SG-Global Strategy weekly-2010-11-4 by mm18881


									                                                                                                                                                   4 November 2010

                                                                          Global Strategy
                                                                          Alternative view

Global Strategy Weekly
“Shame on you Mr Dylan Grice”

Albert Edwards                                  A very good client complained that we were doing a U-turn, ditching our previous Ice Age
(44) 20 7762 5890                               bearish stance on equities and becoming vastly more bullish – using QE as the excuse. And to
                                                be fair, Dylan’s last two notes, suggesting that the Nikkei could go to 63 million in 15 years
                                                and that emerging markets could double, might be construed as being a tad bullish. In this
                                                note I will make MY view crystal clear and tie it into Dylan’s recent work.

                                                   One of the features of my Global Strategy Weeklies over the last 23 years is that I have
                                                always had a clear view. That view may have been wrong, but I do not believe in watering
                                                down the message with endless qualifications and get-out clauses. In my experience,
                                                clients want to read a clear view, preferably in less than 100 pages.

                                                  I have not backed away from my Ice Age view of the world which has underpinned my 14
                                                years underweighting of global equities relative to government bonds. And although that
                                                strategic asset allocation decision has handsomely paid off over the period, for most of this
Global asset allocation                         long-period I have looked hopelessly out of touch with reality because equity bear markets
                          Index          SG     tend to be short and sharp (i.e. 1997-2000, 2003-2007, and 2009-now).
%               Index
                         neutral      Weight
Equities       30-80         60          35       We are in the end game for the Ice Age. Regular readers will know that monetisation,
Bonds          20-50         35          50     competitive devaluation and protectionism always had lead roles in the final act of this
Cash             0-30             5      15     deflationary tragedy. And ultimately, as I have previously stated, I expect successive rounds
Source: SG Cross Asset Research
                                                of QE to produce a repeat of the 25+% inflation I experienced in the UK in the early 1970s.

                                                   Perhaps THE biggest consensus trade at the moment is emerging markets and
                                                commodities. The argument that QE2 will be transferred to emerging markets is entirely
                                                valid. But I still believe there is an irresistible force that will soon hit this immovable object.
                                                Below is a chart from the GSW of 5 March 2008 – link. As we found out then, ultimately the
                                                cycle dominates and its failure will crush EM and commodities – just as it did in 2008.

                                                In H1 2008, wasn’t the bull EM/commodity argument ALSO one based on liquidity?
                                                IMF world growth and CRB commodity index (2yr % ch)
                                                     60                                                                                                       5.00

                                                     50                                            IMF world growth                                           4.50

Global Strategy Team                                                                               (curr exch rates)
Albert Edwards                                       40                                              (rhscale)                                                4.00

(44) 20 7762 5890
                                                     30                                                                                                       3.50
                                                     20                                                                                                       3.00
Dylan Grice
(44) 20 7762 5872                                    10                                                                                                       2.50
                                                       0                                                                                                      2.00

                                                    -10                                                                                                       1.50

                                                    -20                                                                                                       1.00

                                                                                                                   CRB                                        0.50
                                                            79       81     83   85     87    89     91    93      95    97   99   01         03    05   07

                                                Source: Datastream

            Macro                     Commodities              Forex                  Rates               Equity               Credit                Derivatives
    Please see important disclaimer and disclosures at the end of the document
                                                                                                                                                         Global Strategy Weekly

                                                  Our Ice Age views have driven our asset allocation for over a decade. We still believe we are
                                                  locked in a secular valuation bear market for equities that will take many cycles to play out.
                                                  We believe that we are now one recession from outright deflation in the west and that cyclical
                                                  failure will take us to new lows on both equity prices and bond yields.

                                                  It remains my view that recession looms and will trigger yet another 60% decline in equity prices
                                                  – the third in just a decade. But to be sure, the latest US ISM was better than widely expected,
                                                  and the ECRI’s weekly leading indicator has just begun to turn upwards after reaching very weak
                                                  levels recently that are normally consistent with recession (see left-hand chart below). The
                                                  excellent folks at the ECRI recently declared “definitively” the risk of a double dip has now
                                                  passed – link. But while I commend their lack of prevarication, I think this is a premature call
                                                  given the degree of fiscal tightening coming down the tracks. In addition, the Conference Board
                                                  leading indicator has also now moved into recession territory when the now defunct yield curve
                                                  sub-component is excluded (because at zero Fed Funds the shape of the yield curve will now
                                                  always add positively to the lead indicator, see right-hand chart below).

The ECRI weekly leading indicator turning up….                                  ….but the Conference Board lead indicator looks recessionary
                                                                                   8                                                                                                                 8

                                                                                   6                                                                                                                 6


                                                                                   4                                                                                                                 4

                                                                                   2                                                                                                                 2

                                                                                   0                                                                                                                 0

    -10                                                                            -2                                                                                                                -2

                                                                                   -4                                                                                                                -4
    -20                                                                                                     excluding shape of yield curve

                                                                                   -6                                                                                                                -6
    -30                                                                                     96   97    98       99   00        01    02    03       04    05        06     07    08       09   10

      1/1/99     1/1/01       1/1/03          1/1/05    1/1/07      1/1/09

Source: Datastream, ECRI, SG Cross Asset Research

                                                  Meanwhile, bull-bear indicators suggest that the equity rally is now exhausted and crying out
                                                  for a major correction (see left-hand chart below) at a time when the Conference Board
                                                  measure of the jobs market suggests that the unemployment rate may be close to heading
                                                  back up again, stoking further trade tensions with China (see right-hand chart below).

AAII bull-bear indicator shows the S&P is overstretched....                       …..and the US unemployment rate looks set to rise
                                                                                    50                                                                                                              11

                                                                                                      Jobs hard to get-jobs plentiful                                                               10



                                                                                        0                                                                                                           7


                                                                                            unemployment rate
                                                                                    -40      (rhscale)                                                                                              4

                                                                                    -50                                                                                                             3
                                                                                            91   92   93   94   95   96   97    98   99   00   01   02   03    04    05    06   07   08   09 10

Source: Datastream, SG Cross Asset Research

2                                                 4 November 2010

                                                                                                                                                  Global Strategy Weekly

                                                 Dylan Grice and my erstwhile colleague James Montier have one key point in common when it
                                                 comes to their investment approach – namely they both recognise the futility of economic
                                                 forecasting. Dylan’s mantra (apart from “make the tea Albert”) is “there is no such thing as
                                                 toxic assets, only toxic prices”. Hence, like James, he is happy to invest if the asset is cheap
                                                 enough. This approach also applies to insurance. Where there is a credible risk and insurance
                                                 IS CHEAP, then one should buy that insurance. Hence his recent note on the high risk of
                                                 runaway inflation in Japan sending the Nikkei to 63,000,000 in 15 years came to the
                                                 conclusion that insurance is cheap and it is available.

                                                 In the same context, his note last week showed that to the extent that EM had become the
                                                 liquidity and momentum trade de rigueur, valuation was not a binding constraint and prices
                                                 could rise significantly if we were to reach the same excesses seen in 2008 (see charts below).
                                                 Even a wizened bear such as myself would buy out of the money calls if they were cheap
                                                 enough as a hedge against my central case being wrong or, indeed, too early.

Price/Book ratios suggest EM not cheap…..                                                          ..but Dylan’s Shiller PE ratios suggest even more upside
 4.50                                                                                       4.50

 4.00                                                                                       4.00
                                    MSCI Developed World
 3.50                                                                                       3.50

 3.00                                                                                       3.00

 2.50                                                                                       2.50

 2.00                                                                                       2.00

 1.50                                                                                       1.50

 1.00                          MSCI EM                                                      1.00

 0.50                                                                                       0.50
         96   97    98    99   00    01   02   03     04   05   06   07    08    09   10

Source: Datastream, SG Cross Asset Research

                                                 But for me, despite all this liquidity pouring into EM equities, they are just another high beta
                                                 trade, outperforming on the way up and underperforming on the way down (see charts below).
                                                 Show me a period when developed markets are down 20% and EM equities rise by 20% and
                                                 I might be more of a believer. The simple fact is that if, as I expect, QE2 fails and fiscal tightening
                                                 sends the fragile western economies back into recession, we will see the unfolding liquidity
                                                 driven EM and commodity bubble burst just as violently as it did in the second half of 2008.

Emerging markets just look high beta to me…                                                        ..yet inflows pouring into Asia on par with the mid-1990s
 1600                                                                                      1600

                     MSCI Developed World                                                           6
 1400                                                                                      1400                   Asia net capital inflows (% of GDP)
                                                                                                                  Asia (ex Japan & China) net capital inflows (% of GDP)
 1200                                                                                      1200


 1000                                                                                      1000     2

  800                                                                                      800

  600                                                                                      600
                                               MSCI EM                                             -2
  400                                                                                      400
                   2008                        2009                       2010

Source: Datastream, SG Cross Asset Research

                                                 4 November 2010                                                                                                           3

                                                                                                                                     Global Strategy Weekly

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4                                         4 November 2010


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