Credit Suisse -“This Time It’s Different”

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					                                                                                                                 05 November 2012
                                                                                                            Fixed Income Research

                                                 Market Focus

                      Research Analysts          “This Time It’s Different”
                          Jonathan Wilmot        Four words investors should instinctively distrust. And normally do, except when
                         +44 20 7888 3807
                                                 it matters most!
                                                 They are most widely believed when the valuation of some major asset has
                         James Sweeney
                           212 538 4648
                                                 reached a secular extreme, totally unforeseen in advance and never
        experienced before in most investors’ lifetimes. At that point it becomes
                                                 commonplace – in fact almost required – to believe that a new era of some sort
                             Matthias Klein
                         +44 20 7883 8189
                                                 has begun, and as a result that current valuation extremes are set to last much
       longer than they ever have in the past.

                            Paul McGinnie
                                                 Equities at the peak of the tech bubble in 1999/2000, US housing in 2006, oil in
                        +44 20 7883 6481         2008 are three recent examples, and all of them spawned a rash of “this time
        it’s different” narratives. To be sure, many of these stories had some element of
                                  Aimi Plant
                                                 truth to them, but that was small comfort to investors when those overvalued
                          +44 20 7888 7054       assets suddenly collapsed. So in those episodes the new era stories either
           turned out to be only partly true or not relevant for investment purposes.
                           Wenzhe Zhao           Does the same apply today, and how do current valuations look?
                        +1 212 325 1798
                                                 In brief, our simple valuation metrics (the same metrics that identified equities,
                                                 housing, and oil as extremely expensive before) suggest that “safe” bonds, gold,
                                Zhoufei Shi      and oil look (very) “expensive” on a secular basis, while US housing, Japanese
                           44 20 7883 2556
                                                 equities outright, and US and European equities relative to bonds look (very)
                                                 cheap (Exhibit 1).
                          Jeremy Schwartz
                          +1 212 538 6419
                                                 It feels particularly abnormal that such a large share of the world’s savings are
      now invested in financial assets with zero nominal returns or where prospective
                                                 real returns are highly likely to be negative. And that in itself is a big difference
                                                 from previous “bubble” episodes, since it is surely driven by fear of bad
                                                 outcomes, not boundless optimism about good ones. If this is a safe assets
                                                 “bubble,” then it is a bubble born of pessimism.
                                                 Indeed, in very broad terms, today feels almost like the inverse of the tech
                                                 bubble, with investors likely paying too much for safety, just as they paid too
                                                 much for risk 12 years ago.
                                                 This deep undertow of anxiety is rooted in real problems that are unlikely to
                                                 change overnight, no matter how the US election turns out. In coming weeks,
                                                 we will examine in more detail the role of valuation in investment, the specific
                                                 assets that seem most over- or undervalued to us and some of the “new era”
                                                 arguments used to rationalize that curious state of affairs.
                                                 To put that in context, we first review how the global production and risk
                                                 appetite cycle looks as we head into the election. And here things appear to be
                                                 much more interesting – and not quite so different than one might suppose.

CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS                                                          BEYOND INFORMATION™
                                                                                      Client-Driven Solutions, Insights, and Access
                                                                                                                                      05 November 2012

               Exhibit 1: The Secular View: What's Cheap, What's Not (Assets at least one
               standard deviation from long-run trends)
                 4         3.80






                 -2                                                        -1.75
                                                                                         -1.93             -1.98              -2.10


                           Gold        Oil (Brent)      G3+ Bonds       US EB Ratio   E3 EB Ratio      Japan EB Ratio     Japan Equities   US Housing

               Source: Credit Suisse, Thomson Reuters DataStream

               Exhibit 2: Long-Run Real US Yields
               12%         Gold             New Deal                Bretton Woods        Stagflation       Volcker            Greenspan






                Mar 1919      Nov 1929       Jul 1940     Mar 1951       Nov 1961     Jul 1972      Mar 1983            Nov 1993      Jul 2004

               Source: Credit Suisse, Thomson Reuters DataStream

               A Real Life Experiment
               The lack of yield available from so called safe assets is probably the biggest business
               challenge most of our clients face. But in day-to-day terms, the main macro drivers of
               investment decisions are the prospects for global growth, investor risk appetite, and
               economic policy.
               Let’s focus on the first two and try to examine the facts free of any secular bias.

Market Focus                                                                                                                                            2
                                                                                                05 November 2012

               In terms of our favorite metric for the economic cycle – global industrial production – two
               things stand out.
               First, the cumulative rise in global production from its cyclical trough in March 2009 has
               been considerably larger than in the three previous global recoveries (troughs in
               November 1982, December 1992, November 2001), and virtually identical to the recovery
               from the oil shock recession of 1974/75 (Exhibit 3).
               That is exactly what one might expect. After an unusually severe and concentrated output
               decline in response to an exceptional shock (whether financial or otherwise), one would
               expect a bigger initial rebound in growth. That may not have happened at the developed
               world level, but it certainly has at the global level. Paradoxically, that’s a sign of normality,
               not the opposite.
               Second, growth momentum has so far described a rather classic arc, with the highest
               growth rates coming early in the recovery when inventory dynamics are usually most
               intense, followed by a gradual ratcheting down towards zero growth about 3 ½ years from
               the prior recession trough.
               Broadly speaking that is pretty similar to what happened in each of the last three
               recoveries. And in each prior case there was both a significant monetary policy response
               to this mid-cycle slowdown (as in this cycle) and a gradual rebound to growth rates of 5%
               p.a. or higher in the following stage of the expansion (Exhibit 4).
               For what it’s worth, the path of global IP growth in this cycle looks especially like the 1982-
               1990 cycle, once you adjust for the even larger initial rebound. Adding in our bottom-up
               central forecast, it looks as though this close correspondence may well continue in 2013
               (Exhibit 5).
               Equally, the current cycle dynamics look least like the 1992 -2000 cycle, when two shocks
               emanating from the EM world led to temporary, but sharp dips in growth momentum during
               1994/95 (Mexico) and 1997/98 (Asia, Russia).
               Which helps illustrate the risk to our central forecast if there is another growth shock from
               policy failure in Europe, the US, or China in coming months.
               So here are ten brief takeaways on the state of the global cycle as we wait for the election
                   1)   Whatever your prior beliefs about how structurally “different” the world is today,
                        and how much lower global demand or supply growth is supposed to be
                        compared to prior cycles, the evidence from looking at global industrial production
                        as a whole simply does not fit. So far at least, the old normal seems to be pretty
                        much the new normal.
                   2)   If one knew nothing but the past numbers, the obvious forecast for the next 12-18
                        months would be for a meaningful and sustained pick-up in global IP growth and a
                        (slight) narrowing of the global output gap to mirror what happened at this stage of
                        the three previous cycles.
                   3)   But we are about to get that rare thing in economics – a real life experiment. If
                        global growth does not re-accelerate in similar fashion to prior expansions and the
                        world slips quickly back into outright recession, that would definitely favor the “this
                        time it’s different” story.

Market Focus                                                                                                   3
                                                                                                               05 November 2012

               Exhibit 3: Global Industrial Production Levels rebased from trough
               4.95                                                     (logscale)


                 4.7                                                                                       Dec-92

               4.65                                           months from trough                           Nov-01
                         0                   12                    24                36         48                 60

               Exhibit 4: Global Industrial Production Momentum rebased from troughs




                   -5%                                                                                   Nov-82
                 -10%                                                                                    Dec-92
                 -20%               months from trough
                             0                  12                 24                36          48                60

               Exhibit 5: Global IP Cycles Compared – 1982 vs. 2009


                                                                                          Feb-09 (lhs)

                 4.7                                                                      Nov-82 (rhs)                4.68

               4.65                                          months from trough                                       4.63

                 4.6                                                                                                  4.58
                        0                  12                 24               36          48             60
               Source: Credit Suisse, Thomson Reuters DataStream

Market Focus                                                                                                                  4
                                                                                           05 November 2012

               4)   Should that happen it will almost certainly be the result of serious policy failure or
                    a similar exogenous shock: the US actually goes over the fiscal cliff (and stays
                    there for a while); the new Chinese leadership loses control of the economy and
                    credit cycle; the German public successfully revolts against any further “bail-out”
                    packages for the periphery and even manages to undermine the (independent)
                    ECB’s ability to carry through its proposed OMT program. Or perhaps Israel
                    attacks Iran and oil prices go back to the moon. All of these outcomes are
                    thinkable, but in our view highly unlikely and not a suitable basis for any central
               5)   Our own working assumption is that chronic political and policy uncertainty over
                    the past six months has definitely led to some delays or cancellations in corporate
                    spending across all three major regions, even though this is hard to quantify.
                    Uncertainty has probably also reinforced the desire to control production and
                    inventories very tightly, so we think that there will be a some backlog of both
                    production and demand built up by early next year. And however difficult it may
                    be to call the next few weeks, we think policy uncertainty will decrease
                    substantially in the US and China by early next year and probably come down a
                    little further in Europe. If anything, therefore, there may be some upside risk to the
                    central forecast , especially a little deeper into 2013.
               6)   We are not trying to be deliberately obtuse: of course we are aware that for most
                    of the developed world, recovery so far has been very incomplete, more or less
                    whatever metric you use – industrial production, GDP, employment, tax revenue,
                    or disposable income. But it’s still important that at the global level this recovery
                    is by no means under-powered or abnormally weak. It helps to explain, for
                    example, why US corporate profits (a large fraction of which come from abroad)
                    have made such a quick and spectacular recovery. (In fact they have not only
                    exceeded previous highs but are actually about as far above long-term trend as
                    they were in 2007).
               7)   Equally, the painfully slow recovery in developed world production – and the huge
                    G3 and global output gap that remains as a result (Exhibits 6-7) – helps to explain
                    why actual and expected short-term policy rates as well as bond yields are
                    making or recently made new lows so deep into the recovery process. As far as
                    we can see, the front end of the G3 government yield curves are most of the time
                    priced and re-priced quite carefully to evolving views about the likely path of policy
                    rates in coming years.
               8)   Few investors alive today have direct experience of a such large output gap
                    persisting three years or more into recovery, but it is not completely
                    unprecedented. Leaving aside the extreme circumstances of the 1930s, it’s more
                    or less exactly what happened in the 1890s, and indeed was a not uncommon
                    feature of the 19th century. Moreover, it’s also consistent with the gradual
                    (deflationary) drift of the last two decades, in which the amount of excess capacity
                    has tended to get larger in recessions and the amount of excess demand less at
                    each cyclical peak (Exhibit 7).

Market Focus                                                                                              5
                                                                                                                          05 November 2012

               Exhibit 6: Global Industrial Production vs. Capacity
               5.9                                                      (log scale)





                                                                                                      Global Capacity
               4.7                                                                                    Global IP

                 Mar-80 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Mar-10 Mar-13

               Exhibit 7: Global IP Output Gap
                1.00                                                                                                                Forecast

                0.98          Excess Demand






                0.84                                                                           Excess Capacity


                   Mar-80 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Mar-10 Mar-13

               Exhibit 8: EM and G3 IP vs. Capacity
                                                                               (log scale)         Emerging
                     6                                                                             Markets
                                                                                                   Trend (01-11): 8.3%



                                                                                                              Developed Markets
                     5                                                                                        Trend (02-08): 2.0%


                         95    96   97   98    99    00    01      02     03   04   05   06   07    08   09    10    11   12    13     14

               Source: Credit Suisse, Thomson Reuters DataStream

Market Focus                                                                                                                                   6
                                                                                                05 November 2012

                   9)   By now, of course, investors have become highly sensitized to that deflation risk,
                        since the combination of high debt levels and a large output gap leaves any
                        system highly vulnerable to negative demand shocks. How could it be otherwise
                        after the traumas of the Lehman crisis and Europe’s ongoing travails? So another
                        part of today’s unrenumerative safe asset yields (to use Neal Soss’s graphic term)
                        has to do with fear of low probability, but catastrophic events. The global plane is
                        flying so close to the ground and so close to stalling speed, the analogy goes, that
                        even a small risk of a major policy mistake, oil shock, etc. is not worth taking. So
                        long as this psychology remains prevalent, there will be a significant negative risk
                        premium for bad outcomes priced into “safe” bond markets. Or to put it in rather
                        racier terms, bond investors will in effect be ready to pay a hefty slug of
                        “protection money” in the shape of negative or very low real returns on their
                        longer duration fixed income assets.
                   10) Finally, it’s worth observing that an abnormally large output gap so deep into
                       recovery should, in theory, cut both ways, since it suggests more room than usual
                       for real output (and revenues/profits) to grow for an extended period without
                       attracting hostile attention from central banks. Indeed, it’s better than that. Since
                       policymakers (not just central banks, and not just in the developed world) are
                       ultimately highly incentivized to avoid or prevent another Lehman-like catastrophe
                       on their watch, one could argue that a persistently large output gap is extremely
                       bullish, since the actual probability of catastrophe is even lower than generally
                       perceived. So perhaps one can sum it all up by saying we are stuck in a weird
                       sort of oscillating equilibrium between fear and hope, in which the main question
                       macro investors should be asking themselves is this: will the marginal investor
                       (and business leader) feel significantly less or significantly more fearful a few
                       weeks to a few months down the road? If your answer is more fearful, expect
                       lower risk appetite, equity prices, and safe bond yields (and with a short lag
                       somewhat slower growth). If your answer is less fearful, then expect the opposite.
                       (And if you have no opinion, hide in hybrid asset like riskier credit!)
               Seen in this light, one can perhaps say two pithy things about the post-election outlook in
               the US. First, rightly or wrongly, the immediate investor and business response to a
               Romney victory would probably be greater optimism about the future and a short-term
               jump in risk appetite. Whether that optimism would be justified in practice is not absolutely
               clear, but it would likely be a secondary consideration in the short term.
               Confirmation of a second term for the president, by contrast, might excite the opposite
               reaction. But equally, there would soon be a strong set of incentives for the president and
               Congress to find some form of solution to the fiscal cliff conundrum. At least as far as we
               can tell, the real peak of uncertainty about the fiscal cliff issue has either already occurred,
               or is just about to.
               So either way, and bearing in mind our best guesses about Europe and China, we expect
               the marginal investor (and business leader) to be somewhat less fearful in a few months’
               time than they are now, and this is as important in driving our central forecast for global
               Industrial Production as more tangible inputs and historical precedent.
               And if the facts change, we will definitely change our mind!.
               However, so far at least, we take some comfort from both the actual economic data that
               we have seen recently and the behavior of market indicators. Broadly speaking, recent
               cyclical data – with the notable, but we think temporary, exception of US business
               investment spending – are fully consistent with our central case of a gradual bottoming out
               of the mid-cycle slowdown. In particular, we think China and Asia seem to have passed
               the lowest point in the cycle.

Market Focus                                                                                                   7
                                                                                                              05 November 2012

               Risk appetite also has been turning up in a way that seems consistent with our baseline
               forecast for global growth momentum.

               Exhibit 9: Global IP Momentum and Global Risk Appetite
                             Euphoria                                                                                     6
                12%                                                                                                       4

                 8%                                                                                                       2
                 -4%                                                                                                      -2

                 -8%                                                                                                      -4
               -16%                                                     Global IP Momentum
                                                                        Global Risk Appetite, rhs                         -8
               -24%                                                                                                       -10
                       90       92        93        95       97    99       01      03      05      07   09      11
               Source: Credit Suisse, Thomson Reuters DataStream

               But there is an even more interesting point to make about market behavior over the course
               of this recovery so far, which is that our World Wealth Index (the cumulative excess return
               over safe cash of a balanced portfolio of global bonds and stocks) has – like global IP –
               behaved surprisingly like it did in previous recoveries from major shocks or recessions.
               And moreover, World Wealth has recently broken to new highs at the very moment when
               its major component (global equities) has just broken out above its post-2007 downtrend.
               (See Exhibits 10, 11, and 12 below).
               So, however different this cycle may be in the composition of growth between emerging
               and developed markets, the persistence of a very large output gap deep into recovery, or
               for that matter debt levels and the scope for policy error, pretty much the same message
               applies to investment returns on a sufficiently diversified and global portfolio as it does to
               global industrial growth.
               So far at least, the new normal looks remarkably similar to the old normal.
               But there is a slight sting in the tail.
                First of all, there have been two distinct phases so far to the World Wealth recovery. In
               the immediate aftermath of the March 2009 trough, equities outperformed bonds
               massively, in both absolute and risk-adjusted terms. But more or less since the spring of
               2010, when the Greek crisis became truly visible and serious, a version of this global
               balanced portfolio with an 80/20 mix in favor of bonds (but no peripheral European debt)
               would have handsomely outperformed World Wealth and a pure equity portfolio.
               Yet for World Wealth to stay on a similar trajectory to its previous five-year bull markets,
               equity returns will have to improve (and volatility subside somewhat) in both absolute
               terms and relative to bonds. That’s exactly what the valuation metrics we started with
               suggest should happen at some point, and what the tentative, but as yet unconfirmed
               break higher in MSCI World hints may be in store.
               At the very least, this gives added interest to the performance of markets in the immediate
               aftermath of the election. But it is also a good place to start questioning whether the new
               era stories of today are any more reliable or relevant than the ones that took flight when
               equities, housing, and oil were at their peaks in 2000, 2006, and 2008.

Market Focus                                                                                                                   8
                                                                                                                        05 November 2012

               Exhibit 10: World Wealth with tramlines
                6.5                                                       (in logscale)





                      97            99             00              02            04            06        08              10

               Exhibit 11: MSCI World with medium-term downtrend
                  Jan 06           Jan 07           Jan 08          Jan 09            Jan 10        Jan 11      Jan 12

               Exhibit 12: World Wealth Recoveries from troughs
               200                       09/10/2002

               180                       02/03/2009



                                                                    years from trough
                       0                   1                  2                  3                  4               5                6
               Source: Credit Suisse, Thomson Reuters DataStream

Market Focus                                                                                                                             9

               Jonathan Wilmot, Managing Director                                Eric Miller, Managing Director
                      Chief Global Strategist                         Global Head of Fixed Income and Economic Research
                        +44 20 7888 3807                                                 +1 212 538 6480

LONDON                                                                         One Cabot Square, London E14 4QJ, United Kingdom

Paul McGinnie, Director                   Matthias Klein, Director                  Aimi Plant, Associate
+44 20 7883 6481                          +44 20 7883 8189                          +44 20 7888 7054 

Zhoufei Shi, Analyst
+44 20 7883 2556

NEW YORK                                                                                 11 Madison Avenue, New York, NY 10010

James Sweeney, Managing Director         Wenzhe Zhao, Associate                     Jeremy Schwartz, Analyst
+1 212 538 4648                          +1 212 325 1798                            +1 212 538 6419    
Disclosure Appendix
Analyst Certification
Jonathan Wilmot, James Sweeney, Matthias Klein, Paul McGinnie, Aimi Plant, Wenzhe Zhao, Zhoufei Shi and Jeremy Schwartz each certify, with respect to
the companies or securities that he or she analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the
subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or
views expressed in this report.
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