February 9, 2011

Naufal Sanaullah

naufalsanaullah@gmail.comwww.shadowcapitalism.com

Inflation worries weigh on EM & risk overall while 10yr USTauction sees massive foreign participation

Markets took a breather today after strong rallies since the Egypt pullback, with EM once again

leading the way down. With yesterday’s PBoC hike almost completely insignificant in itself,

considering deposit rates are still deeply in negative real territory, inflation worries are the likely

theme behind today’s risk

-off and Chinese hiking has a long way to go.

Last night’s piece noted the

large impact Chinese droughts were having on wheat supply/demand imbalances, and today moretalk of big Chinese import demand for grains abounded, while the State Council issued asmall

subsidy to “encourage production,”

but is likely to do little if anything in my opinion. Importantnote from the WSJ article:

Social stability in China, too, always has depended on grain. Much of the ritual in theancient Chinese court revolved around ensuring a strong crop. During the 1950s and 1960s, exaggerated grain-production figures were published to please Mao Zedong. Anancient Chinese adage says, "Raise sons for old age, pile grain for times of famine."

With a highly significant regime change just around the corner and growth still being led by creditexpansion and leverage, food inflation is likely to be the sociopolitical catalyst that puts the PRC inall-

out “imbalance

addressing” mode.

This is the key risk to Chinese markets and their derivatives(AUD, copper, etc).The S&P gave back a quarter of a percent today, with volume ticking up a bit, for a doji close. Littletechnical development came today, with such a small range and lack of direction. The Dow closedin the green, in fact. However, an earnings outlook miss from Cisco could weigh down on marketstomorrow, particularly tech, although in this market the first reaction is not very likely to be the

“real” reaction.

Shadow Capitalism

Market Commentary by Naufal Sanaullah

February 9, 2011

I noted in last night’s piece that AUDUSD is approaching the apex to a very large triangle pattern

development, and

with today’s risk

-off market and after a lack of resistance penetration duringAsian hours, I went short some Aussie just a big fig below that 1.02 resistance level. Copper andmetals stocks sold off today, and I shorted some FCX & SCCO during US hours as well. FCX andSCCO are both back below their 55d and have made lower highs. Despite a nice employment beatfor January (+24k vs +17.5k expected), a reliance on part-time worker improvement for the beatand a downward revision of the prior data figure led to a sell-the-news reaction in AUD pairs. If bearish Chinese sentiment picks up, AUDUSD could break down rather than up through thetriangle pattern, which would imply a selloff to about the 200d around 94c.GS out with a great report today about the slowing inflows into EM after the breakout 2010 year,as inflation worries weigh down on EM demand while the post-QE2 DM expansion found dip-buyers. As per GS:

However, from January a more insidious force has been at work, namely, concern that thedeteriorating inflation outlook in EM

—

on the back of rising commodity prices

—

will

February 9, 2011

necessitate a sharp monetary tightening to bring inflation back under control. This worry has coincided with better growth momentum in DM economies, which, as we discussed above, has raised the opportunity cost for EM investments. As a result, investor appetite for EM assets shifted quite dramatically in January.

This is a general market theme I have been touting since November, when QE2 was finallyannounced. Also of note is DM/EM relative performance as compared to US Tsy yields. Below is a9mo chart showing the S&P 500/MSCI EM ratio (via SPY & EEM proxies) with 10yr yields overlaid.US govys and EM equity rising and falling together?

Let’s compare this to 2008

-09, using aninverted ratio (EEM priced in SPY, rather than the other way around like above).

Again, a high correlation, but this time it’s EM outperformance that tracked US yields, as risk

-off selloffs were met with UST safe haven demand. The implication is that US govys have become a