World Global Strategy

15 January 2009

Global Strategy Weekly
Technicals say it is time to bail out. Cut equity exposure and prepare for rout. US depression looking likely. While China’s 2009 implosion could get ugly.
Albert Edwards (44) 20 7762 5890

After increasing our equity exposure at the end of October we believe that the market is set to quickly slide sharply towards our 500 target for the S&P. While economic data in developed economies increasingly reflects depression rather than a deep recession, the real surprise in 2009 may lie elsewhere. It is becoming clear that the Chinese economy is imploding and this raises the possibility of regime change. To prevent this, the authorities would likely devalue the Yuan. A subsequent trade war could see a re-run of the Great Depression.

Economic data has been truly dreadful through the fourth quarter. Over a year ago we forecast deep US recession. As it had not suffered one since the early 1980s, we thought this outturn would shock. Yet recent data has been consistent with something far worse than deep recession. There is no agreed definition of a “depression” as opposed to a deep recession. But The Economist magazine is probably more qualified than many to take a view. They consider a peak-to-trough decline in GDP in excess of 10% a reasonable
Global asset allocation
% Equities Bonds Cash
Index Index neutral SG Weight

definition – link. We had been thinking of deep GDP declines of the order of 5% peak to trough but we are now thinking that this view might be too optimistic. But, until yesterday, equity markets had been paddling quite happily sideways for most of the last few months. They have been broadly flat since we increased our equity weighting sharply on 23 October. Within that time the intra-day ‘peak’-to-trough’ rally in the S&P was a creditable 28% from 740 low of Nov 21, but we do not claim to have captured that. Nevertheless we feel very comfortable that the technicals at the end of October cried out to close our extreme underweight equity exposure. They now tell us to cut exposure again.

30-80 20-50 0-30

60 35 5

35(50) 50(45) 15(5)

Previous weighting in (brackets) Source: SG Equity Research

Equity allocation
Very Overweight Overweight Neutral Underweight Very Underweight
Source: SG Equity Research

US UK Cont Europe Japan Emerging mkts

2008 was a shock for investors. But 2009 could be an even bigger shock. There is evidence that the Chinese economy is imploding (see chart). Investors should consider what would happen if China descends into social chaos. Yuan devaluation could spark a 1930’sstyle trade war. Do you really trust the politicians to “do the right thing”?
Lead indicators say that Chinese GDP growth set to collapse


Chinese GDP growth (yoy%, rhscale)

13 12

102 10 100



96 6



OECD leading indicator
92 4 90

88 96 97 98 99 00 01 02 03 04 05 06 07 08


Source: Datastream

But once well known technical indicators such as the MACD oscillator turned upwards at the end of October (see chart below). Two days ago we noticed that the MACD had turned back downwards. Despite being structurally bearish I try to participate in the rallies. At the end of October many technical indicators such as the % of stocks above the 50-day moving average (see chart below . James Montier.Global Strategy Weekly After the savage slide in equity markets in October. despite identifying Europe as cheap. tut-tuts disapprovingly and tries to switch off the power to my computer with his foot. it didn’t take a genius (just as well in my case) to come to the conclusion the markets should enjoy some sort of technical bounce from hugely oversold called for further substantial downside in the US market before it became similarly cheap. We have repeatedly highlighted that during the 2001-03 bear market there were four 25% bear market rallies before the market finally hit bottom. were so extreme we increased our equity weighting from a rock bottom 30% to a still underweight 50%. while my colleague. We remained underweight our benchmark because. unlike many strategists. The same is true for the 1930s bear market. we did not believe we had seen the lows for this bear market. Our favoured valuation measures (such as the cyclically adjusted PE). Moving Average Convergence/Divergence (MACD) Oscillator for the S&P Composite 20 10 0 -10 -20 -30 -40 -50 -60 -70 -80 J F M A M J J A S O N D J Source: Datastream 2 15 January 2009 . we felt comfortable nearer to neutral. and that the breadth indicators (see chart above) had peaked out.

link). This is a signal that the rally is over. Investors Intelligence Bull-Bear Indicator (% gap) 50 50 40 40 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 -40 2001 2002 2003 2004 2005 2006 2007 2008 -40 Source: Datastream We only ever saw our move back to a 50% equity exposure as temporary (see GSW 23 Oct – link). So with the oversoldness unwound and with the MACDs breaking downwards we feel duty-bound to cut our exposure to equities aggressively. The CBOE put/call ratio had moved down to the lowest level for twelve months at the turn of the year (see chart below – this is typically used as a contrary indicator).Global Strategy Weekly Other technical indicators also now suggest it is time to bail out of equities. 15 January 2009 3 . The true awfulness of the economic data since the end of October has certainly limited the ability of the market to enjoy a more heady technical bounce. But we always clearly stated that we believed further dismal profits and economic data during H1 2009 would be sufficient to catalyze a rout that would take the S&P down towards our 500 target – another 40% or so downside. That together with Vix appeared to be bottoming out – link. Individual investors (AAII survey) are also similarly more sanguine at the turn of the year with the number of bulls comprising a surprisingly high 48. This has now bounced sharply from incredible lows at the end of October and is now back to neutral. Another contrary technical indicator we watch closely is the balance of bulls relative to bears (see chart below .Investors Intelligence survey 140 financial newsletters .7%.

We were both agreed that unlike Japan in the 1990s. Annual data – Chinese electric power output and GDP (yoy %) 18 18 16 GDP 16 14 14 12 12 10 10 8 6 8 6 4 4 2 2 0 0 electric power -2 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 -2 Source: Datastream 4 15 January 2009 . Chinese electric power output (yoy %) 20 20 15 15 10 10 5 5 0 0 3mth mav -5 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 -5 Source: Datastream Normally electric power output and GDP move closely together (see chart below). I was discussing the deflation/inflation question the other day with my former colleague Dylan Grice. The year 2008 has surely taught investors to think the unthinkable. That is unusual. Although in the near term (12-18 months) I believe we are sliding into a deflationary quagmire. current US policy makers have a very pronounced bias towards inflation – see Dylan’s blog here. In 2009 it is not the mounting risk of depression in developed economies that will come as a major surprise. We should remain intellectually flexible in these times. it is economic implosion in China and the global and geopolitical risk thereof.Global Strategy Weekly In some respects James and I do feel a lot more bullish than we did one year ago. The extent of the economic implosion is now widely recognized. I have a very open mind on a 2-3 year time horizon. Chinese electric power output has been declining for the last three months (see chart below). Unthinkable you gasp! But you probably said the same thing about my forecasts at the start of 2008. the equity market is far cheaper than it was one year ago and the authorities are becoming increasingly aggressive in their stimulative measures.

Japan and Taiwan industrial production (yoy%. One reasonable explanation for the collapse in electric power output might relate to a switch to oil-based power in the wake of the massive oil-price slump. Taiwan (see chart below). Monetary aggregate M2 (CNY). The shock is that in November exports to China were down 25% yoy compared with growth of 16% as recently as July! The same trends are evident elsewhere in Asia. All the more interesting is that the collapse in electric power concurs with the OECD leading indicator chart we put on our front page. the Chinese OECD lead indicator includes Cargo handled at ports (tonnes). it is not even in it! For the geeks. e. A little research on the OECD website shows that this is not the case – link. The obvious conclusion is that the electric power series is a dominating part of the OECD lead indicator. Chemical fertilizer production (tonnes). Not only does it not dominate.g. Non ferrous metal production (tonnes). Taiwan has 2 month mav) 25 25 20 15 Taiwan 20 15 10 10 5 5 0 -5 0 -5 -10 -10 -15 -15 -20 Japan 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -20 -25 -25 Source: Datastream Developments in the Japanese trade are well known.Global Strategy Weekly A decline in power output of this order of magnitude certainly should raise the possibility that China is sliding into outright recession – no matter what the widely derided official GDP data actually tells us. Taiwan’s exports to China collapse (yoy %) over last six months 60 60 Exports to China 40 40 20 20 0 0 -20 -20 Exports to the US -40 -40 -60 2006 2007 2008 -60 Source: Datastream 15 January 2009 5 . much of Asia that has relied on rapid Chinese growth is also declining at an unusually rapid pace (see chart below). Exports in November were down 25% yoy. with exports to the US down 34%. But these have been weak for some time. But it is concerning that in addition. Enterprise deposits (CNY). and Imports from Asia (USD). That explanation is reasonable.

The collapse in the US trade deficit to only $40bn from $57bn in 6 15 January 2009 . Without full replication of the arguments here. 3m mav) 40 40 35 Exports to China 35 30 30 25 25 20 20 15 15 10 10 5 5 Imports from China 0 0 -5 2006 2007 2008 -5 Source: Datastream We continue to emphasize our long-held view that emerging economies are particularly vulnerable to a reversal in the global liquidity pump that has been reflected in an explosion of global FX reserves over the last few years. The US export data suggest there is a problem with Chinese domestic demand (see chart below). Chinese data shows their exports contracting about 3% yoy in December while imports fell by a massive 21% yoy (although clearly a proportion of the import decline will relate to declining commodity prices – crude oil imports were down 33% yoy). a burgeoning US current account deficit has been reflected in rampant global liquidity growth via EM FX intervention. Either way. Chinese industrial production is slowing sharply (+7% yoy in November v +30% in July). Korean exports to China (yoy%) also collapse over the last six months 40 40 30 30 20 20 10 10 0 0 -10 -10 -20 -20 Exports to the US -30 -30 Exports to China -40 2006 2007 2008 -40 Source: Datastream Are Chinese imports slowing sharply due to the fact the economy processes many components imported from the rest of Asia to be re-exported? Or to what extent is Chinese import growth reflecting a slowdown in domestic demand? The export data from the US to China is unlikely to be production line components in the value added chain. US export and imports with China (yoy%.Global Strategy Weekly The same sudden collapse in Chinese demand for imports is also evident in the Korean data (see chart below).

As The Economist pointed out recently. In my view.Global Strategy Weekly October was long overdue and the reflected declines in trade surpluses elsewhere (including four trade deficits in a row in Japan). The Wall Street Journal reports an increase in worker unrest as the economic situation deteriorates – link. But before the Communist Party accepts being swept away in a tidal wave of worker unrest it has one key tool in its economic armoury it has used before . But surely the authorities have learnt the lessons of the 1930s and we can rely on them to do the right thing? It depends what the alternative is. Amid confidence that the ongoing. There is a touching faith that the authorities are still in control of events. “We must be crystal-clear that without a certain pace of economic growth. economists and bankers begged President Hoover not to sign the 1930 SmootHawley Tariff Act – link. Consumption is still a relatively small part of GDP. massive. In October it was notable that Chinese reserves began to decline. Its relative resilience to date may be due to nothing more than the fact it lags the export cycle which has only recently collapsed. What is unambiguous however is that the authorities are very concerned about the risk of an economic slowdown. underpinned by rapid (excessive) investment growth. At the end of 1993 the authorities devalued the Yuan by 33%. A Yuan devaluation would undoubtedly be likely if the alternative was the overthrow of the Communist Party. monetary and fiscal stimulus will prevent a repeat of The Great Depression. will it instead be competitive devaluation and an implosion of world trade that we should watch out for (see chart below)? 15 January 2009 7 . The very survival of the regime depends on growth. is causing the US authorities to twitch nervously. China is still an export-led economy.mega-devaluation. Could the economic situation become so bad in China that it threatens the regime itself? Of course it could and clients should consider the implications of such an event. The Chinese authorities are no more or less fallible than anyone else. there will be difficulties with employment. The liquidity pump for these economies has gone into reverse and we described this as phase II of The Great Unwind – see Global Strategy Weekly 18 September – link. Crackdowns on dissidents are intensifying in the wake of the publication of the Charter 08 manifesto– link. The authorities face the toughest year since the economic malaise two decades ago led to the crackdown on student/worker unrest in Tiananmen Square. Even the minimal recent slippage in the Yuan after some three years of allowing it to appreciate. The Financial Times recently reported Prime Minister Wen saying. China has a track record of such things. means that EM countries have started to see sharp declines in their FX reserves. fiscal revenues and social development…factors damaging social stability will grow” – link.

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