2 March 2010

Global Strategy
Alternative view
www.sgresearch.com

As the 10th anniversary of the peak of the Tech bubble approaches, should we really care what the market ‘thinks’ about sterling, or indeed much else?
Much hand-wringing is accompanying sterling’s renewed slide. The market is reacting to the rapidly falling odds of an outright Conservative victory in the forthcoming election, which will probably mean the huge public sector deficit will stay larger for longer. But ultimately, in the Ice Age, a weak currency is an escape route of choice from the deflationary quicksand. A look at Japan shows the other extreme - a strong yen pushing Japan back into deep deflation.

Global Strategy Weekly
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

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

Sterling’s latest slump contrasts markedly with the continued resilience in the yen (see chart below). Should investors be as concerned about sterling as they so obviously are? Perhaps not. Market participants are fickle creatures. I have previously likened them to shoaling fish, heading as a group in one direction only to change direction for no particular identifiable reason (perhaps headless chickens would be a better analogy). I read much about market discipline forcing profligate governments into deep spending cutbacks. Sterling’s plunge will be painted as one example of that market discipline and we will no doubt be told that that the market ‘wants’ deep public spending cutbacks. I was left scratching my head after reading the FT’s currency comment last Saturday, “the yen pushed firmly higher yesterday as concerns about sovereign debt ratings in southern Europe sent investors scuttling for the relative safely seen to be provided by the Japanese currency”. That is indeed the market’s perception. Except, as my colleague Dylan Grice has shown, the Japanese fiscal situation is many times worse than almost anywhere else! If any currency should be plunging at the moment, it is surely the yen! It is an anathema to most commentators to suggest that Mr Market can possibly be wrong. But the notion that it can somehow offer us some definitive wisdom about what is the ‘correct’ course of action is surely nonsense. Investors can be totally and utterly wrong for prolonged periods about what ultimately is ‘good’ for an individual stock or bond market, or indeed a currency such as sterling.
Contrast the weakness of the trade weighted sterling to yen strength (JP Morgan narrow index)
115 115

30-80 20-50 0-30

60 35 5

35 50 15

Source: SG Cross Asset Research

110

Sterling

110

105

105

100

100

95

95

90

90

Global Strategy Team
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

85

85

80

80

75

Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

Yen
2006 2007 2008 2009

75

70

70

Source: Datastream

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

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

Global Strategy Weekly

One nice example of why you shouldn’t listen to Mr Market was a story in the wake of the sub-prime debacle from the FT’s John Authers. Writing back in September 2008, he said: “WaMu on Friday became the biggest bank failure in US history (a title it will hopefully keep for a while). Its decline, as has been amply documented, lay in its huge portfolio of mortgages and mortgage-backed bonds. The last WaMu story I wrote covered a day when its share price fell 5 per cent in June 1999. It fell because investors were worried that it was retreating from its policy of levering up by buying mortgage-backed securities. Analysts told me that retreating from leverage would harm WaMu’s revenues in the short term, along with its earnings and its share price. The implicit assumption was that leverage was good. Shareholders punished companies and executives when they paid down their debt and took less risk. This should remind us of the breadth of the failure of the global markets system that we are now witnessing. Shareholders themselves egged on the lending binge in the US, and did so before the stratospheric growth in the credit derivatives market.” – link. This is a prime example that what the market thinks it wants in the short term may not be what it really wants in the long term. In the case of the UK, there is no doubt in my mind that premature tightening of fiscal policy after the election will send the economy back into recession. And as we saw in the case of 1990s Japan, any premature return to recession means the public sector deficit will end up even bigger than it already is now, the BoE would have to resume aggressive monetisation and sterling would be even weaker than it is now. Contrast the recent GDP recoveries in Japan and the UK, one suffering from a very strong currency (perversely?) and the other enjoying a very weak one (see charts below).
Japanese real and nominal GDP (rebased Q1 2007=100)
106 106

UK real and nominal GDP (rebased Q1 2007=100)
106 106

104

104

104

nominal

104

102

102

102

102

100

Real

100

100

100

98

98

98

real

98

96

Nominal

96

96

96

94

94

94

94

92 91 2007 2008 2009

92 91

92 91 2007 2008 2009

92 91

Source: Datastream, SG Cross Asset Research

Japan has seen a 2.4% bounce in real GDP from its depression-like GDP collapse, while the UK has barely recovered. By way of contrast, nominal GDP shows the reverse. In the UK, nominal GDP has enjoyed a heady 4% annualised surge over the last two quarters while Japan has seen stagnation. The UK economy is ‘enjoying’ the benefits of the authorities pulling the competitive devaluation lever, while Japan is still mired in deep deflation. As we stated in our recent note, there is no easy way out of the mess we (globally) are in - link. Either governments pursue the path of fiscal rectitude (although it is a bit late for that) and we subside back into recession or we debauch the currency through deficits, the printing press and devaluation. For many, the UK data suggests we are well on the road to debauchment.

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2 March 2010

Global Strategy Weekly

But certainly in a world where the private sector is trying to de-leverage, it is crucial to avoid a Fisherian debt-deflation trap if one wants to avoid hurtling into a depression. There are no easy answers. The simple fact is we shouldn’t be in this mess in the first place. The certainties we once had as investors will be jolted sharply in other ways over the next few months. One of the most interesting non-consensus calls last year was from our Asian Economist Glenn Maguire, who forecast that the huge Chinese trade surplus would disappear this year (see chart below). Glenn thinks that isn’t just going to be a temporary blip, but something that the markets will really have to get used to. Given that grotesque external imbalances were a feature of the build-up of the credit bubble, what will it mean if China moves into sustained trade deficit?
China’s move into trade deficit will mean less dollars to recycle (USDbn)
50 40 30 20 10 0 -10 Jun-2000 Jun-2002 Jun-2004 Jun-2006 Jun-2008 250 200 150 100 50 0 -50 Jun-2010

China Trade Balance NSA LHS (including SG Forecast till Jun-10) 6 month change in China's US Treasury Holdings RHS
Source: SG Cross Asset Research, CEIC

Clearly to the extent that the rise in China’s official reserves depended on the size of its trade deficit, there will be reduced purchases of US Treasuries. But China has, in part, merely been swapping official dollar purchases of US Treasuries with surging imports of dollardenominated commodities on the trade account (see chart below). The emergence of a trade deficit in Q2, together with Glenn’s view of a likely 5-10% yuan revaluation after the National People’s Congress meets in March (see link), will do one very important thing however – it will head off US protectionist sentiment ahead of the Congressional mid-term elections.
China total imports surge as commodity imports soar (yoy% change)
100 100

80

80

60

exports

60

40

40

20

20

0

0

-20

imports

-20

-40

-40

-60 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

-60

Source: Datastream, SG Cross Asset Research

2 March 2010

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Global Strategy Weekly

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2 March 2010

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