MONTHLY INVESTMENT STRATEGY

1. MONTHLY INVESTMENT STRATEGY November 2011

2. Introduction The last two months has seen a big reassessment of economic prospects . Forecasts across the board for both company earnings and economic activity have fallen to "validate" the fall in markets. Policymakers have largely abandoned the "growth was weak in the last quarter due to special factors but things now normalise" formula. Instead there is recognition that real wage growth has been weak or negative for years and that growth in final demand has been sustained by “bubbleconomics” - the process of bringing forward demand from the future through a combination of falling interest rates and rising asset prices. There is even a dawning realisation that another bubbleconomics experiment may not be successful - or even desirable. In Euroland the process of totting up the losses from the credit bubble clearly reveals [belatedly] that it is the external position of countries that matters.  Bank of England Governor Mervyn King’s speech on 18th October puts the official imprimatur on the process of recognising these new realities. Even so, he remains in the intellectual vanguard and the implications of his observations will be contentious and unwelcome, particularly in Euroland. They fall into two main categories. One involves the recognition that chronic external imbalances eventually threaten national solvency. The other is that monetary policy can affect the time profile of demand e.g. make it stronger now and weaker later, but is powerless to affect its overall level. Jam today means [even] less jam tomorrow. No wonder stock markets have derated. Not long ago conventional wisdom maintained that the banking crisis was itself the problem. Economies had not been obviously dysfunctional in the period preceding the financial crisis; growth had been neither very strong nor very weak, inflation neither obviously high nor alarmingly low and unemployment was at acceptable levels. Greenspan termed it the “Great Moderation”. International imbalances were discussed, of course, but they had either been going on for so long, [in the case of the US trade deficits], or “officially” didn’t matter [ in Euroland’s monetary union] that they were largely ignored. Certainly the relationship between chronic external deficits and the solvency of financial institutions and nation states seemed a remote one. Consequently the first response to the financial crisis was to ease financial conditions -“credit easing” in Fed terminology – in the hope that once financial conditions improved normal service would be resumed. There was a time when the seizure in the financial system was the main issue but it is clear that this is no longer the case. Banks profess themselves eager to lend [though the risk is rising, particularly in Euroland, that they shrink assets to increase capital ratios] - it is a lack of demand that is the problem. After slumping over the summer, equity markets rallied in October. Long dated government bonds mostly sold off – it becomes ever harder to generalise, this is a more heterogeneous category than it used to be. With “benchmark” government markets at very low yield levels, for many sovereign bond markets the “spread” [which currently moves inversely to the price of the “quality” markets] is most of the return. Euroland’s summit took place against a background of markets which had already crashed and of improving economic data, particularly from the US, both of which flatter the achievement. A lengthy process of ratification and the revelation of important detail lies ahead. Nick Carn November 2011

3. GLOBAL MONETARY CONDITIONS

4. The key current influences on global money growth are the QE programmes. The UK has just resumed, the US is likely to and the ECB may do but is unlikely to advertise it.

5. CSFB risk appetite Risk appetite has recovered from what was one of its most severe troughs but remains depressed.

6. ECONOMIC SNAPSHOTS

7. GDP levels The US and those economies most exposed to the global trade cycle have recovered [or exceeded, in the case of smaller Asian economies] their peak level of output, the UK and most European economies remain below it. UK GDP numbers for earlier in the year have been revised down and it is clear that the economy slowed to a crawl in Q3.

8. World composite PMI Purchasing managers indices are among the “A” list leading indicators for the industrial economy and have tracked the dramatic slump and steep recovery in world GDP. The “domestic” economies of the developed world have hardly participated in the recovery – typically housing remains depressed and unemployment high. PMIS in common with most other leading indicators started top lose momentum in April/May. They have now paused close to the 50% boom/bust line.

9. Composite PMIs Broken down by region the UK and the US have their heads above water, China is hovering on the boom/bust line and Japan and Euroland are submerging. The Eurolanders may be cheered by the “summit” [PMIs are survey based] but the outlook for the peripheral economies is still very grim.

10. Economic surprises Data flow has been improving for the US albeit from a low base. In Euroland it seems to have levelled out at a very low level.

11. US ISM US data suggests a slow but not a recessionary economy. Services PMI remains above the 50 boom/bust line and manufacturing PMI has had a little bounce. The latest durable goods show that business is still investing. Incomes will be supported by the recent fall in commodity prices but the outlook remains for weak – if positive - growth.

12. US wages This is taken from PIMCO’s latest letter. Real wage growth has been weak or negative for some years with final demand sustained by borrowing. Although this is now seen as a problem it was good while it lasted. Corporations enjoyed the best of worlds; consumer demand for their products rose while the wages they had to pay those same consumers stayed low; a very good environment for margins to expand.

13. US personal savings rate The savings rate is what links incomes and expenditure. It is very obvious in retrospect that consumer spending was treading air in before the slump. Long term levels of the savings ratio are around 8-10% and adjusted for what the baby boomers “should” be doing are quite a lot higher. Although personal consumption clearly had good momentum going into Q3 the current level of consumer spending [and overall activity in the US] is being sustained by a low and falling ratio.

14. Chinese fixed investment [3m% yoy] Chinese fixed investment has been growing at a cracking pace for years – and not from a depressed level either. Moreover the contribution of investment to growth has also been increasing as net exports have made a smaller contribution hit in 2008/2009 by the financial crisis and prospectively by weaker demand growth in Europe and the US. Such episodes have seldom ended well; China’s level of capex well exceeds Korea in the 1950s and Japan in the 1980s. Both episodes were eventually revealed to have resulted in huge overcapacity although that was [of course] not apparent at the time.

15. China PMI October’s flash PMI saw the index rise above the boom/bust line to 51.1 against 49.9 in September. We continue to characterise China as “down but not out”. There is, however a lot of sinister creaking from the banking system in particular where SMEs are concerned.

16. China Issue 1 “how SMEs can make money” sounds like a fairly important issue to be resolved. The very fact that such a statement can be made with apparently no sense of its absurdity provides a gauge of how psychologically difficult it is to change direction. A personal favourite is the tech bust era piece of research on a satellite company that had gone belly up entitled “Bankruptcy filing raises growth concerns”

17. Japan loan officer survey Japan’s senior loan officers’ survey showed demand more or less flat over the previous quarter. Lessons from Japan are listened to rather more attentively than they used to be - for obvious reasons. The issue remains not one of the level of interest rates or of banks’ willingness to lend but of demand for loans. This is not a situation to which many countries are accustomed and the recognition has been slow to come in spite of attempts [e.g. Mervyn King’s recent speech] to try to raise the level of awareness.

18. Japan – the triumph of demography This is from Japan’s tertiary index survey. Population is one of the more predictable things about the future. Whatever the cyclical ups and downs of the Japanese economy the ageing of the population has distorted historical trends in a consistent fashion. Euroland, in particular Germany Iand taly and much of Eastern Europe have many of the same issues.

19. Euroland PMI The US is “weak but positive”, China “down but not out” it’s Euroland that looks closest to recession. The summit will help sentiment in the short run but the main problems, competitiveness and austerity remain. ECB rate cuts are now very likely. Euroland data tells one little – for a long time the fact that at the aggregate level it was OK [a combination of weakness in the periphery and strength in Germany] disguised rather than illuminated the problems. Forward looking surveys now point to overall weakness as Germany has slowed. Services PMIs are consistent with recession in Q4.

20. German leading indicators The export exposed part of Germany is still positive but is likely to weaken with the global cycle as we go into next year. The ZEW index which measures the expectations of economists has been very subdued – probably by the unremitting debt crisis in Euroland.

21. Progress of deficit reduction Latest numbers show some progress in deficit reduction but there’s a long way to go. The combination of domestic austerity and uncompetitive exchange rates makes the exercise very hard.

22. Eurozone bank lending Euroland bank lending is fairly sluggish, perhaps no surprise given the state of the economy. The consequences of the need to raise capital ratios should be watched carefully. With share prices depressed it may be tempting for banks to go on a crash diet rather than raise expensive new capital.

23. UK average earnings UK real average earnings have been falling since the financial crisis as prices have risen faster than pay – using RPI [which includes housing costs] the fall has been even greater and is intensifying as housing costs [in the UK these are partly proxied by mortgage service costs] have stopped falling.

24. UK private sector employment While unemployment continues to rise and is at its highest level since 1994 total employment had been growing until recently. In the three months to August private employment fell by 178,000 and although it apparently stabilised in September job losses in the Public Sector will likely keep overall conditions weak. There are two elements of “different this time”. One is the weakness in public sector employment [a consistent source of “surprise” in the US jobs numbers. The other is in the comparisons made with the “austerity” of the first Thatcher administration. In that instance consumer spending started to recover even as unemployment was rising. Unlike now, however, the consumer had a strong balance sheet [largely due to the liquidation of mortgage debt by the high inflation of the 1970s] and increased borrowing.

25. UK Q3 activity UK growth was very weak in Q3. Household spending fell; an unusual occurrence, it is more commonly capex and inventories which drive the cycle. This is further confirmation that we should expect different behaviour from post bubble economies; obvious, perhaps, but still a constant source of surprise to mainstream forecasts.

26. MARKETS

27. For Bears The Eurosummit has obviously cheered markets. It’s still not clear how much real substance there is to the agreement and it is easy to forget how difficult it was even in the US to reach political consensus. Even after TARP there was a very rough period.

28. Since 1950 One of the arguments advanced for the stock market is that its dividend yield is high relative to [some] government bonds. Setting aside the fact that this is a different bull argument to that advanced in say, 2000, there is little empirical basis for using this measure. One of investment’s mysteries is the durability of belief in such measures as the “Fed model” which demonstrably have consistently given the wrong answer. The reason is, of course, that all measures of company performance, and in particular earnings, have been very mean reverting. This is the biggest threat to stock markets today; margins are very high.

29. United States bond/equity correlation In many ways the tech bubble [or “New Era” as it was known at the time] was a watershed event. The biggest stock market speculation in history it created such enormous tax revenues that government debt was being repaid at such a rate that treasury bonds were considered a threatened species. TIIPS yielded 4.7% real – even this extraordinary return [competitive with that of the stock market over most periods] was well below what was considered to be the trend growth rate of the economy. It also marked the point at which bond equity correlation flipped over; the real estate mini bubble economy almost returned the relationship to its previous norm but it didn’t last.

30. Germany bond/equity correlation The same thing happened in Germany at about the same time - strongly suggesting that something fundamental changed the relationship. It was certainly the end of the 20 year equity bull market and almost certainly the beginning of a series of failures of bubble economies, including the Eurobubble, the latest to come apart.

31. Italy bond/equity correlation Italy was like the US and Germany until recently but has recently returned to the past [as have Greece Portugal and Spain]. Bond/equity correlations lie on an inflationary/deflationary axis; the recent shift points to a realisation that there is no longer a scenario which is good for bondholders and bad for stockholders. If the economy is weak it spells trouble for both.

32. BONDS

33. Ten year Italy This is the crucial Euroland chart. The way in which officials and markets look at debt and deficits is not really coherent and it is one of the many ironies in Euroland that official praise of Spain’s low debt/GDP ratio [an attempt to deflect attention form its budget deficit] threw an unflattering light on Italy. Italy is too big for any of the proposed bail out arrangements so Italian politics must be asked to solve the problem unless the ECB can be suborned. There are many who think that that is a big ask.