        9        9        0        1        9        9        1        1        9        9        2        1        9        9        3        1        9        9        4        1        9        9        5        1        9        9        6        1        9        9        7        1        9        9        8        1        9        9        9        2        0        0        0        2        0        0        1        2        0        0        2        2        0        0        3        2        0        0        4        2        0        0        5        2        0        0        6        2        0        0        7        2        0        0        8        2        0        0        9        2        0        1        0
Source: Factset, Company report and accounts & I/B/E/S
wages & salariestotal compensation

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