9 August 2011

Global Strategy
Alternative view
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Global Strategy Weekly

Believe the Doom Merchants: Ice Age Part 3 begins
When I look at recent events and in particular the response and statements of policy makers I am minded of a quote from Boris Johnson, the Mayor of London, who said "My friends, as I have discovered myself, there are no disasters, only opportunities. And, indeed, opportunities for fresh disasters." Ben Bernanke is living the Boris dream.
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

This market meltdown has nothing to do with the S&P downgrade of the US the first of many downgrades. The simple fact is that the global economy is falling back into recession or indeed is already in recession. Equity markets were sliding before the downgrade and bond yields were reacting as one would have expected to the dire economic data. The S&P downgrade may have caused the breach of critical support levels of 1250 on the S&P, but anything could have caused that breach and triggered the technical rout. Expect some sort of retest of this neckline before the market ultimately meets its date with destiny.

Global asset allocation

% Equities Bonds Cash
Index Index neutral SG Weight

30-80 20-50 0-30

60 35 5

35 50 15

Recent US GDP revisions revealed QE2 to be an abject failure as far as producing an economic recovery is concerned with dire 0.9% annualised growth reported in H1 2011. Yet to a man with a hammer, everything is a nail. Hence despite rising core inflation, there is certainly a level of economic and/or market pain to prompt QE3. But expect the real fireworks to occur when the adrenalin rush of QE3 wears off even quicker than QE2.

Source: SG Cross Asset Research

There are still some diehard happy clappies out there who think we are going to avert recession and the markets will recover. Yet US GDP growth has now fallen below the wellknown 2% stall speed, below which the economy does not seem to be able to regain altitude but instead crashes directly into recession.

At the current (Q2) rate of 1.6% yoy GDP growth, my fellow bear (realist?), David Rosenberg at Gluskin Sheff, points out in the chart below that a US recession is almost certainly a done deal (never say certain, as in 1956, when recession was temporarily averted for all of nine months). But with this sort of record the onus is now on the optimists to demonstrate why on earth they still believe in a second-half recovery and growth in 2012.

Recession almost certain: GDP growth (yoy%) is now below 1.6% - past the point of no return

Global Strategy Team

Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

Source David Rosenberg, Breakfast with Dave, Gluskin Sheff (shaded areas are recessions)

Macro

Commodities

Forex

Rates

Equity

Credit
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Please see important disclaimer and disclosures at the end of the document

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The problem for me, personally, with the Ice Age thesis is that most of the time the patient is in remission, enjoying both cyclical recovery and coincident equity rallies. The secular derating of equities when it occurs is quick and vicious (see chart below). Hence most of the time therefore my views of the S&P falling to 400 and 1% US 10y bond yields are subject to ridicule, derision and utter contempt. In this lonely quest I am accompanied by a group of similarly battered and beaten up bears. And in the same way that a country is said to get the government it deserves, I believe the market gets the macro commentators it deserves: i.e. perpetually bullish analysts, taking no personal risk with their never-ending consensus chatter.
Total return of global equities, government bonds (10y+) and cash (US$, indexed to 100)
350 350

300

300

250

bonds 10y+

250

200

200

150

150

cash
100 100

equities
50 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 50

Source: Datastream, SG Cross Asset Research

Put into its proper Ice Age context, the events of the past decade are entirely explicable. As we see a short-lived economic recovery failing only two years into the cycle and a plunge back into recession, we remind investors that this was exactly the Ice Age template that Japan showed us. A fragile recovery undermined by private sector deleveraging collapses as a semi-bankrupt government tries to rein in runaway deficits. We are now entering the third phase of the Ice Age when another cyclical failure combines with a secular de-rating of equities and re-rating of government bonds. I and many others have been pointing out for a long time now the simple fact that the global economy has been living way beyond its means for years. A massive transfer of income to the very rich has occurred while middle class real incomes stagnated. The middle classes only tolerated this because Central Bankers created housing booms to keep the impoverished middle classes borrowing and spending to give them the illusion of prosperity and stop them from revolting. I believe the Fed and Bank of England, in particular, were wholly complicit in this daylight robbery (see link). These unsustainable private sector, debt mountains were transferred to the public sector in 2008 to prevent the adjustment to the depression-era reality that the debt unwind would undoubtedly have brought about. Yet, those debts are as unsustainable in the hands of the public sector as they were in the private sector. Central bank polices havent changed though. Print and print and print. And if that doesnt work, print some more. And as London burns, the point I have always made is that the US and UK are not like Japan in one very special way. Although Japan suffered a decade of pain it is a very homogenous, equal society (see below). The UK and US are not. Some readers may not know that rioting and looting has broken out around London. While I hear the UK politicians denounce the looters as common criminals (which of course they are), I cant help but think that Louis XVI in 1789 and Tsar Nicolas II in 1917 might have said the same thing.
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One reason the Japanese didnt riot during their lost decade

Source: Datastream, SG Cross Asset Research

In the Eurozone, the markets are now realising what should have been obvious from the start. The authorities are in very little position to halt the rot. During the bubble (aka The Great Moderation) the Eurozone had the same mechanics of mutually assured economic destruction that was seen on a grander scale between China and the US, viz the excessively loose US monetary policy causing a housing and spending boom that resulted in a huge trade deficit, financed in the main by a willingly mercantilist China printing money ad infinitum to keep their fixed exchange rate link (incidentally its a bit rich for the Chinese to complain about the US profligacy when they are just as bad when it comes to cranking the printing press). The Eurozone has been no different to this unstable US/China nexus, with some member countries enjoying (suffering?) super loose monetary policies through no fault of their own (unlike the US), leading to housing and spending booms causing huge trade deficits funded in the main by Germany with a Chinese-style trade surplus, with their banks lending money to the deficit nations in the periphery to keep the party going.
Public sector debt/GDP projections

Source: The Future of Public Debt, Prospects and Implications, BIS Working Paper 300, Published March 2010, http://www.bis.org/publ/othp09.pdf

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So, during the Great Moderation, although the overall trade situation of the Eurozone seemed to be in external balance with the rest of the world, under the surface the situation was always every bit as unstable and poisonous as the US/China situation. But moving to the here and now, would I rather be in Italian debt than US debt? Yes I probably would. See the government debt projections of the BIS above (published in 2010 but still valid as things havent changed so much as to be really out of date). Even without slashing age-related benefits, at least Italy has a good chance of getting things under control. Most other nations havent got any chance at all (by the way the UK chart is much worse than either France or the US. But I needed to include France as it had the legend on it!). The bulls still point to booming US profits to sustain the market. The problem is that US whole economy profits growth is slowing extremely rapidly (see chart below) and this tends to lead stock market measures. Profits growth is the biggest determinant of corporate expenditure growth which helps explain the weakness in business spending this year.
US domestic non-financial economic profits growth (pre-tax, % change)
80 80

60

yoy

60

yoy 4q mav
40

40

20

20

-20

-20

-40

-40

2q/2q
-60 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 -60

Source: Datastream

Similarly those hoping for emerging market growth to sustain the global economy should think again. Actually emerging markets are slowing even more rapidly than developed markets (see chart below).
OECD leading indicators (ratio to trend, amplitude adjusted, 100 = trend growth)
110 110

105

China

OECD

105

100

100

India
95 95

90

90

Brazil
85 2007 2008 2009 2010 2011 85

Source: Datastream

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I was re-reading one of my favourite authors the other day. Fred Hickey who writes The High Tech Strategist. Many of you will know him as a regular guest on Barrons roundtables. Back in his 2 June issue he mused about the impending end of QE2. His observations about Bernanke are crucial to understanding where we go from here: With 28 days and counting before the end of the Feds quantitative easing, round 2, or QE2 program, I thought it might be worth my while to re-read Fed Chairman Ben Bernankes speech titled: Deflation: Making Sure It Doesn't Happen Here for clues as to what the Feds next move may be. For some years now, Ive called this speech The Playbook for its usefulness in predicting Bernankes next moves. It has not disappointed. One attribute that Bernanke certainly does not lack is conviction. When reading his November 2002 speech it becomes very clear that there is no wavering of opinion. His statements are absolute. Consider the lead-in paragraph above. The central bank should always be able to generate increased nominal spending and inflation even when the short-term nominal interest rate is zero. Always is a powerful word. Theres no wiggle room in it. Similarly, Bernanke left no wiggle-room in his now-infamous December 6, 2010 CBS 60 Minutes interview in which he stated: "We've been very, very clear that we will not allow inflation to rise above 2 percent." Asked by CBS interviewer Scott Pelley what degree of confidence he had in his ability to control inflation, Bernanke responded, one hundred percent. By reading these statements we can conclude that Bernanke absolutely believes that the Fed can ultimately create just the right amount of inflation (about 2%). If deflation threatens, he has a whole assortment of tools (spelled out in the 2002 speech) to always be able to generate inflation. Should he create too much, hes 100% certain hed be able to bring it down to acceptable levels by raising interest rates. In the 2002 speech, Bernanke addressed the most glaring exception to the idea that central bankers should be able to control the economy (spending) and inflation Japan. Towards the end of that speech, Bernanke commented on the long-running Japanese recession/deflation problem. He began by asking, The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why hasJapan not ended its deflation? Bernanke noted that Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Editors Note: Do these conditions sound familiar? Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. Bernanke further blamed political deadlock, where strong policy actions are discouraged and concluded: In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States. As stated in that speech, Bernanke believes that the Fed has the tools to cure deflationary recessions. The problem with the Japanese was that they just didnt use the tools available. As Charlie Munger said, to a man with a hammer everything looks like a nail. For the US and UK governments one key lesson from this crisis yet to be learnt is: do not appoint an academic to head up the Central Bank. Their certainty of view (often an academic characteristic) is simply far too dangerous. I suggest Boris for next Governor.

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