MONTHLY INVESTMENT STRATEGY

1. MONTHLY INVESTMENT STRATEGY June 2011

2. Introduction Recent data confirms that the global two speed economy is still very much with us. World trade is still expanding, activity [and inflation] remains high in China and the developing world and business confidence in the West remains elevated. Developed world consumers are much less happy. Unemployment is high, real incomes are being pushed down by commodity price inflation while house prices, once a source of confidence and the gateway to easy credit, are weak. In fact the most recent data suggests that house prices in the US and the UK have begun another leg down. So much for housing as an inflation hedge. At the moment this doesn’t look like the 1970s; so far, at least, there is little sign that headline inflation is being “validated” by higher nominal wages. The rise in equity prices has provided some cheer but the ownership of equities is narrower than housing; the largest effect has probably been on business confidence. Outside the United States budgetary consolidation is the new norm; the vast US budget deficit [some 11.5% of GDP] is very much the anomaly. Although, as we discussed last time, there is little relationship between equity returns and economic growth, for the moment, day to day movements in markets are being determined by the latest macro data. High frequency data flow is often quite random and the recent “soft patch” is quite likely to be followed by an improvement. Unless trading, along with a corresponding willingness to change positions frequently, is the preferred investment technique, however, a focus on the underlying trends is suggested. One of the charts in the pack shows how economic growth in the US has been systematically overestimated. This is reminiscent of the chronic overestimation of inflation from 1989, the fall of the Berlin Wall, onwards. “Conventional” i.e. cyclical, mean variance models were unable to factor in the effect of the globalisation of the world economy and its effect on the supply side. Something similar is happening at the moment. One of the main reasons why this is not 1993 [in spite of many superficial similarities] is that the baby boomers are twenty years older and the debt supercycle twenty years further advanced. Low interest rates and rising asset prices are “needed” to stem the tendency of savings rates to rise. Aside from the pervasive influence of an aging population on investment markets - markets are how intergenerational claims are mediated – our two other big themes march inexorably forward. A new word has entered the Euroland lexicon “reprofiling”. This is what may happen to Greek bondholders. Whether this is a “credit event” will doubtless keep many lawyers occupied. Italy is now on credit watch. Markets don’t seem over exercised at the moment but “defending the Spanish frontier” remains crucial. Social and political unrest in the “periphery” are now almost certain. Chinese activity is strong but decelerating. The planned and much discussed Chinese economic “transition” still lies in the future – the economy remains as dependent as ever on exports and unprecedented levels of capital expenditure. Nick Carn June 2011

3. GLOBAL MONETARY CONDITIONS

5. CSFB global risk appetite The generalised sell off in risk assets has taken CSFB’s global risk measure down to its average

6. CSFB risk appetite The detail of risk appetite indices is more interesting. Credit is well behaved while equities are skittish. The area of credit which is troublesome is, of course, Europiig debt. This is a new development; we haven’t seen this kind of distress in DM bond markets since the early 1980s – albeit for different reasons.

7. US monetary aggregates The monetary picture in the US has begun to change. A few months ago the story was one of rapidly rising M1 [which historically, at least, has had little relationship with either inflation or activity] and contracting M3. M3 is now growing - a source of comfort to doctrinaire monetarists, rare though that beast is nowadays. The fact remains that the reasons not to pay too much attention [the same reasons that caused the Fed to stop even publishing M3] still entail. The fact that interest rates are so low means that the opportunity cost of holding money is also low. Growth in money balances may not therefore presage spending in the way it has in the past – the foundation of the theory.

8. US money multiplier: Ratio of non M0 M3 to M0 In a simplified form money theory works like this; a rise in cash presages a rise in spending and spending leads to loan growth. What has been happening is that a rise in “cash” has been leading to ever less loan growth.

9. US commercial bank loans [US $bn] Commercial banks are still shrinking their loan portfolios ‘though consumer credit has now stabilised.

10. ECONOMIC SNAPSHOTS

11. US growth was vastly overestimated Error is often more revealing an success. Persistent biases in expectations can take a long time to iron themselves out. The very high ex post real interest rates of the 80s and 90s were very largely a function of inflation expectations which were too high. The same seems now to be happening with growth expectations – they have been persistently too high for a decade. Why? Probably because the related themes of the ageing population and the debt supercycle are not being properly included.

12. US personal savings rate We have often featured this chart before. It tells an eloquent story of how a falling savings rate allowed a higher level of consumption than allowed by growth in incomes. Baby boomers have inadequate savings, are growing old and [should] be doubting the State’s ability to look after them. Very low interest rates and rising asset prices [most recently stocks and previously housing] have so far stemmed the tendency for savings to rise. As can be seen from the chart, when this has failed recession has ensued. The foreground action in the economy is the business sector – demographics, savings and the debt supercycle [all intimately related] are the secular influence. The long postponed adjustment in Government finance is the next major event.

13. US house prices qoq seasonally adjusted US house prices are still falling . In the first quarter they fell at the same rate as at the worst of the financial crisis. The rise in the equity market has rebuilt savings to some extent but housing [a much more widely owned asset] has taken that away.

14. US industrial production Just as elsewhere [and in China above all] it’s been business that’s driven this recovery. US industrial production lost altitude in April. There are some reasons – largely supply disruptions for autos from the Japanese earthquake. Similarly housing starts were well below expectations – tornadoes were cited as the reason. Both may be legitimate explanations but special pleading is often suspect.

15. May ISM index disappointing May’s ISM index, one of the established leading indicators for the industrial economy decelerated in May. It still signals expansion [it’s above the 50%] line but at a slower rate. Conventional wisdom is that this is a “mid cycle pause” and it is true that there is some randomness as well as reflexive behaviour [a weak stock market leads to a weak survey which leads to a weak stock market etc] in surveys. In the bigger picture what needs to be borne in mind is that international [i.e. Chinese centric] demand aside, business conditions have raced ahead of what is happening to employment and incomes.

16. US payrolls and unemployment Source BLS Payrolls hardly grew in May and unemployment nudged up. With real income growth under pressure and attempts to suppress the strong tendency of the savings ratio to rise constantly under threat consumer demand depends on a rising number of employed – businesses will not carry on investing unless there is some follow through.

17. Chinese targets in 12th five year plan These are excerpts from China’s latest five year plan. It’s an impressive wish list and would be even more impressive were it to be achieved. Obviously if anyone else produced such a plan laughter would be the result. What lends it credibility is China’s astonishing success in implementing the capex/export model which has so far powered growth. The next stage involves a change in the growth model. I argue that this lends itself much less well to central planning, that capex is at excessive levels and that execution risk is very high.

18. Chinese retail sales [real 3m % yoy] A hard landing in China is absolutely not discounted so it’s important to closely monitor the planned economic transition. Retail sales are still growing rapidly but are decelerating sharply.

19. Chinese household spending [% GDP] It is one of those uncomfortable truths that while the rhetoric has been about increasing the role of consumer demand its contribution to growth has been flat at best.

20. Current account surpluses [%GDP] China’s c/a surplus has come down but is still at very high levels – well exceeding that of Japan at its peak. The c/a is the external manifestation of the intended shift in policy so is one way to keep score.

21. Chinese commodity imports Chinese commodity imports actually declined on the latest numbers. Power shortages may be a reason. In order to control inflation tariffs have been frozen and since fuel costs have gone up many power stations have shut down rather than run at a loss. This is quite reminiscent of the price and wage controls which were tried [and failed] in the West during the 1970s. If this sounds like a strange way to run an economy that’s because it is.

22. Inflation [cpi % yoy] Inflation remains high throughout Asia and a number of CBs are behind the curve. There are a number of reasons; food and energy are typically a bigger part of indices than in the developed markets and there are fewer underused resources in the economy because their recessions were brief, shallow or nonexistent. In many cases their CBs held back tightening because of the Western financial crisis but now need to catch up.

23. Japan in recession again It’s a depressing fact but Japan has slipped back into recession. The after effects of the earthquake are partly to blame and there will be a rebound but it’s still a story of a bit more volatility around a flat trend.

24. Euroland PMI and GDP The story in Euroland has been one of strong exports and business confidence in the “core”, mediocre consumer demand even in Germany and generalised misery in the periphery. Because Germany is very big the good news has dominated the bad news. The “best bit” is now losing momentum.

25. Euroland ESI Euroland economic sentiment confirmed a downturn.

26. Germany’s ZEW index Germany has been doing very well on the back of strong exports. The leading indicators for the business sector have been losing momentum although still consistent with strong growth. The latest reading for IFO, ZEW’s rival suggested that activity is stable at a very high level.

27. UK inflation The UK has a high inflationary bias and, moreover, had a very large currency devaluation. Even so inflation is staying higher for longer. There is some special pleading surrounding the most recent figures concerning the timing of Easter but pressure is mounting. The trouble is; What if the economy needs lower interest rates but the fight against inflation needs higher interest rates? It’s a long while since a CB faced such an ugly choice. For the time being, however, the Bank of England sees little in the way of wage pressure and this is likely to remain their guide. Mr Market may not choose to be so patient.

28. UK and Eurozone services inflation For many years the inflation story in the developed world has been one of falling manufactured goods prices and rising prices of domestically produced services. This is a particularly marked feature of the UK and one of the reasons for high UK inflation.

29. UK real incomes High inflation has been pressuring real incomes in the UK – in fact this is one of the longest periods of falling real incomes on record.

30. UK consumer confidence Not surprisingly consumer confidence is weak. Falling real incomes are one reason, falling house prices another. Unpleasant ‘though both of these doubtless are they are a “textbook” response to the imbalances in the economy moving in the direction of restoring external competitiveness and a more sustainable p/e for housing.

31. MARKETS

32. Ytd [30 May] and 1w returns Currency has been an important influence on returns this year with USD returns positive and EUR returns flat or negative. “Real” assets have outperformed financial assets and credit has outperformed equities.

33. Regional equity markets Emerging markets have had a tough time as inflation has risen and CBs have been tightening. The DM picture is very different; there economies are operating below capacity and real incomes are falling.

34. Implied volatilities Implied volatility hasn’t really picked up in the latest sell off frustrating those who were using vix as a hedge.

35. Silver ytd We have put silver on our radar screen as one of the prices most sensitive to the sensibilities of this cycle. It does double duty as both a precious and an industrial mettle and so straddles both the China and sovereign debt themes.

36. Silver Although silver has bounced a bit it hasn’t yet resumed an upward trend.

37. BONDS

38. Asset swap spreads Financial credit had a rough end to the month with the nth iteration of the Euro sovereign debacle. Nonetheless this asset class has done very well since the financial crisis partly because banks have kept on raising more equity.

39. 5 yr CDS The main bond story continues to be sovereign debt in Euroland. The latest word to enter Euroland’s financial vocabulary is “reprofiling” – what may – or may not – happen to Greek bondholders. It’s a mistake to believe that restructuring is necessarily an alternative to Greece leaving the Euro - history suggests that it is more likely to be a prelude.