Global Macro Research | US NICK KALIVAS JESSICA HOVERSEN jhoversen@mfglobal.


December 29 , 2009


MF Global Special Report
MF Global Inc. 440 S. LaSalle 20th Floor Chicago, IL 60605



This piece is the first installment of a two part series. Please see tomorrow’s comment for MFGR’s 2010 outlook on equity indices, currencies and interest rates. The financial and commodity markets will be influenced by a number of major events in 2010. Central banks are ripe to exit a period of unprecedented monetary ease, governments in Japan, Europe, and the U.S. will issue historically high levels of debt, parts of the Emerging World face real estate and equity market bubbles, and the U.S. will hold important midterm elections, which could impact consumer and business confidence. Furthermore, the euro will face a test of its reserve currency status with numerous countries failing to meet the Maastricht Treaty. These dynamics are occurring during a historically slow economic rebound. Below are ten themes which should influence market pricing throughout 2010. 1.) Trend toward normalized monetary policy. As the international macro landscape continues to show signs of improvement, the unwinding of the ultra simulative policies that fueled the global recovery will be a major theme of 2010. MFGR sees this theme taking on two characteristics. • Monetary policy tightening will remain very uneven as the continued variation in the pace of regional recoveries dictates a divergent exit. The markets have already forced the hands of some central banks as the degree of economic calamity varied and some economies were able to cushion macro hardship due to dependence on the relative robustness of the emerging world. Australia and Norway stand as the two major central banks that have been bullied into hiking interest rates due to gains in both commodity and home prices which have sparked concerns over inflation. Expect central banks in countries such as Europe, the US and Japan to keep rates at below “neutral” levels for the foreseeable future and will likely not even consider hiking rates until Q3. Developed countries with increased commodity sensitivity as well as emerging markets will tighten policy much sooner. MFGR also expects this exit process to be extremely transparent as the lingering fragility will warrant full communication between central banks and the market. • The draining of excess liquidity will expose the vulnerabilities in the financial system. One can pin point the increase in concern over the Greek government’s balance sheet around the same time when the ECB announced that they would be ending the their 12 month refi-tenders as well cutting back on the frequency of 3 and 6 month tenders. Central banks will also end their QE programs which will elevate rates and could hinder the recovery. It is no coincidence that the end of the Fed’s Treasury purchase program happened around the same time the US 10-yr yield began its 60bps climb to 3.80%. The Fed will end their MBS plan in March and the BOE is set to reconsider their APF in February. Finally, the ECB’s covered bond program has been quite successful in compressing covered bond spreads. The removal of these marginal buyers will expose the true cost of capital to the governments and could injure the recovery in the private sector. 2.) Excessive appreciation in emerging market real estate and equity markets


Global Macro Research | US 12/28/2009 MF GLOBAL SPECIAL REPORT

Policy stimulus in the emerging world was excessive and likely exceeded the amount necessary. At 4 trillion yuan, China’s plan totaled 13% of GDP while the US’s fiscal stimulus was only 5.6% of GDP. This excess allocation of government capital catalyzed an explosive response in EM equity and real estate markets. As of November 2009, Chinese new home prices were up 6.2% Y/Y. Some regions have seen even more robust price gains. The Shenzhen Province, the province which suffered from the earthquake in 2009, is now posting home price gains of 16.6%. These gains have been fostered by lose loan standards. New CNY loans in 2009 totaled 9.176 trillion yuan. The Chinese government has already started to impose stricter lending standards but the risk is that they undershoot allowing the economy to continue on this unsustainable growth path. The policy backdrop remains supportive for EM equities. The cocktail of globally loose policy, the search for yield and a fundamentally appealing EM picture may prove to be a mixture quite alluring to capital, thus encouraging speculative flows. While hefty gains in these asset classes are making central banks uncomfortable, if export demand remains low, then governments may be languid to respond to the building price pressures in fear of hindering the recovery/expansion process. 3.) Growing uncertainty over the ability of governments to fund large deficits The IMF predicts that in 2010 the average government gross debt as a percentage GDP for the 7 major advanced economies will be 109% and 113% in 2011. It was only 84% in 2007 and 77% in 2000. Following the global down turn in the 1990s, average gross debt as a percentage of GDP increased from 58% in 1990 to 80% by 1996. History suggests that post recession, the reduction in government spending is rarely equivalent to the increase catalyzed by the retrenchment in the private sector. Given the breadth and depth of this past recession and lingering risks in the system, the pull-back in government spending will be even less. Moreover, the initiatives of the US government are costly and the passage of the healthcare bill will only increase the financing needs. As the global recovery takes hold it will be increasingly difficult for governments to attract interest in their securities as their yield reside at historic lows. Outside of valuation, fears over defaults will also keep the market wary of government debt. Widening sovereign CDS spreads underscore the market’s already elevated concern. While a widespread tidal wave of defaults is unlikely, poor auction demand in the wake of the recovery and in the face of heavy financing needs will increase trepidation about its possibility. The Euro-Zone will be in focus as the removal of ECB liquidity has brought to light the dependence of the individual countries on funding from the central bank, albeit indirect funding. Outside of the global recovery dampening demand for these securities, the ending of global QE programs will accelerate the repricing of value and expose the true cost of capital for governments. Diluted interest in government debt and an increased budget deficit-to-GDP ratio will put upward pressure on yields and perpetuated the steepness in the curve. 4.) Jobless Recovery 2010 will be characterized by a jobless recovery. MFGR sees the unemployment rate peaking in 2010 at 10.5% and closing the year between 9.5% and 10%. The unemployment rates in EM and ASEAN counties should fall more steadily while it will likely increase in Europe. MFGR is expecting the latter as many of the stimulus programs initiated by European government included programs directed solely at hiring or preventing layoffs. Out of a survey of 10 Euro-Zone countries, 8 employed labour activation measures. Many of these programs are set to expire in the new year. As employers are facing a lack luster recovery, the likelihood of a robust expansion in the labour market sans government incentives is minimal. Furthermore, employers will likely be forced to cut back on labour as its costs up to the point have been subsidized. On the US front, the outlook for taxes is murky and the healthcare initiative which will likely force all employers to provide care or pay a penalty will discourage the expansion of the labour force. Though the Obama administration is extending the capital gains holiday for small businesses, employers need to feel confident that their profit margin will not erode in the future due to tax increases in order to genuinely contribute to job growth. Moreover, budget shortfalls at the state and local government level will cap government hiring. Globally speaking, there has been a significant increase in structural employment that is now part of the new normal. The collapse of the financial markets has led to a permanent shrinkage of the financial industry and the impending

Global Macro Research | US 12/28/2009 MF GLOBAL SPECIAL REPORT

regulation will make financial innovation, a factor that does lead to job growth, very difficult. The manufacturing industry faces the same problem. Globalization will lead to the removal of manufacturing jobs in advance economies and cause a shortage of skilled labour forcing many to look to build other skill sets. 5.) The composition of global growth in 2010 is not significantly different than 2009. MFGR believes that the recovery pattern witnessed in 2009 will continue into 2010. Asia will see steady expansion. The US’s economic outlook will pick-up gradually and Europe will face a stagnant and anemic recovery. The following themes should be noted: • The US will lead the recovery out of the Euro-Zone and Japan. The financial problems in the UK will hinder the improvement in the macro landscape and the outlook for taxes will cause capital flight, making the environment unfavorable for growth. In the Euro-Zone, the structural problems and the widespread violations of the Maastricht Treaty will spark the consideration of the possibility of the failure of the euro and the currency union. Moreover, the liquidity unwind will unveil the fragility of the Euro-Zone banking system which will keep credit tight and disallow the firming of the macro environment. Japan will face the hangover of the stronger currency, growing debt and the internal political struggle over what strategy (endogenous demand vs. exogenous demand) will best fit the new Japan. • Global imbalances will continue to unwind. As the developed consumer deleverages and the unemployment outlook stays poor, the savings rates should continue to climb. Simultaneously, the emerging world will see a strengthening of their consumer. EM will move toward a paradigm which will lead their economies to be less dependent on exports and more reliant on the endogenous demand. The above point will lead countries such as China to ultimately move toward tighter monetary policy and looser fiscal policy in terms of tax regimes in order to control inflation but perpetuate growth. These factors will be bullish for the yuan. While global pressure will not cause the government to once again break the peg as it did in 2005, economic fundamentals will dictate the necessity. MFGR sees this glacial process commencing in H210. The global economy is past the inventory rebalance portion of the recovery cycle and the market is forced to consider if the current macro make-up is muscular enough to extend the economic upturn. Pent-up demand and large corporate cash-balances will provide some support. The emerging consumer will also contribute to the greater global growth picture. Interest rates at below neutral levels coupled with the glacial unwind of liquidity facilities will keep the policy backdrop supportive to growth. However, higher taxes, a jobless recovery and the continuation of the public sector crowding out the private sector will keep the outlook for growth muted.

6.) Passage of the Democratic healthcare plan will mark an apex in U.S. liberalism. Government policy will shift toward the center into midterm elections. Polling data highlights the falling popularity of the Democratically controlled Congress and President Obama. The NBC/Wall Street Journal poll displayed the Congressional disapproval rating at an elevated 68% in mid December. At the same time, data produced by Rasmussen has shown President Obama’s approval index falling from a peak of +30 on January 22, 2009 to a post Christmas reading of -12. The champion legislation of the Democratic Party, healthcare, is also finding limited support. The recently passed Senate healthcare bill has displayed a high level of public disapproval highlighting anger over the intervention of government into healthcare. Rasmussen’s polling numbers on healthcare show most voters oppose the healthcare plan and just 25% believe they will be better off.

Global Macro Research | US 12/28/2009 MF GLOBAL SPECIAL REPORT

The likely and soon to be passed healthcare bill has been passed on a totally partisan basis in the face of growing opposition to government policy. Recent Democratic losses of governorships in New Jersey and Virginia spotlight the tilt of support by the public toward the party out of power. Furthermore, Alabama Congressman Parker Griffith recently switched to the Republican Party from the Democratic Party. The “Blue Dog” feared losing his seat in 2010. The high level of discontent with politicians is occurring in the back drop of “Tea Parties” and grass root movements to stop the reach of government given excessive spending and a high tax burden. Unemployment is still elevated, and income growth is slow. The public is angry over the impact of a stimulus plan which may have saved the financial system from melt down, but did little to improve standards of living. Democrat leaders in Congress have fought for their agenda at all costs, and will now try to reverse their tactics in order to improve their public image. Politicians, at the core, are survivalists and thus policy is likely to move toward the center to attract discontented voters. The Democratic leadership is aware that history is not on their side for mid term election victories and power loss can be expected. For example, during the 1994 mid term election, President Clinton and the Democrats lost 9 seats in the Senate and 54 in the House. In 1946, President Truman and the Democrats lost 12 Senate seats and 55 House seats. Going back further, FDR and the Democrats picked up 10 Senate seats and 9 House seats in 1934, but suffered major losses in 1938 and 1942 with 7 House seats (6 Senate seats) and 45 House seats (9 Senate seats) lost in 1938 and 1942 respectively. 7.) The tax burden in the U.S. and Europe is likely to increase. The on going deterioration in public finances, at both the state and government levels, will put upward pressure on taxes in the U.S. Moreover, the Bush tax cut is expected to sunset in 2011. There is some feeling that Congress will vote to extend lower tax rates, but this is likely to come for earners making less than $250,000. Somehow, the $250,000 income level has become the definition of rich in America. Capital gain and dividend taxes are also likely to rise for high income workers and risk leading to a re-pricing downward of assets. Furthermore, the healthcare bill contains another tax hike on high income workers, and will likely lead to higher healthcare insurance fees. The healthcare mandate will act like a tax by raising the cost of healthcare for many workers. At the state level, California, Illinois, and New Jersey face massive fiscal strain and politicians are reluctant to address pension, healthcare, and wage costs in order to boost the productivity of government workers. Unions are a strong constituent and politicians do not want to upset a large voting block. In Europe, taxes are increasing for higher income workers in the U.K., and the Greek budget will work to cut down on tax evasion, while raising tax on property transactions. Fiscal troubles in Spain and Portugal may also lead to higher taxes. The one exception rests in Germany where a tax cut has been passed. The E8.5 bln measure is relatively small, but a tax cut none-the-less. Relief is expected for businesses and families. Overall, countries in Europe are breaking the Maastricht treaty budget deficit criteria which will place upward pressure on taxes and downward pressure on spending as growth firms from the recession trough. 8.) The VIX is likely to remain capped. Historically, the VIX moves inversely to the path of profit growth and positively correlates with the trend in the fed funds rate with a 2 year lag. The trend in profit growth and the level of the fed funds rate argue for low volatility through 2010. Profit growth for the S&P 500 is expected to continue higher through 2010 as corporations recover from the recession. Although economic growth will not be quick, it will likely be high enough to raise revenues and place downward pressure on default rates. FY 2010 EPS growth for the S&P 500 is expected up 24.8% y/y. Additionally, the fed funds target rate hit a low of 25 bps in December 2008 and has remained flat throughout 2009. The traditional relationship between the fed funds rate and the VIX argues for the VIX to be pressured until at least December 2010. A major or lasting rally in capital market volatility looks more likely in 2011. 9.) Investor appetite for commodity investment is uncertain, but most likely to ease.


Global Macro Research | US 12/28/2009 MF GLOBAL SPECIAL REPORT

Investment flow into commodities has been strong in recent years. The low interest rate environment and distrust of equity markets have supported commodity buying. Furthermore, commodities have been a play on emerging market growth. Barclays recently indicated that it expects commodity fund inflows to be $60 bln in 2009. EPFR said that nd $15.8 bln flowed into commodity funds through December 2 . Going into 2010, some of the headwinds supporting commodities as an asset class will diminish. First, capital market returns were very strong in 2009 with the S&P 500 up nearly 25%, and corporate debt returns robust. The Ishares high yield ETF, HYG, posted a year to date total return of nearly 29%, while the investment grade ETF, LQD, returned 8.5%. Returns are much higher if measured from the spring lows. Money may be more attracted to stock and debt markets given the return profile. Second, the dollar is expected to see a more two way trade given fiscal troubles in Europe and the jaw boning of the dollar higher by international financial officials. Third, treasury yields have risen and central banks are working on exit strategies. The opportunity cost of holding commodities will likely rise. Fourth, major commodity markets look to be well supplied. Oil stocks are ample, and soybean and wheat ending stocks are projected to rise into 2010. However, corn supplies are expected to shrink. Commodities like sugar and cocoa are in mature bull markets. Fifth, real estate has cheapened and may provide an attractive return to hot money seeking capital appreciation and/or income. Sixth, investors have been increasing allocation to commodities in recent years and portfolios may be subject to more of an equal allocation. It is hard to believe that investors will year after year raise their allocations to commodities. Seven, China is still growing quickly, but the government is acting to slow lending and curb a real estate bubble. Having highlighted the negative, lack of faith in politicians, still historically low interest rates, and geopolitical uncertainty will keep investors interested in commodities. Geopolitical risks in Iran, for example, continue high with social unrest and an on going nuclear program.

10.) Intermarket correlations will erode as individual market fundamentals become the predominate driver of capital and commodity market price direction. The heavy liquidation of all asset classes in late 2008 and early 2009 has ended and money has moved back into the financial and commodity markets. The normalization of investment flow should allow markets to focus more on individual fundamental factors. Hot money is not likely to just flow in and out of the market based on risk taking, as most books should be near desired weighting. As a result, individual market fundamental factors are likely to drive trade as players go over or under weight based on technical and fundamental factors -- the trade will be more fixated on individual supply and demand stories with the highest return stories winning the most investment flow. Weather in South America and the South American harvest will drive grain prices, while weather in India and Brazil will influence the outlook for sugar. Oil markets remain well supplied, but the pick up in demand on the back of better growth in the emerging world continues to provide offset. North American weather and the spat between Russia and the Ukraine over payment could also impact energy prices. Livestock markets will focus on export demand, and signs of a reduction in the hog herd. The dollar will be driven more by growth and interest rate differential and the health of the European fiscal and financial systems, while treasuries will focus on supply, inflation and the pace of economic growth.

Copyright by MF Global Inc. (2008) 440 S LaSalle Street. The information contained in this report has been taken from trade and statistical services and other sources which we believe are reliable. MF Global Inc. does not guarantee that such information is accurate or complete and it should not be relied upon as such. Any opinions expressed reflect judgments at this date and are subject to change without notice. The principals of MF Global and others associated or affiliated with it may recommend or have positions which may not be consistent with the recommendations made. Each of these persons exercises independent judgment in trading, and readers are urged to exercise their own judgment in trading.


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