25 May 2011
Global Strategy Weekly
Let me re-emphasise our 400 S&P forecast with sub-2% US bond yields
Albert Edwards Amid the equity market enjoying yet another Fed induced mega-rally, many commentators
(44) 20 7762 5890 have been left grasping (gasping?) for explanations for the continued low level of global bond
yields despite the ruination of the public sector balance sheet. Most have latched onto QE2 as
the explanation and hence expect a sharp rise in yields from June onwards as the Fed’s
buying programme ends. We expect new lows in bond yields.
Recent weaker-than-expected economic data around the world concur with our analysis
that the current downturn in the change in analyst optimism is suggestive of weaker
economic data just around the corner. China and Eurozone PMIs were notably weaker than
expected in May, as were some of the US regional manufacturing surveys eg Philadelphia
and New York Empire State. For many, much of this weakness is explained by temporary
component supply problems in Japan slowing production (especially autos) around the
world. And to an extent there is surely some merit in this argument.
Global asset allocation
But this analysis reminds me too much of commentators who blamed the collapse in the
% Index global economy towards the end of 2008 on the bankruptcy of Lehmans in mid September
Equities 30-80 60 35 of that year. To be sure this made a very bad situation much worse. But make no mistake;
Bonds 20-50 35 50 the US economy was already in deep recession by the time Lehmans went bankrupt. Non-
Cash 0-30 5 15
farm payrolls declined a massive 434,000 in September 2008 BEFORE the post Lehmans
Source: SG Cross Asset Research
credit seizure had a chance to affect the economy. Yet those who had failed to predict the
deep recession already upon them seized on Lehmans as an excuse to hide their error.
Despite fully acknowledging the ruination of the government balance sheets as years of
excess private sector debt are transferred to the public sector, we still expect to suffer
another deflationary bust that will take government bond yields to new lows BEFORE
government profligacy and the Feds printing presses take us back to both double-digit
inflation and bond yields. For now, we remain heavily overweight government bonds.
US 10y bond yields still locked in long bull market. Get ready for a lower low
Global Strategy Team
(44) 20 7762 5890
(44) 20 7762 5872
Macro Commodities Forex Rates Equity Credit Derivatives
Please see important disclaimer and disclosures at the end of the document
Global Strategy Weekly
Many think I am mad. But I am not the only commentator expecting a deflationary bust the
sort of bust that will take the S&P down to 400 from the current 1300. I recently watched John
Authers of the FT Lex and Long View columns interview Russell Napier, formerly of CSLA and
a leading stockmarket historian. Russells views are as interesting as ever and well worth 11
minutes of watching time. His views are similar to mine, although he articulates his thoughts
far more clearly than I - Long View: Historian sees S&P fall to 400 - ft.com 16 May.
For those of you who cannot see the video let me try and paraphrase Russell. He believes
massive central bank balance-sheet expansion has failed to boost broad money in the west,
but rather this huge monetary stimulus has been transferred to emerging markets (EM) via
foreign exchange (FX) intervention to peg EM currencies to a weakening US dollar (most
notably the Chinese Renminbi). Together with the impact of a weak dollar driving commodity
prices higher, the emerging markets own version of QE has led to overheating and inflation.
EM countries are now far more inclined to aggressive monetary tightening, including allowing
currency appreciation, which will halt the flow of EM-driven demand for US Treasuries. The
creditor Chinese and other EM nations will tighten global liquidity, not the debtor US. This will
cause what Russell terms “The Great Reset” which will drive US real bond yields higher and,
amid a deflationary bust send the S&P down to its ultimate bottom commensurate with
levels of compelling cheapness represented on the Shiller PE at around 400 on the S&P
Where I diverge slightly from Russell is that the world he describes sounds pretty recessionary
to me. Clearly the S&P falling to 400 destroys household balance sheets and consumption
anew. And EM liquidity tightening could causes hard landings. In China, for example, a recent
calculation showed FX intervention accounted for around one half of the countrys runaway
money supply which has helped propel the boom). My own view would be that despite the
cessation of the EMs need to buy US Treasury debt as they curtail liquidity, weak economic
fundamentals will drive US Treasury yields still lower in the near term. The printing presses
being turned off will hit risk assets hard and that should boost Treasuries. So in my world, 400
on the S&P goes hand-in-hand with lower, not higher US bond yields. Ultimately I would
concur that there is also going to be “The Great Reset” on US yields as well, but that will
come after a frenzied orgy of balance sheet debauchment (both Fed and Federal) which will
make events over the last three years look like an afternoon tea-party with the Vestal Virgins.
As it stands, the recent softer tone in US economic data is already lowering inflation
expectations embedded in the bond market (see chart below). Yet recent work from the San
Francisco Fed shows that 1 year ahead inflation expectations as measured by the University
of Michigan tend to be increasingly dominated by what food and energy is doing.
US inflationary expectations topping out as domestic economy weakens
10y implied inflation expectations
manu ISM 35
98 99 00 01 02 03 04 05 06 07 08 09 10
2 25 May 2011
Global Strategy Weekly
The study shows that households, in their assessment of inflation expectations are
increasingly ignoring what core inflation is doing. Indeed at the moment they “can no longer
be sure that households are paying attention to the core inflation rate when forming inflation
expectations.” This the authors show is a mistake link. Hence a deflationary bust involving
commodity prices could see a sharp decline in both inflation expectations and bond yields.
But despite the cyclical slowdown in the US reducing inflation expectations, Chinas inflation
problems should not be ignored. To the extent that the Feds QE1&2 is driving Chinese CPI
inflation upwards (and the CPI measure severely understates wider Chinese inflation with the
GDP deflator running closer to 10% yoy), it is coming back into the US via higher US import
prices of Chinese goods which is in turn impacting core inflation (see charts below).
Look out Helicopter Ben……Chinese inflation…. …is coming up behind you!
10 6 10 5
US import price inflation 5
of Chinese goods (rhscale) 8
China CPI 3
(led 20 mths)
4 1 1
China CPI 0
2 (led 4 mths)
US core goods inflation
-2 -4 -4
2002 2003 2004 2005 2006 2007 2008 2009 2010 01 02 03 04 05 06 07 08 09 10 11 12
Source: Datastream, SG Cross Asset Research
We expect a global deflationary bust to reverse the clear inflationary pressures building from
monetary debauchment around the world more so EM than developed. If as last year we see
a severe economic slowdown unfolding around the turn in the year, this could rekindle geo-
political tensions as the US is currently suffering a record seasonally adjusted (Datastream
measure) trade deficit with China, disguised for the moment by favourable seasonal effects
(see charts below). But from June onwards record reported deficits will increase trade tension
sharply, especially if as last year we get US growth spluttering badly as QE draws to a close.
US trade deficit with China (US dotted line and China red) Seasonally adjusted bilateral deficit (dotted) at all-time high
Source: Datastream, SG Cross Asset Research
25 May 2011 3
Global Strategy Weekly
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4 25 May 2011