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Albert Edwards Gordon Brown Peso & 'Paper Bugs'

Albert Edwards Gordon Brown Peso & 'Paper Bugs'

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Published by: denar11 on Mar 02, 2010
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Macro Commodities Forex Rates Equity Credit DerivativesPlease see important disclaimer and disclosures at the end of the document
2 March 2010
Global Strategy
 Alternative view
www.sgresearch.com
Global Strategy
Weekly
 As the 10
th
anniversary of the peak of the Tech bubble approaches, should wereally care what the market
thinks
about sterling, or indeed much else?
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
Global asset allocation
%
IndexIndexneutralSGWeight
Equities 30-806035Bonds 20-503550Cash 0-30515
Source: SG Cross Asset Research
Global Strategy Team
Albert Edwards
(44) 20 7762 5890
albert.
edwards
@sgcib.com
Dylan Grice
(44) 20 7762 5872dylan.grice@sgcib.com
Much hand-wringing is accompanying sterling’s renewed slide. The market is reacting to therapidly falling odds of an outright Conservative victory in the forthcoming election, which willprobably mean the huge public sector deficit will stay larger for longer. But ultimately, in theIce Age, a weak currency is an escape route of choice from the deflationary quicksand. A lookat Japan shows the other extreme - a strong yen pushing Japan back into deep deflation.
 
Sterling
s latest slump contrasts markedly with the continued resilience in the yen (seechart below). Should investors be as concerned about sterling as they so obviously are?Perhaps not. Market participants are fickle creatures. I have previously likened them toshoaling fish, heading as a group in one direction only to change direction for no particularidentifiable reason (perhaps headless chickens would be a better analogy). I read muchabout market discipline forcing profligate governments into deep spending cutbacks.Sterling
s plunge will be painted as one example of that market discipline and we will nodoubt be told that that the market
wants
deep public spending cutbacks.
 
I was left scratching my head after reading the FT
s currency comment last Saturday,
“the yen pushed firmly higher yesterday as concerns about sovereign debt ratings in southern Europe sent investors scuttling for the relative safely seen to be provided by the Japanese currency”.
That is indeed the market
s perception. Except, as my colleague DylanGrice has shown, the Japanese fiscal situation is many times worse than almost anywhereelse! If any currency should be plunging at the moment, it is surely the yen!
 
It is an anathema to most commentators to suggest that Mr Market can possibly bewrong. But the notion that it can somehow offer us some definitive wisdom about what isthe
correct
course of action is surely nonsense. Investors can be totally and utterly wrongfor prolonged periods about what ultimately is
good
for an individual stock or bond market,or indeed a currency such as sterling.
Contrast the weakness of the trade weighted sterling to yen strength (JP Morgan narrow index)
Source: Datastream
2006 2007 2008 2009707580859095100105110115707580859095100105110115
SterlingYen
 
Global Strategy Weekly 
2 March 20102
One nice example of why you shouldn
t listen to Mr Market was a story in the wake of thesub-prime debacle from the FT
s John Authers. Writing back in September 2008, he said:
“WaMu on Friday became the biggest bank failure in US history (a title it will hopefully keep for  a while). Its decline, as has been amply documented, lay in its huge portfolio of mortgages and  mortgage-backed bonds. The last WaMu story I wrote covered a day when its share price fell 5 per cent in June 1999. It fell because investors were worried that it was retreating from its policy of levering up by buying mortgage-backed securities. Analysts told me that retreatingfrom leverage would harm WaMu’s revenues in the short term, along with its earnings and its share price. The implicit assumption was that leverage was good. Shareholders punished companies and executives when they paid down their debt and took less risk. This should  remind us of the breadth of the failure of the global markets system that we are nowwitnessing. Shareholders themselves egged on the lending binge in the US, and did so beforethe stratospheric growth in the credit derivatives market.” 
 
 link.This is a prime example that what the market
thinks
it wants in the short term may not be whatit really wants in the long term. In the case of the UK, there is no doubt in my mind thatpremature tightening of fiscal policy after the election will send the economy back intorecession. And as we saw in the case of 1990s Japan, any premature return to recessionmeans the public sector deficit will end up even bigger than it already is now, the BoE wouldhave to resume aggressive monetisation and sterling would be
even
weaker than it is now.Contrast the recent GDP recoveries in Japan and the UK, one suffering from a very strongcurrency (perversely?) and the other enjoying a very weak one (see charts below).
Japanese real and nominal GDP (rebased Q1 2007=100) UK real and nominal GDP (rebased Q1 2007=100)
Source: Datastream, SG Cross Asset Research
Japan has seen a 2.4% bounce in real GDP from its depression-like GDP collapse, while theUK has barely recovered. By way of contrast,
 nomina
l GDP shows the reverse. In the UK,nominal GDP has enjoyed a heady 4% annualised surge over the last two quarters whileJapan has seen stagnation. The UK economy is
enjoying
the benefits of the authoritiespulling the competitive devaluation lever, while Japan is still mired in deep deflation. As we stated in our recent note, there is no easy way out of the mess we (globally) are in -link.Either governments pursue the path of fiscal rectitude (although it is a bit late for that) and wesubside back into recession or we debauch the currency through deficits, the printing pressand devaluation. For many, the UK data suggests we are well on the road to debauchment.
2007 2008 200991929496981001021041069192949698100102104106
nominalreal
2007 2008 200991929496981001021041069192949698100102104106
RealNominal
 
Global Strategy Weekly 
2 March 20103
But certainly in a world where the private sector is trying to de-leverage, it is crucial to avoid aFisherian debt-deflation trap if one wants to avoid hurtling into a depression. There are noeasy answers. The simple fact is we shouldn
t be in this mess in the first place.The certainties we once had as investors will be jolted sharply in other ways over the next fewmonths. One of the most interesting non-consensus calls last year was from our AsianEconomist Glenn Maguire, who forecast that the huge Chinese trade surplus would disappearthis year (see chart below). Glenn thinks that isn
t just going to be a temporary blip, butsomething that the markets will really have to get used to. Given that grotesque externalimbalances were a feature of the build-up of the credit bubble, what will it mean if Chinamoves into sustained trade deficit?
China’s move into trade deficit will mean less dollars to recycle (USDbn)
Jun-2000Jun-2002Jun-2004Jun-2006Jun-2008Jun-201050403020100-10250200150100500-50
China Trade Balance NSA LHS (including SG Forecast till Jun-10)6 month change in China's US Treasury Holdings RHS
 
Source: SG Cross Asset Research, CEIC
Clearly to the extent that the rise in China
s official reserves depended on the size of its tradedeficit, there will be reduced purchases of US Treasuries. But China has, in part, merely beenswapping
official 
dollar purchases of US Treasuries with surging imports of dollar-denominated commodities on the trade account (see chart below). The emergence of a tradedeficit in Q2, together with Glenn
s view of a likely 5-10% yuan revaluation after the NationalPeople
s Congress meets in March (seelink ), will do one very important thing however
it willhead off US protectionist sentiment ahead of the Congressional mid-term elections.
China total imports surge as commodity imports soar (yoy% change)
Source: Datastream, SG Cross Asset Research
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009-60-40-20020406080100-60-40-20020406080100
exportsimports

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