Thunder Road report

Into a Bubble?
Buying Time in a Brought Forward World
S&P 500 - since 1996
1800

1600

1400

1200

1000

800

600

400

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Sectors/stocks: as pressure on consumers grows, companies supplying essential goods & services will be relative beneficiaries

Strategy
October 2013

2013

Into a bubble?

Bubbling Up Megaphones and Domed Houses Polar Opposites - middle of a bull market or imminent peak? Need a Plan B? Trying to Make Sense of Bubbles

3 3 5 6 7 11 11 11 12 14 14 19 20 31

Buying Time in a Brought Forward World Manipulating the Time Horizon

It Should Work Both Ways Theme: Essential Goods & Services Is the Cycle Slowing Again? Slowdown versus 2004-05 Style Mid-Cycle Acceleration The US Consumer The Picture Outside the US

Inflation Versus Deflation: short-term resolution imminent?

Ambiguous Signals Bigger Picture Gibson’s Paradox Interest rates and Interest Rates (Repos)

31 34 36 38

Research: Paul Mylchreest +44 207190 7242 pmylchreest@monumentsecurities.com
This is a marketing communication. It has not been prepared under the Independent Investment research regulatory requirements and accordingly there is no prohibition on dealing ahead of the dissemination of this research material.

Bubbling Up
Megaphones and Domed Houses
Here we go again, creating another asset bubble for the third time in a decade and a half. This chart holds particular significance for us since our colleague, David McCreadie, has been writing about it in his daily “Tactical Trader” emails for nearly 5 years.
Dow Jones Industrial Average - megaphone pattern since 1996
18000

16000

Source: Bloomberg, Monument Securities.

14000

12000

10000

8000

6000

4000

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Eckhart Tolle was voted the most spiritually influential person in the world and teaches that: “the primary cause of unhappiness is never the situation but your thoughts about it” Which seems apt right now. We noticed the immediate spike to an all-time high in the S&P 500 on the release of last week’s NFP data at the same time that increasing doubts are surfacing over • Whether the US economy will reach “escape velocity” and; • The benefit of QE on the real economy rather than asset prices. It’s getting increasingly difficult to argue that we haven’t crossed the threshold into bubble territory in equities. Are we going to bounce off the upper resistance of the “megaphone” pattern in the chart above and fall sharply? Another near-perfect chart set up came and went. George Lindsay’s “Three Peaks and a Domed House” pattern was forming through 2011-12, until the QE3-driven rally (pre and post the September 2012 announcement) in equities ultimately “blew out” the last wall of the domed house - and the chart only shows the early stages.

October 2013

3

2013

Similarly, the widely used equity model - ISM manufacturing index versus the year-on-year change in the

S&P 500 – had an excellent long-term track record, but became almost redundant between mid-2012 and

Source: Bloomberg, Monument Securities.

Source: Carl Futia

Source: ISM, Bloomberg, Monument Securities

October 2013
1050 1100 1150 1200 1250 1300 1350 1400 1450 1500 1550

0.0%

-60.0% 60.0%

-40.0%

-20.0%

20.0%

40.0%

May-99

01/12/2010 22/12/2010 12/01/2011 02/02/2011 23/02/2011 16/03/2011 06/04/2011 27/04/2011 18/05/2011 08/06/2011 29/06/2011 20/07/2011 10/08/2011 31/08/2011 21/09/2011 12/10/2011 02/11/2011 23/11/2011 14/12/2011 04/01/2012 25/01/2012 15/02/2012 07/03/2012 28/03/2012 18/04/2012 09/05/2012 30/05/2012 20/06/2012 11/07/2012 01/08/2012 22/08/2012 12/09/2012 03/10/2012 24/10/2012 14/11/2012 05/12/2012 26/12/2012 16/01/2013

Sep-99

Jan-00

May-00

Sep-00

Jan-01

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

S&P 500 v. ISM

S&P 500: December 2010 - January 2013

Which perhaps says something about the power of “unconventional” monetary policy?

mid-2013. Once again, it was the QE3-related rally which led to the correlation breaking down.

S&P 500 yoy %

4

May-06

Sep-06

Jan-07

May-07

Sep-07

ISM

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

Jan-12

May-12

Sep-12

Jan-13

May-13

Sep-13

32.0

37.0

42.0

47.0

52.0

57.0

62.0

67.0

The ISM/S&P 500 model is no longer suggesting that equities are significantly overvalued. However, that is thanks to the spike in the ISM which has likely reached its zenith and should roll over shortly (see below).

Polar Opposites - middle of a bull market or imminent peak?
We were intrigued recently how the same data in the form of the 2013 year-to-date chart pattern, were used to justify polar opposite views for equities, i.e. continuation of a mega-bull market or an imminent crash. This appealed because our gut feeling is that the reassessment of QE along with the tapering debate is an important period in the post-Lehman recovery. Just to illustrate... The similarity between the US equity market’s performance in 1954 and 1995 with that in 2013 has been cited by commentators on the bullish tack. 1954 was a great year for equities - not only did the Dow Jones finally surpass the 1929 all-time high, but the index rose 44.0%.
Dow Jones Industrial Average: 1954 v. 2013
410 17250 16750

390

16250 370 15750 350

Source: Bloomberg, Monument Securities.

15250

330

14750

14250 310 13750 290

13250

270

12750

01/01/1954

15/01/1954

29/01/1954

12/02/1954

26/02/1954

12/03/1954

26/03/1954

09/04/1954

23/04/1954

07/05/1954

21/05/1954

04/06/1954

18/06/1954

02/07/1954

16/07/1954

30/07/1954

13/08/1954

27/08/1954

10/09/1954

24/09/1954

08/10/1954

22/10/1954

05/11/1954

19/11/1954

03/12/1954

17/12/1954

1954

2013 (since 11 Dec 2012)

This comment recently appeared on the Seeking Alpha markets forum. “The two years that have the highest correlation to 2013 continue to be 1954 and 1995...In the bigger picture, both 1954 and 1995 were right in the middle of the longest and strongest two bull markets of the 20th Century. They came nowhere near the end of a bull market. In fact, they marked the beginning of the longest and strongest growth legs of those two gigantic ‘El Toro Grande’ bull markets.” The Dow rose another 19% in 1955 and 24% in 1996 (after 33.3% in 1995). Meanwhile, bearish commentators have pointed to similarities between the 2013 chart pattern with two infamous crash years of 1929 and 1987. Despite the similarities, we seem to have avoided the 1987 scenario, although the 1929 scenario is still “in play”, as Tom DeMark has highlighted recently. We’ve recreated his chart here.

October 2013

5

31/12/1954

Dow Jones Industrial Average: 1928-30 v. 2012-13
400 17000 16500 350 16000

Source: Bloomberg, Monument Securities.

15500 300 15000 14500 250 14000 13500 200 13000 12500 150 12000

03/01/1928

03/02/1928

03/03/1928

03/04/1928

03/05/1928

03/06/1928

03/07/1928

03/08/1928

03/09/1928

03/10/1928

03/11/1928

03/12/1928

03/01/1929

03/02/1929

03/03/1929

03/04/1929

03/05/1929

03/06/1929

03/07/1929

03/08/1929

03/09/1929

03/10/1929

03/11/1929

03/12/1929

03/01/1930

03/02/1930

03/03/1930

Jan 1928 - Apr 1930

May 2012 - Oct 2013

Policy makers are pushing monetary systems and experimental policies to their limit, so shouldn’t we consider the possibility of correspondingly extreme outcomes in financial markets in due course... cause and effect?

No Plan B?
After Lehman, policy makers went “all-in” on bailouts/ZIRP/QE etc. This avoided an “all-out” collapse and bought time in which a self-sustaining recovery could materialise. The Fed’s tapering threat showed that, five years on from Lehman, the recovery was still not self-sustaining. Our study of long-wave (Kondratieff) cycles, however, leaves us concerned as to whether it ever will be. More commentators are having doubts, e.g. Andrew Law of Caxton in the recent FT interview. The problem looming into view is that we might need a new “plan.” Does the incoming Fed Chairwoman have a new plan and, more importantly, one which could work? We have our doubts, the default strategy being continued reliance on liquidity-driven asset bubbles, while hoping for the best in terms of traction with the real economy. Our colleague, Andy Ash, commented last week. “The biggest impact of QE1 was on metals and EM (emerging markets) indicating that the result of QE was predicted to be growth. The three lowest beneficiaries of QE3 have been Gold , Metals and EM, all SIZEABLY NEGATIVE IN RETURNS. So QE3’s effect unlike QE1’s has been nothing to do with global growth. The biggest return on QE3 was/is Western equities.” If the US is locked into low growth for the foreseeable future, should the S&P 500 be trading on a 12-month forward earnings multiple of 16.2x, slightly higher than the 15.5x long-term average? Let’s not forget that Europe appears to be stuck in an even lower growth scenario and China’s growth rate is moderating. Moreover, corporate margins are close to an all-time high and earnings forecasts are being progressively downgraded. So higher and higher valuations for more distant, and (arguably) increasingly uncertain, cash flows. With the temporary deal agreed in Washington, QE looks set to continue running at US$85bn until March 2014, maybe longer. We’ve written about the QE/repo linkage a lot in recent months and it’s our opinion that the collateralisation of excess deposits created by QE has positively impacted equities via shadow banking conduits, e.g. repos.

October 2013

6

03/04/1930

S&P 500 v. Deposits minus Loans ("deposit to loan gap" in banks from QE)
1800 2500

1600

2000

Source: Federal Reserve, Monument Securities

1400 1500 1200 1000 1000

800

500

600

0

Even the US Treasury (Treasury Borrowing Advisory Committee report for Q2 2013) noted the correlation between weeks when QE exceeded US$5bn and strength in the S&P 500.

Mar09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 Jun10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Aug-13 Sep-13 Oct-13

S&P 500

Deposits - Loans: All Commercial Banks (US$bn)

Have we really got to the point where it’s just about more and more QE, corralling more and more flow into the equity market until it becomes (unsustainably) “top-heavy”?

Source: TBAC

Trying to Make Sense of Bubbles
If we are in a centrally-planned bubble (and it feels like it to us), we are reliant on second guessing policymakers, trying to gauge flows (positive for equities right now) and utilising any indicators which seem to be showing good correlations. An example of the latter is the Summation Index. This is a measure of market breadth, being a running total of Advance minus Decline values of the McClellan Oscillator. A pattern of declining peaks had formed since the correction in late-May, but this reversed with the recent upward move.

October 2013

7

S&P 500 v. Summation Index
1800 1750 1700 1650 1600 1550 1500 1450 1400 1350 1300 -500 1500 2500 4500 5500

Source: Bloomberg, Monument Securities.

3500

500

Sep-12

Feb-13

Apr-13

Mar-13

Dec-12

Sep-13

Jun-13

Oct-12

Jul-13

Aug-12

Nov-12

S&P 500

Summation Index

We are still in the biggest debt crisis in history and the banking sector will remain at the centre of its ebbs and flows. The divergence of the sector’s performance from the broader market pre-empted the Lehman collapse in 2008. In the US, we are keeping a close eye on the breakdown in the BKX.
BKX Banks Index relative to S&P 500
0.040

0.038

May-13

Aug-13

Oct-13

Jan-13

Source: Bloomberg, Monument Securities.

0.036

0.034

0.032

0.030

Apr-12

Feb-12

Sep-12

Feb-13

Apr-13

Mar-12

Mar-13

Aug-12

Dec-12

May-12

Nov-12

There is a similar story in the UK.
FTSE Banks v. FTSE All Share
1.55

1.50

1.45

May-13

Aug-13

Sep-13

Jun-12

Jun-13

Jul-12

Oct-12

Jan-12

Jan-13

Jul-13

Source: Bloomberg, Monument Securities.

1.40

1.35

1.30

1.25

1.20

1.15

1.10

Apr-12

Feb-12

Sep-12

Feb-13

Apr-13

Mar-12

Mar-13

Aug-12

Dec-12

May-12

Nov-12

October 2013

8

May-13

Aug-13

Sep-13

Jun-12

Jun-13

Jul-12

Oct-12

Jan-12

Jan-13

Jul-13

In such extreme circumstances, we should also keep an idea of “crash patterns” in the back of our minds in case. These often play out as a peak followed by a failure to make a new high and a subsequent break of support. Here are some notable examples.

Dow Jones Industrial Average: 1929 (Apr-Dec)
390 2800 370 2600 350

Dow Jones Industrial Average: 1987 (Apr-Dec)

330 2400 310

290

2200

270 2000 250

Source: Bloomberg, Monument Securities.

230 1800 210

190 10/04/1929 10/05/1929 10/06/1929 10/07/1929 10/08/1929 10/09/1929 10/10/1929 10/11/1929 10/12/1929

1600 01/04/1987 01/05/1987 01/06/1987 01/07/1987 01/08/1987 01/09/1987 01/10/1987 01/11/1987 01/12/1987

NASDAQ Composite: 1999-2000 (Sept-May)
5200 5000 4800 4600 4400 4200 11000 4000 3800 10000 3600 3400 3200 3000 2800 2600 01/09/1999 01/10/1999 01/11/1999 01/12/1999 01/01/2000 01/02/2000 01/03/2000 01/04/2000 01/05/2000 7000 03/03/2008 03/04/2008 8000 12000 13000 14000

Dow Jones Industrial Average: 2008 (Mar-Dec)

9000

03/05/2008

03/06/2008

03/07/2008

03/08/2008

03/09/2008

03/10/2008

03/11/2008

03/12/2008

And we can compare these with the year-to-date chart for the S&P 500 (which is currently leading the Dow).
S&P 500: 2003 year-to-date
1800

1750

Source: Bloomberg, Monument Securities.

1700

1650

1600

1550

1500

1450

1400 02/01/2013 02/02/2013 02/03/2013 02/04/2013 02/05/2013 02/06/2013 02/07/2013 02/08/2013 02/09/2013 02/10/2013

October 2013

9

If there’s one market that makes us very nervous right now (hat tip to Ben Davies of Hinde Capital), it’s the ChiNext...”a NASDAQ-type exchange for high-growth, high-tech start-ups” (Wikipedia). Besides the pattern, it’s also risen by 110% since last November.
ChiNext: 2013 (Mar-Oct)
1500

1400

Source: Bloomberg, Monument Securities.

1300

1200

1100

1000

900

800 01/03/2013 01/04/2013 01/05/2013 01/06/2013 01/07/2013 01/08/2013 01/09/2013 01/10/2013

A final word on equity market indicators. In our reports since May, we’ve been “road-testing” a model for the US equity market (using the DJIA which has a longer history). It is based on cycles, not economic indicators, but cycles in time. It is created from the interaction of 18 cycles in US equities. These vary in length from just under 3 months to more than 30 years. Most of these cycles were discovered by the Foundation for the Study of Cycles (FSC), which has published a vast body of work during the last 70 years. We’d like to make contact with any readers who’ve also looked into this type of work, as trying to incorporate it into our research is very much work in progress. While in its very early days, the model has been a reasonably good predictor of market direction since the beginning of 2009 (having also picked out most of the market peaks and troughs since 1905). We are slightly alarmed because it’s predicting that the Dow should be rolling over now into the first part of 2014.
Dow Jones Industrial Average: actual versus predicted 2009-13
1.40 1.008 1.30 1.003

1.20

Source: Bloomberg, Monument Securities.

1.10

0.998

1.00

0.993

0.90 0.988 0.80 0.983 0.70 0.978

0.60

0.50

0.973

2009-01-02

2009-03-02

2009-05-02

2009-07-02

2009-09-02

2009-11-02

2010-01-02

2010-03-02

2010-05-02

2010-07-02

2010-09-02

2010-11-02

2011-01-02

2011-03-02

2011-05-02

2011-07-02

2011-09-02

2011-11-02

2012-01-02

2012-03-02

2012-05-02

2012-07-02

2012-09-02

2012-11-02

2013-01-02

2013-03-02

2013-05-02

2013-07-02

2013-09-02

2013-11-02

Actual

Predicted

October 2013

10

2014-01-02

While this fits with our current view of the fundamentals (see below), it obviously flies in the face of the trend, “risk-on” sentiment and, most importantly perhaps, the continuation of US$85bn per month of QE for now. Please note: the Y-axes on the above chart do not represent absolute levels for the Dow. Rather, the left hand Y-axis represents the Dow Jones versus a moving average and the right hand Y-axis is a measure of the amplitude in the predicted trend.

Buying time in a brought forward world
Manipulating the Time Horizon
We’ve been reflecting on the idea that using unconventional monetary policies, i.e. QE at the long end of the yield curve, central banks have “bought time” in a profound sense by manipulating the time horizon. This leads to longer-term cash flows associated with financial assets being discounted at artificially low rates. It has been crossing our minds as to how much equity investors have really considered this issue, even if (like us) they are believers in equities overcoming bonds in the inflationary endgame (see “Inflationary Deflation” report from December 2012? Fixed income investors are acutely aware that QE has forced them to extend duration. That comes with the scary knowledge that they might all rush for the exit at the same time. While many financial assets have long duration, equities have very long “duration,” often reflecting theoretical cash flows to infinity. Equity investors typically make detailed estimates for corporate cash flows, e.g. for 7-10 years. Beyond that, cash flows to infinity are capitalised (using long-term growth rate assumptions, ROIC fades, etc) in the form of terminal values...or until analysts predict that the deposit/reservoir will be depleted in the case of mining/ energy stocks. QE obviously keeps rates lower than they would otherwise be and increases the value of these capitalised cash flows - especially more distant ones. When we think about long-term economic cycles, one of (if not) the biggest single driver is the growth in debt (and, problematically, its eventual reduction at the end of the cycle). If we consider the US economy, the huge increase in debt has brought forward consumption over an extended period of several decades. That process has become increasingly “long in the tooth”, so it’s hardly surprising that credit and consumption growth is currently subdued. When so much consumption has already been “brought forward”, it might seem counter-intuitive that the valuation of distant cash flows is being inflated via PEs above their historic average AND artificially suppressed interest rates. When you also consider that corporate margins are close to a historic peak, the market takes on the appearance of an athlete that is expected to continue performing at peak level almost indefinitely. Hmmm, as Grant (“Things That Make You Go Hmmm”) Williams might say.

It Should Work Both Ways
In a world of US$85bn per month QE, the corollary of the discussion above should be that the valuation of long duration financial assets should be unusually sensitive on the downside to anything that threatens this current “buying time” and “brought forward” model for long-term financial assets. The obvious candidates are: • A rise in interest rates; and/or • An event which leads to a significant contraction in the time horizon for investors, such as a sudden deterioration in the macro outlook, or a geo-political shock.

October 2013

11

The market turmoil induced by Bernanke and his colleagues with the taper threat (quickly watered down and subsequently canned) seems entirely fitting in this light. The consequence is that the Fed’s ability to taper looks ever more serious with regard to asset prices. This is the two-way version of the “Stockholm syndrome” between the Fed and markets we’ve highlighted before. Boxed in? In our July 2013 report, we noted the “spectacular irony” that Bernanke’s plan to taper directly contradicted his criticism (in the “Money, Gold and the Great Depression” speech from March 2004) of the Federal Reserve policy in the Great Depression era of the 1930s. We noted (with our emphasis). “Each mistake Bernanke highlighted during 1928-33 involved a tightening of monetary policy, exactly as the Fed has proposed recently. However, the real irony is the manner in which the Fed tightened monetary policy in 1932 VIA THE REVERSAL OF OPEN-MARKET OPERATIONS, basically reducing QE.” Reversing the open market operations in 1932 caused interest rates to rise and Bernanke was scathing in his criticism. “These policymakers did not appear to appreciate that, even though nominal interest rates were very low, the ongoing deflation meant that the real cost of borrowing was very high because any loans would have to be repaid in dollars of much greater value.” Below is the trend in real long-term US rates (Barclays US Inflation linked 7-10 years average real yield) – which haven’t reversed all the increase since the possibility of tapering was floated and subsequently shelved.
Barclays US Inflation linked 7-10 years real yield (%)
1.00

0.50

Source: Bloomberg, Monument Securities.

0.00

-0.50

-1.00

-1.50

Sep-12

Feb-13

Apr-13

Mar-13

Dec-12

Sep-13

Jun-13

Jul-12

Oct-12

Jul-13

Aug-12

Nov-12

Given the contradiction with Bernanke’s “doctrine”, we are slightly more sympathetic now with the view from a “down the rabbit hole” source who explained that the reason for the Fed floating the idea of tapering was to “test” the resilience of the financial system. It appears to have failed that test. Boxed in?

Theme: Essential Goods & Services
If many long duration financial assets are, indeed, moving into bubble territory, it’s been crossing our minds to ask whether assets at the short end of the duration spectrum are becoming structurally undervalued?

October 2013

12

May-13

Aug-13

Oct-13

Jan-13

It’s amusing to turn over in your mind the idea that a 3-month German Treasury Bill, on a yield of 3 basis points, could be “cheap”. The answer is obviously “yes” in an unfolding crisis (contraction in time horizon) and these Bills traded on -20.5 basis points before Draghi threatened to do “whatever it takes” to save the Euro (just as Spanish 10-year yields were spiking to 7.62%).
Germany: 3-month Treasury Bill
2.40

2.00

Source: Bloomberg, Monument Securities.

1.60

1.20

0.80

0.40

0.00

-0.40

2009

2010

2011

2012

What about commodities which are both staples and perishable. Like the raw material for bread, for example?
Wheat (Active contract)
1000

900

2013

Source: Bloomberg, Monument Securities.

800

700

600

500

400

300

2009

2010

2011

2012

Aside from “assets”, what about the idea of goods in terms of short “duration”? This is Wikipedia on fast moving consumer goods (FMCG)... “The term FMCGs refers to those retail goods that are generally replaced or fully used up over a short period of days, weeks, or months, and within one year. Examples include non-durable goods such as soft drinks, toiletries, etc, and grocery items...Fast-moving consumer electronics are a type of FMCG and are typically low priced, generic or easily substitutable consumer electronics, including mobile phones, MP3 players, game players, and digital cameras...Global leaders in the FMCG segment include Johnson & Johnson, Colgate-Palmolive, Anheuser-Busch InBev, Henkel,

October 2013

13

2013

Kellogg’s, S.C. Johnson, Beiersdorf, Mars Inc., Heinz, Nestle, Reckitt Benckiser, Unilever, Procter & Gamble, L’Oreal, Coca-Cola, General Mills Inc., PepsiCo, Mondelez and Kraft Foods.” In the “Inflationary Deflation” report referred to earlier, we set out our long-term investment strategy. We argued that as pressure on consumers intensifies, equity portfolios should be progressively aligned towards stocks which are relative beneficiaries of the shifts in real disposable income. In general, we favour companies supplying ESSENTIAL ITEMS AND SERVICES as we expect that these expenditures will account for a growing share of the “economic pie” in future. In thematic terms, many of the sectors we highlighted: • Food/agriculture; • Energy; • Personal & household care; • Healthcare; • Mobile telephony & networking; and • Defence (for governments). Are, in fact, skewed towards faster moving consumer goods. Some analysts seem to be thinking along similar lines. We were interested to read Sandeep Jaitly’s (of Fekete Research and portfolio manager at First International) latest “Course of the Exchange” report in which he argued in typically forceful fashion. “When it comes to the picking of stocks going forward to capture this expected nominal rally in the global equity exchanges – the concept of marketability must always be borne in mind. Companies that produce the most marketable goods – such as Procter & Gamble, or Unilever – will always have a ready market for their equity. However, it’s a question of the denomination of this ready market as fiat squeezes such stocks into being hoarded just like gold. Some companies which are just capitalised claims to fiat – such as banking or insurance shares – will lose all relative exchange value at some point compared to the companies that produce marketable goods of various shades.” By “marketable”, he means acceptable. This brings gold to mind as a universally accepted currency and store of wealth. Professor Fekete argues that the marginal utility of gold declines more slowly than any other substance. I think this is relevant to the discussion about time horizons/duration but I need to think more about it.

Is the cycle slowing again?
Slowdown versus 2004-05 style Mid-Cycle Acceleration
Sticking with our defensive theme, we are concerned that the rebound in global growth is about to level off once again, likely driven by more subdued activity in the US and a stabilisation of the Eurozone recovery. Our biggest fear is that the US consumer, so often the saviour of global growth, is really starting to struggle, although pressure on real incomes is a much broader international theme. We should preface this view by admitting how surprised we were by the strength of the ISM manufacturing survey in recent months. October 2013

14

US: ISM Manufacturing Index (since 1990)
65.0

60.0

55.0

50.0

Source: ISM, Monument Securities

45.0

40.0

35.0

30.0

Apr-95

Apr-02

Feb-94

Sep-94

Feb-01

Sep-01

Feb-08

Sep-08

Apr-09

Jun-96

Jun-03

Mar-91

Mar-98

Mar-05

Jun-10

Jul-93

Jul-00

Jul-07

Mar-12

Dec-92

Dec-99

Dec-06

Oct-91

Oct-98

Oct-05

Aug-90

Aug-97

Aug-04

Nov-95

Nov-02

May-92

May-99

May-06

Nov-09

Aug-11

Oct-12

Jan-90

Jan-97

Jan-04

Jan-11

The ISM has risen by 7.2 points during the last four months (June to September 2013) from 49.0 to 56.2.
US: 4-month change in ISM Manufacturing Index (since 1990)
15.0

10.0

5.0

0.0

May-13 May-13

Source: ISM, Monument Securities

-5.0

-10.0

-15.0

-20.0

Apr-95

Apr-02

Feb-94

Sep-94

Feb-01

Sep-01

Feb-08

Sep-08

Apr-09

Jun-96

Jun-03

Mar-91

Mar-98

Mar-05

Jun-10

Jul-93

Jul-00

Jul-07

Mar-12

Dec-92

Dec-99

Dec-06

Oct-91

Oct-98

Oct-05

Aug-90

Aug-97

Aug-04

Nov-95

Nov-02

May-92

May-99

It’s worth putting such a strong rise in context. In the almost 24 years (285 months) since 1990, such a strong (or stronger) rise has only happened on 15 occasions, or 5.2% of the time. Of these, 11 were within six months of the official end of a recession, i.e. when the economy was undoubtedly in recovery/bounce back mode. Currently, we are more than four years away from the end of the last recession in June 2009. The other four “mid-cycle” occasions were May 1992, June 1996, November 2003 and January 2004. The key question is whether the ISM is signalling a “mid-cycle” acceleration in US growth this time? Let’s consider the four previous occasions. Within four months of May 1992, the ISM had fallen back by 6.0 points to 49.7. The month after June 1996, the ISM was back below 50.0 at 49.7 and did not exceed the June 1996 level for six months. So on two of these four occasions, things began to slow down shortly afterwards. The exceptions were November 2003 and January 2004. The ISM peaked at 60.8 in January 2004 and remained remarkably strong (above 55.0) through to March 2005. The November 2003 and January 2004 ISM readings pre-empted the strongest period of US GDP growth between the 2001 and 2007-09 recessions – a genuine mid-cycle acceleration.

October 2013

15

May-06

Nov-09

Aug-11

Oct-12

Jan-90

Jan-97

Jan-04

Jan-11

US Real GDP growth (yoy %)
5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0

Source: BEA

-3.0

-4.0

-5.0

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Is a pick-up in growth like 2004-05 in store this time? We think it’s unlikely and it’s worth comparing current trends with 2004-05. First, let’s highlight one issue which could have given the ISM a temporary boost. Some keen observers noted a surge in aerospace orders in June as the supply chain geared up.
US Durable Goods Orders - Aircraft & Parts (US$m)
35000

30000

25000

20000

2013

Source: US Census Bureau

15000

10000

5000

0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Surging aerospace orders did not only benefit the US. We also saw a stronger-than-expected rebound in German manufacturing orders in June following the Paris Air Show. Alcoa led off the current earnings season and we were very interested in what the company said about trends in aerospace. Here are a couple of quotes on the fourth quarter outlook from the results presentation: “Aero plate shipments continue to be impacted by high OEM inventories” And: “Aerospace remains strong, temporarily impacted by engine market inventory realignment and lower U.S. Defense spare parts demand”

October 2013

16

2013

With something of a “softer spot” for aerospace coming in Q4, it looks like we should expect those strong ISM numbers to roll over. Aerospace aside, let’s consider other indicators of US economic strength and compare them (where possible) with 2004-05 when we experienced a prolonged mid-cycle acceleration in growth. The current situation is very different in our view. The US is a credit-driven economy and household debt growth is non-existent right now, but was running at double-digit rates during 2004-05.

Household debt growth yoy % (1961-2013)
20%

15%

10%

5%

Source: Federal Reserve

0%

-5%

Outstanding balances on credit cards tend to grow during buoyant economic periods. Current growth is nonexistent compared with the acceleration from c.2% in early 2004 to a peak of 12% in late-2006.
US revolving credit outstanding (yoy %)
25.0%

20.0%

15.0%

10.0%

5.0%

0.0%

Q1 1961 Q1 1962 Q1 1963 Q1 1964 Q1 1965 Q1 1966 Q1 1967 Q1 1968 Q1 1969 Q1 1970 Q1 1971 Q1 1972 Q1 1973 Q1 1974 Q1 1975 Q1 1976 Q1 1977 Q1 1978 Q1 1979 Q1 1980 Q1 1981 Q1 1982 Q1 1983 Q1 1984 Q1 1985 Q1 1986 Q1 1987 Q1 1988 Q1 1989 Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013
-5.0% -10.0% -15.0%

Source: Federal Reserve

Apr-95

Apr-02

Feb-94

Sep-94

Feb-01

Sep-01

Feb-08

Sep-08

Apr-09

Jun-96

Jun-03

Mar-91

Mar-98

Mar-05

Jun-10

Jul-93

Jul-00

Jul-07

Mar-12

Dec-92

Dec-99

Dec-06

Oct-91

Oct-98

Oct-05

Aug-90

Aug-97

Aug-04

Nov-95

Nov-02

May-92

May-99

May-06

Nov-09

Aug-11

Oct-12

Jan-90

Jan-97

Jan-04

Jan-11

Growth in personal consumption expenditure is also in the doldrums compared with 6-7% growth during much of 2004-05

October 2013

17

May-13

The University of Michigan’s Consumer Confidence survey remains below late-2003/early-2004 levels.

Optimism Index has recovered since the crisis but remains well below the peak levels reached in 2004-05.

A thriving small business culture is usually associated with a vibrant economy. The NFIB Small Business

Source: BEA

Source: University of Michigan

Source: NFIB, Monument Securities.

October 2013
100 110 120 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 50 60 70 80 90

100

105

110

80

85

90

95

Jan-01 Jun-95 Nov-95 Apr-96 Sep-96 Feb-97 Jul-97 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Dec-97 May-98 Oct-98 Mar-99 Aug-99 Jan-00 Jun-00 Nov-00 Apr-01 Sep-01 Feb-02 Jul-02 Dec-02 May-03 Oct-03 Mar-04 Aug-04 Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 May-13 Oct-13 May-02 Jan-02 Sep-01 May-01

Jan-95 Jan-01

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

US Consumer Confidence (UoM)

NFIB Small Business Optimism Index

US: Personal consumption expenditure (yoy %)

18

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

Jan-12

May-12

Sep-12

Jan-13

May-13

Sep-13

Then there’s the much vaunted housing recovery which appears to have slowed in response to the rates spike. If it is in its early stages, which we doubt, it still has a long way to go before we return to the heady days during the middle of the last decade.
Housing Starts and MBA Mortgage Purchase Index
2500 550

500 2000

450

400 1500 350

Source: MBA, Monument Securities.

300 1000 250

500

200

150

0

100

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

May-01

May-02

May-03

May-04

May-05

May-06

May-07

May-08

May-09

May-10

May-11

May-12

Housing Starts (000s)

MBA Mortgage Purchase Index

If there is a catalyst out there which will drive a mid-cycle acceleration in US GDP growth, we are finding it hard to see right now.

The US Consumer
The above discussion on US economic prospects makes us concerned about the prospects for the US consumer...especially when consumer discretionary stocks have seen an almost unbroken five-year run of outperformance.
S&P Consumer Discretionary / S&P 500
0.30

0.28

May-13

Sep-13

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Source: Bloomberg, Monument Securities.

0.26

0.24

0.22

0.20

0.18

0.16

2009

2010

2011

2012

On the subject of the US economy and the health of US consumers, there’s an indicator (we wish we could remember where we first saw it - please contact us if you are the creator for delayed attribution) which is flashing a RARE warning sign right now. This is shown in the chart below which shows a moving average of Real Personal Income minus Current Transfer Payments (RPI-CTP).

October 2013

19

2013

Real personal income less current transfer receipts per capita (3m m.a.)
10.0% 8.0%

6.0%

4.0%

2.0%

0.0%

Source: Conference Board

-2.0%

-4.0%

-6.0%

-8.0%

-10.0%

Apr-82

Apr-85

Apr-88

Apr-91

Apr-94

Apr-97

Apr-00

Apr-03

Apr-06

Apr-09

Apr-12

Jul-81

Jul-84

Jul-87

Jul-90

Jul-93

Jul-96

Jul-99

Jul-02

Jul-05

Jul-08

Oct-80

Oct-83

Oct-86

Oct-89

Oct-92

Oct-95

Oct-98

Oct-01

Oct-04

Oct-07

Oct-10

Jan-80

Jan-83

Jan-86

Jan-89

Jan-92

Jan-95

Jan-98

Jan-01

Jan-04

Jan-07

Jan-10

Jul-11

Please note that recessions are marked with red boxes. Before now, there has only been one instance when this indicator turned negative without the US being in recession since 1980. Historically, RPI-CTI also correlated fairly well with S&P 500 Consumer Discretionary relative to S&P 500 Consumer Staples. In a directional sense, it broke down in 2011 as CD stocks continued to power ahead. This trend is beginning to look very extended.
RPI - CTR v. S&P 500 Consumer Discretionary / Consumer Staples
10.0% 8.0% 1.20 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% 0.70 -8.0% -10.0% 0.60 0.90 1.10 1.30

Jan-13

Source: Conference Board, Bloomberg

1.00

0.80

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

May-01

May-02

May-03

May-04

May-05

May-06

May-07

May-08

May-09

May-10

May-11

May-12

Real Personal Income - Current Transfer Receipts

S&P 500 Consumer Discretionary / Consumer Staples

Time for a more defensively-oriented sector rotation?

The Picture Outside the US
If the US seems more subdued than the consensus believes, and a mid-cycle acceleration is questionable, what about the global picture? Although the global manufacturing PMI has picked up somewhat, the current reading is almost identical to trough readings during 2004-05!

October 2013

20

May-13

Sep-13

Jan-01

Jan-02

Jan-03

Jan-04

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-05

In late-2003/early-2004, Dr Copper’s price was poised for a parabolic rise from US$2,300/tonne to US$8,800/

Source: Markit.com, Monument Securities

Source: Monument Securities

Source: Bloomberg, Monument Securities.

October 2013
0% -40% 10% 20% 30% 40% 50% 60%
30 35 40 45 50

-30%

-20%

-10%

55

60

10000

11000

1000

2000

3000

4000

5000

6000

7000

8000

9000

Jan-01 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13

2001

tonne in the first half of 2006.

2002

2003

World trade was much stronger then.

2004

2005

2006

Developed world imports

Global manufacturing PMI

Copper LME (US$/tonne)

Developed world imports & BRICS exports (% y-o-y)

21
BRICS exports

2007

2008

2009

2010

2011

2012

2013

Chinese real GDP growth was ramping up into the 10-12% p.a. range, not stabilising in the 7-8% p.a. range.
China Real GDP growth (yoy %)
13.0

12.0

11.0

Source: China National Bureau of Statistics

10.0

9.0

8.0

7.0

6.0

5.0

4.0

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

When the Chinese government attempted to crack down on the shadow banking system in May/June 2013, the economy seemed briefly to go into freefall. Simon Hunt of Simon Hunt Strategic Services is the best commentator on China that we’ve found. He noted recently. “To stabilise the economy, government had to turn to the SOE sector in the process liquefying many local governments with credit being issued directly by banks such as the China Development Bank. We understand that these credit lines do not get captured in official credit statistics. As a result, the economy went from weakening to recovering in the space of a few weeks in July as friends in the economic trenches told us.” Year-on-year growth in iron ore imports rebounded sharply in July 2013 after the decline in June - these months are highlighted in the chart below.
China Iron Ore imports since January 2012 (m tonnes)
75

70

2013

Source: China National Bureau of Statistics

65

60

55

50

Apr-12

Feb-12

Sep-12

Feb-13

Apr-13

Mar-12

Mar-13

Aug-12

Dec-12

May-12

Nov-12

October 2013

22

May-13

Aug-13

Sep-13

Jun-12

Jun-13

Jul-12

Oct-12

Jan-12

Jan-13

Jul-13

After the May/June 2013 experience, we expect the Chinese authorities to adopt a more “softly softly” approach to discourage excessive credit creation in shadow banking. The next chart puts the recent rise in 7-day repo rates in context.
China Interbank 7-day Repo (%)
12.00

10.00

Source: Bloomberg, Monument Securities.

8.00

6.00

4.00

2.00

0.00

Feb-13

Apr-13

Mar-13

Sep-13

Jun-13

Jul-13

In Simon Hunt’s view: “The economy has stabilised; a cyclical recovery is underway but without structural reforms it is unsustainable“ Fears about the ChiNext market aside, we subscribe to this view and see the likelihood of reasonable growth continuing in China into the year-end and possibly early 2014. The HSBC/Markit Flash PMI for October 2013 showed another modest improvement to 50.9 from 50.2, while the latest official PMI for new orders (September 2013) showed the strongest reading since April 2012.
China: Official PMI - new orders
70

65

60

55

50

45

May-13

Aug-13

Oct-13

Jan-13

Source: China FLP

40

35

30

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

May-06

May-07

May-08

May-09

May-10

May-11

May-12

Mar-13

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11

Nov-12

October 2013

23

May-13

Sep-13

Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jul-13

If the US looks set to weaken, while China should be okay for a few months, what about the other key variable, i.e. Europe? We think that the strong rebound since the Spring will have levelled off by early 2014. The Eurozone Composite Flash PMI fell marginally from 52.2 (27-month high) to 51.5 in October.
Eurozone Composite PMI
65

60

55

Source: Markit.com, Monument Securities

50

45

40

35

30

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11

Feb-12

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12

Feb-13

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11

May-05

May-06

May-07

May-08

May-09

May-10

May-11

May-12

Nov-12

Our economist, Stephen Lewis, also noted that: “In any case, the ‘hard’ data have started to lag the survey evidence of recovery. The euro zone’s industrial production in July and August was, on average, marginally below the Q2 level, which had been 0.7% higher than the Q1 average.” We are still waiting for some signs of a pick-up in credit growth across the region as a whole - September 2013 was -0.1%.
Eurozone consumer credit
5400000 6.0%

5300000

May-13

5.0%

5200000 4.0% 5100000 3.0% 5000000 2.0% 4900000 1.0% 4800000

Aug-13
0.0% -1.0%

Source: Eurostat

4700000

4600000

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Mar-09

Mar-10

Mar-11

Mar-12

May-09

May-10

May-11

May-12

Mar-13

Nov-08

Nov-09

Nov-10

Nov-11

Nov-12

Consumer credit outstanding (Eur m)

yoy %

The acceleration in Eurozone M1 growth which preceded this year’s rebound in GDP has flattened off. Based on the historic correlation, GDP growth itself should level off in January/February of 2014.

October 2013

24

May-13

Sep-13

Jul-09

Jul-10

Jul-11

Jul-12

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jul-13

Eurozone: M1 (9 months forward) v. GDP growth
14.0 4.0 3.0 12.0 2.0 10.0 1.0 0.0 -1.0 6.0 -2.0 -3.0 -4.0 2.0 -5.0 0.0 -6.0

8.0

4.0

Source: Eurostat

Feb-01

Feb-02

Feb-03

Feb-04

Feb-05

Feb-06

Feb-07

Feb-08

Feb-09

Feb-10

Feb-11

Feb-12

Feb-13

M1 9-months forward (yoy %)

GDP (yoy %)

The CESI is worth keeping an eye on as it’s starting to rollover.
Eurozone: Citi Economic Surprise Index
80

60

40

20

0

Feb-14

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Jun-12

Oct-00

Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12

Jun-13

Oct-13

Source: Citi, Monument Securities

-20

-40

-60

-80

-100

Apr-12

Feb-12

Sep-12

Feb-13

Apr-13

Mar-12

June-12

Mar-13

Dec-12

June-13

Sep-13

Jul-12

Oct-12

Jul-13

Aug-12

May-12

Nov-12

Looking at the periphery, the PMIs for Italy and Spain have both flattened off recently.
Spain & Italy: PMI manufacturing 2013 (year-to-date)
52

50

48

May-13

Aug-13

Oct-13

Jan-12

Jan-13

Source: Markit.com, Monument Securities

46

44

42

40

Feb-13

Apr-13

Mar-13

Spain

May-13

Italy

October 2013

25

Aug-13

Sep-13

Jun-13

Jan-13

Jul-13

continues to improve (although consumer credit growth was -5.0% year-on-year in September 2013).

Spain looks better than Italy. Retail sales have crossed into positive territory and consumer confidence

Source: Bloomberg, Monument Securities.

Source: Bloomberg, Monument Securities.

Source: Bloomberg, Monument Securities.

October 2013
0% 15.0 -30% -20% -10% 10% 20% 30%
0% -30% -20% -10% 10% 20% 30%

-15.0

-10.0

10.0

-5.0

0.0

5.0

Jan-01 May-99 Sep-99 Jan-00 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Apr-04 Jan-04

Jan-99

May-01

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Export growth has turned negative.

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Retail sales (yoy %)
Industrial production

Sep-06

Jan-07

May-07

Italy: Exports (yoy %)

Spain: Retail sales v. Consumer confidence

Italy: Industrial production & Consumer credit (yoy %)

There is no sign of a pick-up in industrial production or consumer credit growth in Italy.

26
0

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Consumer confidence

Consumer credit

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

Jan-12

May-12

Sep-12

Jan-13

May-13

Sep-13

-5

-50

-45

-40

-35

-30

-25

-20

-15

-10

In spite of its President, we had been a little more encouraged by trends in France recently. Both business

Source: Bloomberg, Monument Securities.

Source: Bloomberg, Monument Securities.

Source: Eurostat, Monument Securities.

October 2013
100 110 120 130 60 70 80 90
0% -40% -30% -20% -10% 10% 20% 30% 40%

10%

12%

14%

0%

2%

4%

6%

8%

Jan-04 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13

Jan-01

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

and consumer confidence are rising.

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Spanish imports are back on a declining trend.

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Business Confidence Composite Indicator

Spain: Imports (yoy %)

France: Business & Consumer confidence

France: Consumer credit outstanding (yoy %)

Consumer credit is still in positive territory and has even accelerated during recent months.

27
Consumer Confidence

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

Oct-11

Jan-12

Apr-12

Jul-12

Oct-12

Jan-13

Apr-13

Jul-13

Unfortunately, the most recent data has taken the edge off things a little. August 2013 had seen the first reduction in the number of jobseekers since April 2011, only for it to immediately rebound in September.
France: Jobseekers v. Unemployment rate
3400 12.0 11.5 11.0 3000 10.5 10.0 2600 9.5 9.0 8.5 2200 8.0 7.5 1800 7.0

Source: Bloomberg, Monument Securities.

Apr-00

Apr-05

Sep-00

Feb-01

Sep-05

Feb-06

Apr-10

Sep-10

Feb-11

Jun-99

Jun-04

Jun-09

Jul-01

Jul-06

Mar-03

Mar-08

Jul-11

Mar-13

Dec-01

Dec-06

Dec-11

Oct-02

Oct-07

Aug-03

Aug-08

Oct-12

Nov-99

Nov-04

May-02

May-07

Nov-09

Jobseekers (000s)

Unemployment rate (%)

The Flash Eurozone PMI report commented that “France registered only a negligible expansion as its PMI dipped closer toward neutrality.” Both German IFO surveys (Climate and Expectations) were slightly down in October 2013 versus the previous month, confirming the Flash PMI. The main drags were domestic, i.e. retail and services, while exports remained resilient (China?).
Germany: IFO Business climate & Expectations
120

115

110

105

100

95

90

May-12

Aug-13

Jan-99

Jan-04

Jan-09

Source: IFO Institute

85

80

75

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

May-01

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May-03

May-04

May-05

May-06

May-07

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May-09

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May-12

Business climate

Expectations

So a plateau in activity seems to be on the horizon in the Eurozone, but we can’t help feeling that some of its structural weaknesses have been brought sharply into focus again in recent weeks, although not assimilated into current sentiment. The first relates to the banking system. The ECB is gearing up for direct oversight and new (improved?) stress tests, but what caught our eye were Draghi’s comments to the European Parliament after the German election.

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28

May-13

Sep-13

Jan-01

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Jan-13

“We are ready to use any instrument, including another LTRO if needed, to maintain the shortterm money market rates at a level which is warranted by our assessment of inflation in the medium-term...While repayment of central bank credit is certainly a sign of normalisation, the resulting reduction in excess liquidity can reinforce upward pressures on term money market rates.” So more LTROs are needed because earlier LTROs are being successfully REPAID – entirely logical! We think that his comments emphasise the extreme fragility of the weaker European banks...and we wonder if this includes one or two larger ones? The comment about upward pressure on money market rates most likely refers to Eonia (Euro Over Night Index Average). This is the weighted average rate for overnight unsecured loans in the European interbank market. It is currently trading at 9.6bp - well below the 50bp for the ECB’s MRO (Main Refinancing Operation) policy rate. Prior to the 2008 crisis, Eonia traded at a small positive spread to the MRO as the latter is secured. Since the 2008 crisis, the provision of excess liquidity by the ECB has pushed Eonia to a discount to MRO in the Eurozone interest rate corridor. Draghi is clearly concerned that a sudden rise in Eonia – from the extremely low level of 9.6bp - could threaten the banking system. The next chart shows EONIA in a longerterm context.
EONIA (%)
4.00

3.50

Source: Bloomberg, Monument Securities.

3.00

2.50

2.00

1.50

1.00

0.50

0.00

2009

2010

2011

2012

European banks recovered from a 5-year low after Draghi’s “Whatever it takes” speech in July 2012. They have been on a tear as confidence in the Eurozone recovery emerged over the Summer - although the outperformance has rolled over in the last couple of weeks.

October 2013

29

2013

Euro Stoxx Banks price relative
0.050 0.048

0.046

Source: Bloomberg, Monument Securities.

0.044

0.042

0.040

0.038

0.036

0.034

0.032

0.030

Apr-12

Feb-12

Sep-12

Feb-13

Apr-13

Mar-12

Mar-13

Dec-12

Sep-13

Jun-12

Jun-13

Jul-12

Oct-12

Jul-13

Aug-12

May-12

Nov-12

This sector is for braver investors than us and we would avoid. The other major structural flaw in the Eurozone is obviously the excessive level of sovereign debt. This is not lost on the “authorities” who are actively, it was clear from page 58 of the recent IMF report (Taxing Times, October 2013), considering ways to address it. The key section, not discussed by any mainstream media sources that we saw, is shown below without comment (although the emphasis is ours). “The sharp deterioration of the public finances in many countries has revived interest in a capital levy, a one-off tax on private wealth, as an exceptional measure to restore debt sustainability. (1) The appeal is that such a tax, if it is implemented before avoidance is possible, and there is a belief that it will never be repeated, does not distort behavior (and may be seen by some as fair). There have been illustrious supporters, including Pigou, Ricardo, Schumpeter, and, until he changed his mind, Keynes. The conditions for success are strong, but also need to be weighed against the risks of the alternatives, which include repudiating public debt or inflating it away (these, in turn, are a particular form of wealth tax on bondholders that also falls on non-residents). There is a surprisingly large amount of experience to draw on, as such levies were widely adopted in Europe after World War I and in Germany and Japan after World War II. Reviewed in Eichengreen (1990), this experience suggests that more notable than any loss of credibility was a simple failure to achieve debt reduction, largely because the delay in introduction gave space for extensive avoidance and capital flight, in turn spurring inflation. The tax rates needed to bring down public debt to pre-crisis levels, moreover, are sizable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) A TAX RATE OF ABOUT 10% ON HOUSEHOLDS WITH POSITIVE NET WEALTH.”

October 2013

30

May-13

Aug-13

Oct-13

Jan-12

Jan-13

Inflation Versus Deflation: short-term resolution imminent?
Ambiguous Signals
The fight to the death between the forces of inflation and deflation continues. Obviously, whether the macro trend is becoming more inflationary or more deflationary normally has consequences for asset allocation, so the current lack of clarity is unhelpful. While our long-term conviction in the inflationary endgame remains as strong as ever, a shorter-term resolution of the conflict seems close at hand. One of our favourite charts right now is the divergence between US Treasury yields and breakeven inflation rates. Rising Treasury yields would typically be indicative of rising expectations for growth and inflation, but breakeven inflation rates remain very subdued.
10 year Treasury yield v. break even inflation
3.00 2.80 2.60 3.00 2.40 2.20 2.00 1.80 1.60 2.20 1.40 1.20 1.00 2.00 2.80 3.40

3.20

Source: Bloomberg, Monument Securities.

2.60

2.40

1.80

Sep-12

Feb-13

Apr-13

Mar-13

Dec-12

Sep-13

Jun-13

Jul-12

Oct-12

Jul-13

Aug-12

Nov-12

US 10-yr Treasury yield

US 10-yr break even inflation

The world’s reserve currency (such as it is) is currently testing the 79.0-80.0 level, but a significant break to the downside could be inflationary.
US Dollar Index
85

84

May-13

Aug-13

Oct-13

Jan-13

Source: Bloomberg, Monument Securities.

83

82

81

80

79

78

Feb-13

Apr-13

Mar-13

Dec-12

Sep-13

Jun-13

Oct-12

Jul-13

Nov-12

October 2013

31

May-13

Aug-13

Oct-13

Jan-13

Our preferred index for commodity prices is the Thomson Reuters Continuous Commodity Index which is composed of 17 equally weighted commodities. It recently put in a double bottom at the support level around 500, which could signal that the decline in commodity prices since 2011 is drawing to a close. The rebound has been lacklustre, though, so far.
Continuous Commodity Index
700

650

Source: Bloomberg, Monument Securities.

600

550

500

450

400

350

300

2009

2010

2011

2012

There are some slightly stronger signs in some of the agricultural commodities, like Wheat (shown above) and others, like Live Cattle, remain in bull (!) markets.
Live Cattle Contract (CME)
140

130

2013

Source: Bloomberg, Monument Securities.

120

110

100

90

80

70

2009

2010

2011

2012

Sugar has been a fairly good leading/coincident indicator for the Continuous Commodity Index and, having broken out recently, is something we are watching.

October 2013

32

2013

Sugar v. Continuous Commodity Index
35 750

700 30 650

Source: Bloomberg, Monument Securities.

25

600

550

20

500

450 15 400

10

350

2009

2010

2011

2012

Sugar

Continuous Commodity Index

It was notable that in the inflation-prone UK economy, inflation expectations have suddenly spiked upwards thanks to increases in utility costs and rising house prices. This was our economist, Stephen Lewis, again. “According to the latest Citi/YouGov survey, for October, prices were seen rising in the year ahead by 3.2%, well above September’s 2.5% expectation. More alarming still, because it suggested the public’s confidence that price rises would be contained had started to erode, was the finding that inflation on a 5-10-year view was, this month, seen as high as 3.9%, up from 3.3% in September.” The octogenarian, newsletter legend, Richard Russell, uses the gold/bond ratio, in the form of spot gold versus the TLT (iShares 20+ year Treasury bond ETF) as his inflation versus deflation indicator. This does rely on the assumption that both markets are “free”. Nonetheless, deflationary forces remain in the ascendancy on this basis.
Gold v. TLT
18.0

16.0

2013

Source: Bloomberg, Monument Securities.

14.0

12.0

10.0

8.0

6.0

2009

2010

2011

2012

A lesson for us since the announcement of open-ended QE last year has been the danger of under-estimating the power of deflationary forces during the biggest debt crisis in history. However, even if deflationary forces temporarily regain the ascendancy, it’s worth putting our current position in a much broader long-term perspective.

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2013

Bigger Picture
It strikes us that there is a major blind spot regarding the bigger picture “inflationary mega-trend” in which we find ourselves. We like to put our current situation in the context of previous inflationary waves, or “Great Inflations”, during the last millennium. We are currently in the fourth “Great Inflation” of the last one thousand years. The first took place during 1209-1317 - the price level is shown in the chart below. It’s noticeable how inflation increased sharply in its final stages.
First Price Inflation 1209 - 1317 (index 1209 = 100)
450

Source: Price History of English Agriculture, Measuring Worth

400

350

300

250

200

150

100

50

0

The second, during 1496-1650, was focused on the Spanish Empire – once again inflation increased sharply in its final stages. The people who lived through this period christened it the “Price Revolution” on account of the severity of the inflation. The compound average growth rate in prices across this period was 1.5% p.a. – a level which today’s central bankers would define as “price stability.”
Second Price Inflation 1496 - 1650 (index 1496 = 100)
700

1209 1211 1213 1215 1217 1219 1221 1223 1225 1227 1229 1231 1233 1235 1237 1239 1241 1243 1245 1247 1249 1251 1253 1255 1257 1259 1261 1263 1265 1267 1269 1271 1273 1275 1277 1279 1281 1283 1285 1287 1289 1291 1293 1295 1297 1299 1301 1303 1305 1307 1309 1311 1313 1315 1317

Source: Price History of English Agriculture, Measuring Worth

600

500

400

300

200

100

0

The third inflationary mega-trend was slightly shorter at 80 years during 1733-1813, but once again there was a surge in prices during its final stages.

October 2013

1496 1499 1502 1505 1508 1511 1514 1517 1520 1523 1526 1529 1532 1535 1538 1541 1544 1547 1550 1553 1556 1559 1562 1565 1568 1571 1574 1577 1580 1583 1586 1589 1592 1595 1598 1601 1604 1607 1610 1613 1616 1619 1622 1625 1628 1631 1634 1637 1640 1643 1646 1649

34

Source: Price History of English Agriculture, Measuring Worth

Third Price Inflation 1733 - 1813 (index 1733 = 100)
350

300

250

200

150

100

50

0

1733

1735

1737

1739

1741

1743

1745

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1785

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1791

1793

1795

1797

1799

1801

1803

1805

1807

1809

1811

The current one began in 1896 and accelerated (not surprisingly) after the collapse of Bretton Woods in 1971.
Source: Price History of English Agriculture, Measuring Worth

Fourth Price Inflation 1897 onwards (index 1897 = 100)
3,000

2,500

2,000

1,500

1,000

500

0

1897

1900

1903

1906

1909

1912

1915

1918

1921

1924

1927

1930

1933

1936

1939

1942

1945

1948

1951

1954

1957

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

Will the trajectory of the current one increase in its final stages like the other three? It’s almost comical to put all four on the same axes. Earth to Alan Greenspan and Ben Bernanke...
Source: Price History of English Agriculture, Measuring Worth

Four Price Inflations Compared (y-axis = no. of years)
3,000

2,500

2,000

1,500

1,000

500

0

October 2013

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100 103 106 109 112 115 118 121 124 127 130 133 136 139 142 145 148 151 154

First (1209 - 1317)

Second (1496 - 1650)

Third (1733 - 1813)

Fourth (1897 onwards)

35

2011

1813

Gibson’s Paradox
Long-term data shows that consumer/wholesale prices and interest rates have tended to rise and fall together, although the relationship has changed slightly (see below) since the collapse of Bretton Woods (BW) and the permanent adoption of floating currencies. The simultaneous rise in prices (N.B. the price level not the rate of inflation) and interest rates is known as “Gibson’s Paradox”. Wikipedia notes. “Gibson’s Paradox is the observation that the rate of interest and the general level of prices are positively correlated...The term was first used by John Maynard Keynes, in his 1930 work, A Treatise on Money.” In their academic paper, “Gibson’s Paradox and the Gold Standard”, Larry Summers (the one who nearly became Fed Chairman) and Robert Barsky commented (with our emphasis). “Monetary theory leads us to expect a correlation between nominal interest rates and the rate of change, rather than the level, of prices. Yet, as emphasized by Keynes (1930), two centuries of data do not confirm this expectation... Keynes referred to the strong positive correlation between nominal interest rates and the price level, which he called ‘Gibson’s Paradox’ as ‘ONE OF THE MOST COMPLETELY ESTABLISHED EMPIRICAL FACTS IN THE WHOLE FIELD OF QUANTITATIVE ECONOMICS.” We break down the last 230-odd years (since 1788) into four long economic (Kondratieff) cycles of which the fourth is still to be completed, helped in no small way by the unconventional monetary policies of our central banking friends. The most clear cut example of Gibson’s Paradox in operation was during the third long economic (Kondratieff) wave, 1897-1933 as we define it.
Gibson's Paradox 1897 - 1933
21.0 6.50%

19.0

6.00%

Source: BLS, US Census, Measuring Worth

17.0

5.50%

15.0

5.00%

13.0

4.50%

11.0

4.00%

9.0

3.50%

7.0

3.00%

1897

1898

1899

1900

1901

1902

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1909

1910

1911

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1929

1930

1931

1932

Index of Consumer Prices

Long-term Interest Rate (%)

Please note: the above chart uses annual data.

October 2013

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1933

However, as we noted, this relationship broke down with the collapse of BW as we transited from a Gold Standard into today’s free floating US dollar. Here is the chart of the relationship since 1968, the year which saw the collapse of the London Gold Pool, and prefaced BW’s subsequent demise.
Breakdown of Gibson's Paradox: CPI index v. interest rates since 1968
250.0 16.0

14.0 200.0 12.0

Source: Bloomberg, Monument Securities.

150.0

10.0

8.0

100.0

6.0

4.0 50.0 2.0

0.0

0.0

However, the next chart shows that, while Gibson’s Paradox broke down, the relationship shifted from the level of prices to its first derivative, i.e. to the rate of inflation itself...marking the end of the “Paradox.”
End of Gibson's Paradox: US CPI v. 10-yr Treasury yield (since 1968)
16.0 16.0 14.0

12.0 12.0 10.0 10.0

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

US CPI index (1982-84 = 100)

US 10-year Treasury yield (%)

14.0

Source: Bloomberg, Monument Securities.

8.0

6.0

8.0

4.0

6.0

2.0 4.0 0.0 2.0

-2.0

-4.0

0.0

It’s interesting to look back to the biggest inflationary spike during 1976-80 and see how interest rates lagged the rise in inflation for most of that period. It illustrates the monumental challenge facing today’s policy -makers if (when!) inflation does start to increase. Back then, total debt/GDP in the US was between 160170%. Today that figure is 350% and a rise in inflation would put policymakers between the proverbial rock and hard place. Allowing rates to rise sufficiently quickly to temper rising inflation would likely crash an overindebted economy, while doing nothing, or even trying to suppress rates further, would risk runaway inflation. Policymakers could lose control... Back in 1976-80, the situation wasn’t made much more hazardous by an interest rate derivative mountain and a vast shadow banking system either.

October 2013

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

US CPI (%)

US 10-yr Treasury yield (%)

37

Interest Rates and Interest Rates (Repos)
If we asked you whether interest rates have been rising or falling since the announcement of QE3 last September, what would your answer be? Well, there are interest rates and interest rates... 10-year US Treasury yields had almost doubled by early-September 2013 - and are still nearly 60% higher. In contrast, the growing shortage of collateral has caused rates in the large (and systemically important) US$4.6 trn repo market in the US to collapse - down almost 75% from 20 b.p. to about 5 b.p. in early-September 2013. We have inverted the General Collateral Repo Rate in the chart below, which shows an almost perfect negative correlation between 10-year Treasury yields and Repo Rates.
10-year Treasury yield v. General Collateral Repo Rate (Inverted)
3.00 0.00

2.80 0.05

Source: Bloomberg, Monument Securities.

2.60 0.10 2.40

2.20

0.15

2.00 0.20 1.80 0.25 1.60

1.40

0.30

Sep-12

Feb-13

Apr-13

Mar-13

Dec-12

Sep-13

Jun-13

Oct-12

Jul-13

Nov-12

US 10-year Treasury Yield (%)

General Collateral Repo Rate Inverted 20 day M.A. (%)

For much of the last 3-4 months, banks operating in the US were able to fund (leverage) their inventories of securities at an average of 5-10 b.p. (General Collateral). If it had been all about the underlying strength of the US economy, we don’t believe that tapering would even have been considered. The unspoken benefit from tapering would have been to free up the QE-driven shortage of “high quality” collateral (i.e. Treasuries and MBS) in the repo market. In the words of the Oliver Wyman consulting firm, the repo market is the “structural backbone of US financial markets” and its primary source of leverage. The IMF, Bank for International Settlements, Bank of England, US Treasury (TBAC) and Janet Yellen have all warned about the risks from the repo market in recent months. We also wonder whether Dallas Fed Governor, Richard Fisher’s, post-FOMC quote... “The largest financial institutions are a dagger pointed at the heart of the economy.” ...was an oblique reference to repos?

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May-13

Aug-13

Oct-13

Jan-13

An aside: it has become noticeable in recent months how more and more equity investors are taking an interest in shadow banking, and repos in particular. If you’d mentioned Long Term Capital Management, Bear Stearns, Lehman and MF Global in the same sentence as repos only six months ago, you would probably have received many confused looks. Last month, more OTC derivative trades moved on exchange (requiring additional collateral) and some Treasury repos went “special” implying collateral shortages. We are going to find out whether, by not tapering, the Fed makes the collateral issue worse in the short term, or whether it’s a problem which can stay on the back burner for a while longer. Given the increasing recognition of QE-driven collateral shortage, it might not be coincidental that the possibility of fixed rate overnight reverse repos with full allotment was proposed at the July 2013 FOMC meeting and a pilot test authorised at last month’s meeting. Reverse repos can drain excess cash held by banks AND (unlike the Fed Funds market) non-bank financial institutions and replace them with overnight loans of high quality collateral, e.g. Treasury securities, from the Fed’s balance sheet. The Fed can set the rate on these reverse repos which will give it greater control over overnight rates in money markets. The official reason for these “pilot” reverse repos is for the Fed to test its exit instruments, which it could employ as part of its strategy to tighten monetary policy. When Bill Dudley of the FRBNY was asked why this facility was being set up, one of the two reasons he gave (besides setting a floor for money market rates) was that it would “increase the availability of a risk-free asset, satisfying the demand when the appetite for safe assets increases.” Which sounds suspiciously like an acknowledgement that one of its purposes is to address collateral shortage. The reverse repo test began during the week beginning 23 September with market participants limited to US$500m at 1bp. The limit was doubled to US$1.0bn only three days later! On 30 September 2013, 87 bidders borrowed a very large US$58.2bn of Treasury collateral from the Fed. Does that really fall into the definition of a “test” quantity. The so-called test runs until late-January 2014. With US$3.47 trn of securities on the Fed’s balance sheet (US$2.06 trn Treasuries), the Fed has plenty of ammunition with which to supply the repo market if financial markets become “stressed”. This should provide a substantial stability “buffer” in the early stages of a crisis in the US. However, we are sceptical that it will be enough if there is a sharp deterioration in the global economy, or one or more major financial institutions get into trouble. For example: • If the debt crisis erupts again, the natural instinct of lenders, including those in the repo market, will still be to withdraw credit. This is a frightening prospect when the majority of repo loans are overnight; and • The next crisis could be a sovereign debt crisis - which would put the valuation of the vast majority of the collateral underpinning the repo market in question. We spent quite a lot of time in this report talking about “duration” in one form or another. Then you stop to think that there’s US$4.6 trn of leverage in US financial markets which is largely OVERNIGHT.

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