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SocGen-Alternative-View-2011-05-25-Albert-Edwards

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					                                                                                                                                       25 May 2011


                                                                     Global Strategy
                                                                     Alternative view
                                                                     www.sgresearch.com




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
albert.edwards@sgcib.com
                                               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       SG
%                 Index                        global economy towards the end of 2008 on the bankruptcy of Lehman’s in mid September
                           neutral   Weight
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 Lehman’s went bankrupt. Non-
Cash               0-30         5       15
                                               farm payrolls declined a massive 434,000 in September 2008 – BEFORE the post Lehman’s
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 Lehman’s 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 Fed’s 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
Albert Edwards
(44) 20 7762 5890
albert.edwards@sgcib.com


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




                                               Source Datastream


             Macro                   Commodities             Forex             Rates           Equity             Credit             Derivatives
    Please see important disclaimer and disclosures at the end of the document
                                                                                                                           F174540
                                                                                  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. Russell’s 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 country’s 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
      3.50                                                                                             65

                              10y implied inflation expectations
      3.00
                                                                                                       60

      2.50

                                                                                                       55
      2.00


      1.50                                                                                             50



      1.00
                                                                                                       45


      0.50
                                                                                                       40

           0

                                manu ISM                                                               35
     -0.50


     -1.00                                                                                             30
                98       99       00     01    02     03     04    05   06   07    08       09    10




    Source: Datastream



2   25 May 2011


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                                                                                                                                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, China’s inflation
                                                 problems should not be ignored. To the extent that the Fed’s 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

     8
            of Chinese goods (rhscale)                                                 8
                                                                                                                                                              4


                                                                              4

                                                                                                               China CPI                                      3
                                                                                       6

     6
                                                                              3
                                                                                                               (led 20 mths)
                                                                                                                                                              2
                                                                              2
                                                                                       4


     4                                                                        1                                                                               1


                                                                                       2
          China CPI                                                           0
                                                                                                                                                              0
     2   (led 4 mths)
                                                                              -1
                                                                                       0
                                                                                                                                                              -1

                                                                              -2
     0
                                                                                      -2
                                                                                                                                                              -2
                                                                              -3
                                                                                                          US core goods inflation
    -2                                                                        -4      -4
                                                                                                          (rhscale)                                           -3
             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


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                                                                                                                     Global Strategy Weekly




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4                                    25 May 2011


                                                                                                                           F174540

				
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