Nomura

Harnessing the predictability of inflation
Lessons from the 1970s ANY AUTHORS NAMED ON THIS

REPORT ARE RESEARCH
ANALYSTS UNLESS OTHERWISE
INDICATED
Anthony Morris Swati Aggarwal SEE DISCLOSURE APPENDIX A1
+44 (0)20 7102 9215 +44 (0)20 7102 0583 FOR ANALYST(S)
anthony.morris@nomura.com CERTIFICATION(S) AND
swati.aggarwal@nomura.com
IMPORTANT DISCLOSURES
6 April 2011
STRICTLY PRIVATE AND CONFIDENTIAL © Nomura

Table of contents
Ŷ Data show inflation is predictable
Ŷ Achieving real returns requires Adaptation
Ŷ Discipline proves better than discretion
Ŷ Current outlook for inflation

Data
Inflation is not a random walk²it trends
US inflation in the long run displays clear cycles
16%
14%
12%
10%
8%
CPI y-‐o-‐y
6%
4%
2%
0%
-‐2%
-‐4%
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Next period changes in inflation are predictable
Average monthly change (annualised) Standard deviation (annualised)
Unconditional 0.1% 1.5%
Conditional on positive change in previous month 1.0% 1.5%
Conditional on negative change in previous month -0.9% 1.5%
Source: Bloomberg, Nomura Research. Inflation refers to US CPURNSA Index. 4

Business cycles and monetary policy drive inflation
Excess money supply growth appears to be a major Close link between inflation and excess money supply
determinant of inflation at high levels growth
2006-‐10 12%
5-‐year average inflation (1966-‐2010)

R² = 0.91
2001-‐05
10%
1996-‐00
8%
1991-‐95
6%
1985-‐90
4%
1981-‐85
2%
1976-‐80
0%
1971-‐75
-‐2% 0% 2% 4% 6% 8% 10%
1966-‐70 5-‐year average excess money supply growth (1966-‐2010)
-‐5% 0% 5% 10%
Average inflation, y-‐o-‐y Average excess money supply growth, y-‐o-‐y
Source: Bloomberg, Nomura Research. Data pertain to US. Excess M2 growth is defined as M2 growth in excess of what is prescribed by the Mc Callum rule for monetary aggregate targeting. Prescribed money supply =
target nominal growth rate ± observed increase in velocity + 0.5*(target nominal growth rate ± actual nominal growth rate). Target nominal growth rate = Target real growth rate +2% 5
Inflation is linked to the business cycle
Output gap changes seem to be more important that actual levels
20%
15%
10%
5%
0%
-‐5%
-‐10%
1970 1975 1980 1985 1990 1995 2000 2005 2010
NBER Recessions Output Gap Inflation, y-‐o-‐y

Source: Bloomberg, Nomura Research. 6
The business cycle trends
The economy is not a random walk
6%
4%
Output gaps (% of potential GDP)

2%
0%
-‐2%
-‐4%
-‐6%
-‐8%
1970 1975 1980 1985 1990 1995 2000 2005 2010
Next period changes in output gaps are predictable
Average quarterly change (annualised) Standard deviation (annualised)
Unconditional -0.2% 2.9%
Conditional on positive change in previous quarter 1.9% 2.5%
Conditional on negative change in previous quarter -2.4% 3.2%

... and so does monetary policy
Central banks seldom seek to surprise markets
25%
Fed funds target rate 20%
15%
10%
5%
0%
1971 1981 1991 2001 2011
Rate movements follow trends
Proportion of rate hikes Proportion of rate reductions
Unconditional 46% 54%
Conditional on being in a rate hiking cycle 90% 10%
Conditional on being in rate reduction cycle 9% 91%
Source: Bloomberg, Nomura Research. A rate change is considered to be in the rate hiking (reduction) cycle if the last change was positive (negative) 8
Even commodity returns are pro-cyclical, not random
Bretton Woods unwinds Iran±Iraq war Kuwait invasion
Oil embargos Volker rate hikes S&L aftermath Asia crisis Tech bust Credit crisis
1200
1000
800
600
400
200
0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Global recessions Commodities excess returns index
Source: Bloomberg, IMF World Economic Outlook, Nomura Research. A period is defined as global recession if growth rate during the period was in the bottom quartile. 9
But what about shocks?
10
Lesson from the 1970s: policy vs. shocks
The Great Inflation (1965-1983) is often blamed on oil shocks
30%
25%
20%
CPI y-‐o-‐y
15%
10%
5%
0%
-‐5%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
US UK
Source: Bloomberg, Nomura Research 11

Inflation was rising before the oil-price shocks
30%
25%
20%
CPI y-‐o-‐y
15%
10%
5%
0%
1965 1970 1975 1980 1985
Oil price shocks US UK

Inflation was not high everywhere
16% 120%
Imported oil as a % of total oil consumption

14%
100%
12%
80%
10%
8% 60%
6%
40%
4%
20%
2%
0% 0%
UK Australia Canada US Japan Germany
Average inflation (1975-‐1983), lhs Dependence on imported oil (1974-‐1980), rhs
Source: Bloomberg, BP Statistical Review, Nomura Research 13

0RQHWDU\SROLF\GLIIHUHQFHVDUHPRUHUHOHYDQW«
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Average excess money supply growth (1975-‐1983) Average inflation (1975-‐1983)
Source: Bloomberg, Nomura Research. Excess M2 growth is defined as M2 growth in excess of what is prescribed by the Mc Callum rule for monetary aggregate targeting. Prescribed money supply = target nominal growth
rate ± observed increase in velocity + 0.5*(target nominal growth rate ± actual nominal growth rate). Money supply is taken to be M2 for US ,Germany and Canada, M4 for UK, M2+CDs for Japan, and M3 for Australia. 14
«WRJHWKHUZLWKH[FKDQJHUDWHV
20%
15%
10%
5%
0%
-‐5%
Average excess money supply growth (1975-‐1983) Average inflation (1975-‐1983) Average annual NEER appreciation (1974-‐1983)
Source: Bloomberg, Nomura Research. NEER is the Nominal effective exchange rate. For Germany, we have taken the exchange rate appreciation against USD rather than a trade-weighted basket. 15
Adaptation
(TXLWLHVVXIIHUGXULQJLQIODWLRQ«
Equities have done better than cash in the long term But performed worse during the Great Inflation
10000 160
140
Cumulative real returns (log scale)
120
Cumulative real returns

1000
100
80
60
100
40
20
10 0
1960 1970 1980 1990 2000 2010 1965 1970 1975 1980 1985
US equities Cash US equities Cash
Source: Bloomberg, Nomura Research. Cash returns are defined as US fed funds over inflation. US equities refers to the MSCI TR index for US. The S&P 500 has been used for before 1970 with an assumed dividend yield. 17
... and so do nominal bonds
Nominal bonds outperformed cash in the long run But also suffered during the Great Inflation
1000 160
Cumulative real returns (log scale)
140

120
100 100
80
60
10 40
1960 1970 1980 1990 2000 2010 1965 1970 1975 1980 1985
Cash US bonds (<10 years) US bonds (>10 year) Cash US bonds (<10 years) US bonds (>10 year)
Source: Bloomberg, Nomura Research. Cash returns are defined as US fed funds over inflation. US bonds refer to Bloomberg EFFAS data and Nomura estimates 18
&RPPRGLWLHVKHGJHLQIODWLRQVRPHWLPHV«
They gained from the collapse of the gold peg Spot prices gained in real terms
250 160
Real price index ( Jan 1965 prices)

200
120
150
80
100
40
50
0 0
1965 1967 1969 1971 1973 1965 1967 1969 1971 1973
CRB Index Gold ($/oz.) CRB Gold ($/oz.)

«EXWQRWRWKHUV
But prices have not kept up with inflation since Real returns in line with cash, but more volatile
120 600
Real prices Index ( Jan1975 =100)
100 500

80 400
60 300
40 200
20 100
0 0
1975 1980 1985 1990 1995 2000 2005 2010 1975 1980 1985 1990 1995 2000 2005 2010
S&P GSCI spot S&P GSCI Cash
Source: Bloomberg, Nomura Research. Cash returns are defined as US fed funds over inflation. S&P GSCI real returns have been obtained by adding cash returns to S&P GSCI excess returns index. 20
Adaptive strategies using nominal bond futures work...
10000
(log scaled and volatility-‐ adjusted)
1000
100
10
1960 1970 1980 1990 2000 2010
Cash US bonds (<10 years) US bonds (>10 year) Macro Duration
Source: Bloomberg, Nomura Research. Cash returns is defined as US fed funds over inflation. US bond returns are Bloomberg EFFAS indices and Nomura estimates. US bond excess returns and Macro duration excess
returns have been vol-adjusted to have a volatility of 5% and then the cash real rate has been added to get the real returns for each. 21
... across countries and across inflationary regimes
Country-wise performance Performance in different inflation regimes
7%
Average real returns (1960-‐2010),
6% Average real returns (1960-2010), annualised
5% Macro Duration US Bonds Risk Free

annualised
4%
High inflation 2% -3% -1%
3%
Medium inflation 6% 4% 1%
2%
1% Low inflation 9% 8% 3%
0%
US Germany UK Japan Canada Australia
Macro Duration Bonds Cash
Source: Bloomberg, Nomura Research. Cash returns is defined as policy rates over inflation. Bond returns are Bloomberg EFFAS indices and Nomura estimates. Bond excess returns and Macro duration excess returns
have been vol-adjusted to have a volatility of 5% and then the cash real rate has been added to get the real returns for each. For Japan bond returns are only available after 1966. High inflation, low inflation and medium
inflation have been defined by dividing the sample into three parts based on US inflation 22
0DFURGXUDWLRQZRUNHGGXULQJWKHV³RLOVKRFNV´
Strategy outperforms long-only bonds in countries with different inflation experiences

8%
Average real returns (1974-‐1983), annualised
6%
4%
2%
0%
-‐2%
-‐4%
Macro Duration Bonds Cash

Source: Bloomberg, Nomura Research. Cash returns is defined as US fed funds over inflation. Bond returns are Bloomberg EFFAS indices and Nomura estimates. Bond excess returns and Macro duration excess returns 23
have been vol-adjusted to have a volatility of 5% and then the cash real rate has been added to get the real returns for each.
Adaptive commodity positioning outperforms long-only
10000
Cumulative excess returns
(Volatility-‐adjusted)
1000
100
10
1975 1980 1985 1990 1995 2000 2005 2010
MaCS S&P GSCI Cash
Source: Bloomberg, Nomura Research. Cash real returns are defined as US fed funds over inflation. S&P GSCI real returns index has been calculated by adding the S&P GSCI excess returns to the cash real returns. MaCS
real returns index has been calculated by adding the 2.5 times the MaCS unfunded returns to the cash real returns in line with the MaCS UCITS fund format 24
Adapting in both commodities and rates works best
10000
1000
(log -‐scaled)
100
10
1970 1975 1980 1985 1990 1995 2000 2005 2010
Combined adaptive strategy Bonds Commodities Equities Cash

Source: Bloomberg, Nomura Research. Cash real returns are defined as US fed funds over inflation. Commodities returns index has been calculated by adding the S&P GSCI excess returns to the cash real returns. Equities
refers to the MSCI TR index for US. The S&P 500 has been used for before 1970 with an assumed dividend yield. Bond returns are Bloomberg US EFFAS indices (1-10 years) and Nomura estimates. Combined adaptive
strategy is a combination of Macro Duration and MaCS until 1990. After 1990 Macro Pulse is also included. The combined strategy excess returns have been vol scaled to have the same volatility as US bonds excess
25
returns.
Discipline
Ability to adapt is not the same as willingness
High correlation with equities The absence of alpha
100% 10%
Correlation with MSCI World
8%
80%
6%
Alpha, p.a
60% 4%
40% 2%
0%
20%
-‐2%
0% -‐4%
1990-‐2003 2003-‐2007 2008-‐2011 1990-‐2003 2003-‐2007 2008-‐2011
HFRI FWI HFRI FOF HFRX Global HFRI FWI HFRI FOF HFRX Global
Source: Bloomberg, Nomura research. Alpha has been measured from regression on MSCI World 27
Hedge funds show high correlation with equities
Discretionary real returns are as absent as alpha
14%
12%
Real returns, p.a. (volatility-‐adjusted)
10%
8%
6%
4%
2%
0%
-‐2%
-‐4%
1990-‐2003 2003-‐2007 2008-‐2011
IRIS MaCS HFRI FWI HFRI FOF HFRX Global
Source: Bloomberg, Nomura research. Real returns have been calculated by first vol adjusting the excess returns to have a vol of 5% and then adding the cash real returns. 28
Current outlook for inflation
Inflation is rising as central banks delay rate hikes
6%
5%
4%
3%
2%
1%
0%
Jan-‐10 Mar-‐10 May-‐10 Jul-‐10 Sep-‐10 Nov-‐10 Jan-‐11
UK RPI Europe HICP US CPI

How much slack is actually there?
Growth momentum is strong in Europe Mixed picture in UK: What is the right measure?
4 6% -‐30%
3 4% -‐20%
2
% of potential GDP
2% -‐10%
1
0 0% 0%
-1 -‐2% 10%
-2
-‐4% 20%
-3
-‐6% 30%
-4
-5 -‐8% 40%
1991 1994 1997 2000 2003 2006 2009 1981 1986 1991 1996 2001 2006 2011
Output gap - production function OECD UK output gap (deviation from 10-‐yr moving average, lhs)
Output gap - HP filtered
CBI % of firms below capacity (deviation from 10-‐yr moving average,
Output gap - linear trend inverted, rhs)
Output gap - NEWRI based

How much slack is actually there?
US capacity utilisation appears low in absolute terms However, it is equal to the 10-year moving average
95% 8%
90%
4%
85%
0%
80%
-‐4%
75%
-‐8%
70%
65% -‐12%
1967 1977 1987 1997 2007 1977 1987 1997 2007
US capacity utilisation (% of total capacity)

Current capacity utilisation -‐ 10-‐year moving average
Historical average

Macro duration is getting short around the world
Duration scorecard is turning bearish ... ... led by macro factors (real growth, inflation)
4
5
4 3
Contribution of Macro factors

Long Duration
3 2
Long Duration
2
Duration Scores
1
1 0
0
-‐1
-‐1
-‐2
-‐2
-‐3 -‐3
Short Duration
-‐4 -‐4
Short Duration
-‐5 -‐5
Mar-‐10 May-‐10 Jul-‐10 Sep-‐10 Nov-‐10 Jan-‐11 Mar-‐11 Mar-‐10 May-‐10 Jul-‐10 Sep-‐10 Nov-‐10 Jan-‐11 Mar-‐11
US Euro-‐Area UK Japan US Euro-‐Area UK Japan
Source: Nomura Research. Scores are as of 23 March 2011 33

Macro Commodity Strategy (MaCS) is generally long
Commodities have been gaining since June 2010 MaCS is positioned for the trend to continue
160 Cotton
Corn
150
Silver
Cumulative excess returns
140 Gold
Brent
130 Gasoline
Gas oil
120 Lead
Soybean
110 Cocoa
Coffeee
100 Heating oil
Sugar
90 Nickel
Lean Hog
80 Aluminium
Jan-‐10 Mar-‐10 May-‐10 Jul-‐10 Sep-‐10 Nov-‐10 Jan-‐11 WTI
Copper
S&P GSCI all commodities Zinc
Live Cattle
Energy Natural Gas
Agriculturals Wheat
Industrial metals -‐10 -‐5 0 5 10

Precious metals Maximum short Maximum long
Source: Bloomberg, Nomura Research. Scores are as of 23 March 2011 34

Key conclusions
Ź Inflation is predictable
Ź Shocks drive headlines, but policy and business cycles drive inflation
Ź Adaptive positioning in nominal bonds and commodities can provide good real returns
Ź Discipline outperforms discretion
35
Disclosure Appendix A1
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Harnessing the predictability of inflation

Lessons from the 1970s ANY AUTHORS NAMED ON THIS

STRICTLY PRIVATE AND CONFIDENTIAL © Nomura

Ŷ Data show inflation is predictable

Ŷ Achieving real returns requires Adaptation

Ŷ Discipline proves better than discretion

Ŷ Current outlook for inflation

Next period changes in inflation are predictable

Average monthly change (annualised) Standard deviation (annualised)

Unconditional 0.1% 1.5%

Conditional on positive change in previous month 1.0% 1.5%

Conditional on negative change in previous month -0.9% 1.5%

Source: Bloomberg, Nomura Research. Inflation refers to US CPURNSA Index. 4

5-­‐year average inflation (1966-­‐2010)

1966-­‐70 5-­‐year average excess money supply growth (1966-­‐2010)

NBER Recessions Output Gap Inflation, y-­‐o-­‐y

Output gaps (% of potential GDP)

Next period changes in output gaps are predictable

Average quarterly change (annualised) Standard deviation (annualised)

Unconditional -0.2% 2.9%

Conditional on positive change in previous quarter 1.9% 2.5%

Conditional on negative change in previous quarter -2.4% 3.2%

Source: Bloomberg, Nomura Research. 7

Fed funds target rate 20%

Rate movements follow trends

Proportion of rate hikes Proportion of rate reductions

Unconditional 46% 54%

Conditional on being in a rate hiking cycle 90% 10%

Conditional on being in rate reduction cycle 9% 91%

Global recessions Commodities excess returns index

Source: Bloomberg, Nomura Research 11

Oil price shocks US UK

Source: Bloomberg, Nomura Research 12

Imported oil as a % of total oil consumption

Source: Bloomberg, BP Statistical Review, Nomura Research 13

Cumulative real returns

US equities Cash US equities Cash

Cumulative real returns

Real price index ( Jan 1965 prices)

CRB Index Gold ($/oz.) CRB Gold ($/oz.)

Source: Bloomberg, Nomura Research. 19

Cumulative real returns

S&P GSCI spot S&P GSCI Cash

Cash US bonds (<10 years) US bonds (>10 year) Macro Duration

Country-wise performance Performance in different inflation regimes

6% Average real returns (1960-2010), annualised

5% Macro Duration US Bonds Risk Free

Macro Duration Bonds Cash

Strategy outperforms long-only bonds in countries with different inflation experiences

Macro Duration Bonds Cash

MaCS S&P GSCI Cash

Combined adaptive strategy Bonds Commodities Equities Cash

High correlation with equities The absence of alpha

Discretionary real returns are as absent as alpha

IRIS MaCS HFRI FWI HFRI FOF HFRX Global

UK RPI Europe HICP US CPI

Source: Bloomberg, Nomura Research 30

Source: Bloomberg, Nomura Research 31

US capacity utilisation (% of total capacity)

Source: Bloomberg, Nomura Research 32

Contribution of Macro factors

US Euro-­‐Area UK Japan US Euro-­‐Area UK Japan

Source: Nomura Research. Scores are as of 23 March 2011 33

5-‐year average inflation (1966-‐2010)

1966-‐70 5-‐year average excess money supply growth (1966-‐2010)

NBER Recessions Output Gap Inflation, y-‐o-‐y

US Euro-‐Area UK Japan US Euro-‐Area UK Japan

Industrial metals -‐10 -‐5 0 5 10