socgen global strategy weekly may 21, 2010

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21 May 2010

Global StrategyAlternative view

www.sgresearch.com

Global Strategy WeeklyThe US and eurozone now stand on the edge of a deflationary precipice

Albert Edwards(44) 20 7762 [email protected]

Global asset allocation% Index Indexneutral SGWeightEquities 30-80 60 35

Bonds 20-50 35 50

Cash 0-30 5 15

Source: SG Cross Asset Research

Global Strategy TeamAlbert Edwards(44) 20 7762 [email protected]

Dylan Grice(44) 20 7762 [email protected]

Amid all the recent euro-related turbulence, the markets have not focused enough attentionon the rapidly vanishing core CPI inflation rates in the US and eurozone. With both movingbelow 1%, we are now only one cyclical mishap from joining Japan in outright deflation. Givenour view that this cyclical recovery will end surprisingly early, slipping into the deflationarymire will trigger further, more extreme rounds of Central Bank monetisation, inevitably drivingus towards our ultimate destination 1970s style 20-30% inflation will surely return. Of all the inflation data released this week, the one that caught the markets attention wasthe UKs dramatically higher than expected 3.7% yoy rise for April. Even the core measure

of CPI managed to creep up above the 3% mark. Meanwhile the old RPI, to which most

state benefits are indexed, rose a heady 5.3% the highest pace since July 1991. While

many commentators proceeded to berate the Bank of England for consistently under-

forecasting inflation in recent years, many also saw the first signs of the quantitatively eased

pigeons coming home to roost.

But I would argue that in a year or so, we will see the UK s relatively high inflation rate asa godsend. For elsewhere, it went almost unnoticed this week that core CPI inflation rates inthe US and eurozone continue to slip-slide their way down towards zero (see chart below).

Although this is seen as buoying bond prices at the margin, it is a pernicious development

that investors will focus on when this cycle starts to fail. Regular readers will know that I

believe that in a post-bubble world, recession follows recession with surprising rapidity. We

are now only one cyclical failure away from Japanese-style outright deflation in the US and

the eurozone at a time when de-leveraging still has years to run (falling prices bring the risk

of a classic debt deflation trap). Impending cyclical failure and a deflation scare will trigger

new lows in equities as the valuation bear market finally plays itself out with the S&P falling

below 500. We therefore maintain our long-standing target of sub-2% US 10y bond yields

and that is the point when QE will really begin to get serious.

US and eurozone core CPI inflation

2002 2003 2004 2005 2006 2007 2008 2009

0.50

1.00

1.50

2.00

2.50

3.00

0.50

1.00

1.50

2.00

2.50

3.00

Eurozone

US

Source: Datastream


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Global Strategy Weekly

21 May 20102

Dylan Grice has shown us clearly over the past few months that governments are insolvent. At

some point, as can be seen most vividly along the periphery of the eurozone, the market

demands action. And amid renewed zeal for fiscal retrenchment within the new UK

government, it is worth repeating one key point namely, premature fiscal retrenchment was

one of the key policy errors Japan made in a post-bubble, de-leveraging economy (see GSW

12 Feb, To cut or not to cut? Actually it doesnt really matter. Were stuffed anyway!link).

I remain persuaded by Richard Koos book about the lessons from Japans balance sheet

recession. The crux of his analysis is that governments have no option but to stimulate

aggressivelyall the while the private sector is de-leveraging. ANYattempt at fiscal cuts simply

results in renewed recession and a further loss of confidence, thus making it even harder and

more costly to sustain any subsequent recovery and hence the budget deficit ends up

bigger than before (see chart below). A repeat of Japans mistakes is exactly the outcome I

expect. Renewed recession awaits and with the eurozone and the US core CPI inflation lessthan 1%, the icy tentacles of outright deflation are now just within reach. (Attached is a link to

an interview by welling@weeden with Mr. Koo. It is well worth a read link.).

Richard Koo says premature fiscal tightening in Japan 1997 and 2001 weakened the economy,reduced tax revenue and ultimately made the fiscal deficit even bigger

Source: Welling@Weedon

Competitive devaluation is one way to try and wriggle free from the deflationary quicksand.

OECD real effective exchange rate indices (using CPI, indexed to 2000=100)

Source: Datastream, SG Cross Asset Research

2001 2002 2003 2004 2005 2006 2007 2008 2009

70

80

90

100

110

120

130131

70

80

90

100

110

120

130131

UK

Eurozone

US
http://www.sgresearch.com/publication/en/992335CAC08215DBC12576C8002C6860.pubhttp://welling.weedenco.com/reprinthttp://welling.weedenco.com/reprinthttp://welling.weedenco.com/reprinthttp://welling.weedenco.com/reprinthttp://welling.weedenco.com/reprinthttp://www.sgresearch.com/publication/en/992335CAC08215DBC12576C8002C6860.pub


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The UK has clearly embraced this option with gusto and is enjoying the benefits of a relatively

high inflation rate. This resembles closely the UKs experience of the 1930s when it was

ejected from the Gold Standard, only to devalue aggressively and so suffer a relatively mild

depression compared to those who remained on gold. The eurozone clearly needs to

devalue and the Greek crisis is allowing that much needed adjustment to occur. Competitive

devaluation might allow the eurozone overall to escape the deflationary fate of some of its

most vulnerable members (see chart below) and export its deflation elsewhere.

Spain slips into outright deflation (joining Portugal and Ireland). Eurozone next?

Source: Datastream, SG Cross Asset Research

But as my old friend Jim Saft pointed out in his Reuters opinion piece yesterday, it wont just

be deflation the eurozone will be exporting but also trade tensions as the dollar riseslink. Jimmakes the very good point that the US primary elections on Tuesday showed voter anger is

focused on incumbents in general and Washington in specific. It would not be a surprise for

the administration to try and focus that anger outside of the country. A renewed global

downturn with rising trade tensions is exactly the environment that will see the shock Chinese

yuan devaluation. I continue to remain of the view that a global downturn is close. Too many

are focusing on the buoyant economic data that is entirely consistent with continued strength

of the coincidentindicators, yet all the while the leading indicators continue to slow (see chart

below). Renewed recession will never be forecast until after we are back in one!

US Economic Cycle Research Institute leading and coincident indicator (yoy%)

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

1/1/1999 1/1/2001 1/1/2003 1/1/2005 1/1/2007 1/1/2009

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

leading indicator

coincident indicator (rhscale)

Source: ECRI

2002 2003 2004 2005 2006 2007 2008 2009

-0.50

0

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

-0.50

0

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Eurozone

Spain
http://blogs.reuters.com/great-debate/2010/05/20/euro-woes-increase-risk-of-trade-wars/http://www.businesscycle.com/resources/http://www.businesscycle.com/resources/http://blogs.reuters.com/great-debate/2010/05/20/euro-woes-increase-risk-of-trade-wars/


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21 May 20104

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socgen global strategy weekly may 21, 2010

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