World Global Strategy

2 September 2009

Global Strategy Weekly
Prepare for the next leg in the Ice Age journey into deflation
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

Commentators have been perplexed by recent strength in government bond markets, especially set beside continued resilience in equities. They should not be. The bond market is responding to two key events. First, it is clear to us the ongoing march into outright deflation will accelerate during this short-lived economic recovery. Second, post-bubble realities will force commercial banks to aggressively step up their buying of government bonds.

Recent weeks have seen commentators either busy throwing in their towels, as the equity bull market has marched resolutely upwards and onwards (maybe that will change after Monday), or wrestling with their conundrums. Many have found the robustness in government bond prices through August most perplexing, especially when set beside continued resilience in developed equity markets. Once again, equity participants are missing the big picture. For despite clear signs from the business surveys of some sort of H2 recovery, firm evidence is emerging that the global economy is sliding towards a full-blown deflationary episode once this recovery falters. My former colleague Rob Parenteau pointed out something interesting to me the other day. He noted the huge divergence between US economy-wide inflation as measured by the gross domestic product (GDP) deflator and a slight variant of GDP, the deflator for gross domestic purchases (see chart below). The key definitional difference between the two measures is that the latter includes recent savage import deflation (as GDP includes exports and excludes imports). Hence the gross domestic purchases deflator is a better measure of what is going on in the US domestic economy. With import prices down some 19% yoy and even a record 7.3% yoy if one excludes petroleum, no wonder the price of domestic purchases has already fallen into deflation. If anything, domestic purchases inflation leads trends in both GDP and core CPI, so this is significant news. (For those who have never come across Rob Parenteau, I believe he is one of the best and bravest commentators out there. His printed thoughts can be found in the renowned Richebächer Letter –link.)
US GDP measure of inflation lags domestic purchases inflation…or is that deflation?
5 5

Global asset allocation
% Equities Bonds Cash
Index Index neutral SG Weight

30-80 20-50 0-30

60 35 5

35 50 15

Source: SG Global Strategy

Equity allocation
Very Overweight Overweight Neutral Underweight Very Underweight
Source: SG Global Strategy

US UK Cont Europe Japan Emerging mkts

4

4

gross domestic product (GDP)
3 3

2

2

IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS BEGINNING ON PAGE 4

1

1

0

gross domestic purchases

0

-1 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-1

www.sgresearch.socgen.com

Source: Datastream

Global Strategy Weekly

While there can be no doubt that survey evidence is pointing to a more robust second half, equity markets should be far more nervous than they currently are. We heartily concur with GMO’s Jeremy Grantham who remarked recently that after 20 years of more or less permanent overvaluation of US equities, we saw just five months of under-pricing through the March trough. Do bursting global equity valuation bubbles really end like this? Of course they don’t. One of the lessons from Japan was that, in a post-bubble world, equities were subject to far more violent swings. We expect to see an exact replica event play out in the west. The Great Moderation - where the 1980’s debt super-cycle filled in troughs of recessions – will now give way to far more violent swings in the economic cycle more usually seen in the pre-war years and the 19th century. Meanwhile, as we saw in Japan, each economic downswing will sink us deeper and deeper into the deflationary mire (see chart below).
Japan’s core CPi (ex food and energy) crashes back into deep deep deflation
3.50 3.50

3.00

3.00

2.50

2.50

VAT hike
2.00 2.00 1.50 1.50

1.00

1.00

0.50

0.50

0

0

-0.50

-0.50

-1.00

-1.00

-1.50 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

-1.50

Source: Datastream

Investors will continue to be shocked by the robust performance of government bonds in the coming months as core CPI crunches lower despite the economic recovery (see chart below). For it is quite clear that it is the recovery phase that takes core CPI to new lows in each cycle.
US core CPI crashes lower in the recovery phase
35 6.00

headline ISM (inverted, 6mth mav)
40

5.50

5.00

4.50 45 4.00

50

3.50 3.00

55 2.50

2.00 60

core CPI (rhscale)
65 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

1.50

1.00

Source: Datastream

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2 September 2009

Global Strategy Weekly

This is because it is in the recovery phase where the lagged impact of yawning output gaps does its pernicious work to core CPI and companies lower prices in response to the cyclical impact of lower unit labour costs. Hence, while the market focuses on the recovery of volumes as signaled by survey evidence, nominal GDP and consequently nominal revenue growth continue to see lower highs in the recovery and lower lows in the downturn. The bond market has already caught onto this event and yields will continue to decline on a secular basis. But what about massive supply of government bonds I hear you ask? Won’t that drive yields higher? Well it never did in Japan. But let’s cast our minds back to the early 1990’s US credit crunch (which seems so minor in retrospect!). What happened then is that US commercial banks bought US Treasuries aggressively at the same time as they contracted lending to the private sector (see chart below). This continued well after the end of recession in early 1991.
US commercial banks buy government bonds aggressively in 1990s credit crunch, yoy %
14 20

12

loans to gov (treasuries)
15

10

8

10

6

4

total

5

2

0

0 -5 -2

recession bank loans (private)
-10 1989 1990 1991 1992 1993 1994 1995

-4

Source: Datastream

I note with interest that Swedish Riksbank recently took its target interest rate negative, in an attempt to force banks to remove surplus reserves and resume lending to the private sector. Of course, no such thing will happen as banks are continuing to buy government paper in unlimited quantities - I note here the recent collapse in UK 1 and 2 year yields to new lows. In the US and elsewhere, where commercial bank exposure to government paper is still close to all-time lows, the unwinding of grotesque over-exposure to bubble sectors like real estate (see chart below) will continue to underpin the secular bull market in government bonds.
Share of US total domestic commercial bank loans to real estate and US government, %
50 50

45

45

40

40

35

real estate lending as % of loan book

35

30

30

25

25

20

20

15

15

10 74 76 78 80 82

Govies as % of loan book
84 86 88 90 92 94 96 98 00 02 04 06 08

10

Source: SG Global Strategy

2 September 2009

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Global Strategy Weekly

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2 September 2009

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