21 May 2010

Global Strategy
Alternative view
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Global Strategy Weekly
The US and eurozone now stand on the edge of a deflationary precipice
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

Amid all the recent euro-related turbulence, the markets have not focused enough attention on the rapidly vanishing core CPI inflation rates in the US and eurozone. With both moving below 1%, we are now only one cyclical mishap from joining Japan in outright deflation. Given our view that this cyclical recovery will end surprisingly early, slipping into the deflationary mire will trigger further, more extreme rounds of Central Bank monetisation, inevitably driving us towards our ultimate destination – 1970’s style 20-30% inflation will surely return.

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

Of all the inflation data released this week, the one that caught the markets’ attention was the UK’s dramatically higher than expected 3.7% yoy rise for April. Even the core measure of CPI managed to creep up above the 3% mark. Meanwhile the old RPI, to which most state benefits are indexed, rose a heady 5.3% – the highest pace since July 1991. While many commentators proceeded to berate the Bank of England for consistently underforecasting inflation in recent years, many also saw the first signs of the quantitatively eased pigeons coming home to roost. But I would argue that in a year or so, we will see the UK’s relatively high inflation rate as a godsend. For elsewhere, it went almost unnoticed this week that core CPI inflation rates in the US and eurozone continue to slip-slide their way down towards zero (see chart below). Although this is seen as buoying bond prices at the margin, it is a pernicious development that investors will focus on when this cycle starts to fail. Regular readers will know that I believe that in a post-bubble world, recession follows recession with surprising rapidity. We are now only one cyclical failure away from Japanese-style outright deflation in the US and the eurozone at a time when de-leveraging still has years to run (falling prices bring the risk of a classic debt deflation trap). Impending cyclical failure and a deflation scare will trigger new lows in equities as the valuation bear market finally plays itself out with the S&P falling below 500. We therefore maintain our long-standing target of sub-2% US 10y bond yields – and that is the point when QE will really begin to get serious.
US and eurozone core CPI inflation
3.00 3.00

30-80 20-50 0-30

60 35 5

35 50 15

Source: SG Cross Asset Research

US
2.50 2.50

2.00

2.00

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

1.50

1.50

1.00

1.00

Eurozone
0.50 2002 2003 2004 2005 2006 2007 2008 2009 0.50

Source: Datastream

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

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

Global Strategy Weekly

Dylan Grice has shown us clearly over the past few months that governments are insolvent. At some point, as can be seen most vividly along the periphery of the eurozone, the market demands action. And amid renewed zeal for fiscal retrenchment within the new UK government, it is worth repeating one key point – namely, premature fiscal retrenchment was one of the key policy errors Japan made in a post-bubble, de-leveraging economy (see GSW 12 Feb, To cut or not to cut? Actually it doesn’t really matter. We’re stuffed anyway! – link). I remain persuaded by Richard Koo’s book about the lessons from Japan’s balance sheet recession. The crux of his analysis is that governments have no option but to stimulate aggressively all the while the private sector is de-leveraging. ANY attempt at fiscal cuts simply results in renewed recession and a further loss of confidence, thus making it even harder and more costly to sustain any subsequent recovery – and hence the budget deficit ends up bigger than before (see chart below). A repeat of Japan’s mistakes is exactly the outcome I expect. Renewed recession awaits and with the eurozone and the US core CPI inflation less than 1%, the icy tentacles of outright deflation are now just within reach. (Attached is a link to an interview by welling@weeden with Mr. Koo. It is well worth a read – link.).
Richard Koo says premature fiscal tightening in Japan 1997 and 2001 weakened the economy, reduced tax revenue and ultimately made the fiscal deficit even bigger

Source: Welling@Weedon

Competitive devaluation is one way to try and wriggle free from the deflationary quicksand.
OECD real effective exchange rate indices (using CPI, indexed to 2000=100)
131 130 131 130

Eurozone
120 120

110

110

100

100

90

90

UK
80

US
2001 2002 2003 2004 2005 2006 2007 2008 2009

80

70

70

Source: Datastream, SG Cross Asset Research

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21 May 2010

Global Strategy Weekly

The UK has clearly embraced this option with gusto and is enjoying the benefits of a relatively high inflation rate. This resembles closely the UK’s experience of the 1930s when it was ejected from the Gold Standard, only to devalue aggressively and so suffer a relatively mild “depression” compared to those who remained on gold. The eurozone clearly needs to devalue and the Greek crisis is allowing that much needed adjustment to occur. Competitive devaluation might allow the eurozone overall to escape the deflationary fate of some of its most vulnerable members (see chart below) and export its deflation elsewhere.
Spain slips into outright deflation (joining Portugal and Ireland). Eurozone next?
4.00 4.00

3.50

Spain

3.50

3.00

3.00

2.50

2.50

2.00

2.00

1.50

1.50

1.00

1.00

Eurozone
0.50 0.50 0 0

-0.50 2002 2003 2004 2005 2006 2007 2008 2009

-0.50

Source: Datastream, SG Cross Asset Research

But as my old friend Jim Saft pointed out in his Reuters opinion piece yesterday, it won’t just be deflation the eurozone will be exporting but also trade tensions as the dollar rises– link. Jim makes the very good point that “the US primary elections on Tuesday showed voter anger is focused on incumbents in general and Washington in specific. It would not be a surprise for the administration to try and focus that anger outside of the country.” A renewed global downturn with rising trade tensions is exactly the environment that will see the shock Chinese yuan devaluation. I continue to remain of the view that a global downturn is close. Too many are focusing on the buoyant economic data that is entirely consistent with continued strength of the coincident indicators, yet all the while the leading indicators continue to slow (see chart below). Renewed recession will never be forecast until after we are back in one!
US Economic Cycle Research Institute leading and coincident indicator (yoy%)
30.0 20.0 4.0 10.0 0.0 -2.0 -10.0 -20.0 -30.0 1/1/1999 1/1/2001 1/1/2003 1/1/2005 1/1/2007 1/1/2009 leading indicator -8.0 -10.0 -4.0 -6.0 2.0 0.0 coincident indicator (rhscale) 8.0 6.0

Source: ECRI

21 May 2010

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Global Strategy Weekly

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21 May 2010