05112009_edwards_darkness Lies One Step Ahead

5 November 2009

Global Strategy Weekly www.sgresearch.socgen.com

Global Strategy Weekly As the Japanese say, “Darkness lies one step ahead”

Albert Edwards (44) 20 7762 5890 [email protected]

One can almost see the stirrings of cyclical discontent within the market. Risk trades are looking increasingly vulnerable and correlations are beginning to break down. Investors should focus on the nominal quantities, which continue to wither on the vine.

OK, I know I’m getting old. Yet last weekend I managed two new life changing events. Having visited James Montier on his gardening leave a few months back, I got very excited about his bread-maker. In a fit of “me too” consumerism I had to have one of those and last weekend I lovingly gave birth to my first ever home-made loaf. Bread will never be the same. That very same day I had new experience number two as my wife, Rowan, dragged me off to my very first spin class. Now that might not sound much to my finely honed, Adonis-like readers. But I had not ever done any exercise in the 30 years since leaving school, except briefly in the run-up to my wedding just over a year ago. My body was indeed a temple – but to the moob god. (For those non-English readers, the word moob has nothing to do with flabby male chests. The word was invented in 1985 meaning a sagging economy. It is ‘boom’ spelt backwards – link.) Q

Global asset allocation %

Index

Index neutral

SG Weight

Equities

30-80

60

35

Bonds

20-50

35

50

0-30

5

15

Cash

Source: SG Global Strategy

Now, I have to admit that I’ve been working in finance since the very start of the long bull market in 1982. It’s been fun and I’ve met many very interesting people over the years. But there are an awful lot of puffed-up toucans in this business, strutting around and fluffing themselves up so as to appear incredibly self-important. Q

We all know that Warren Buffet is not one of those. The investment guru’s foray into railroads this week has attracted much attention. The FT’s Lex column called it “one almighty bet on the US economic recovery” – link. Funnily enough I was looking at railroad traffic earlier in the week. It was notable, I thought, that on a seasonally adjusted basis, there is very clear evidence that the cycle is stalling out (see chart below).

Q

US weekly traffic of railroads (12 week mav, up to Oct 17, carloads originated) 000'S 350

000'S 350

340

340

330

330

320

320

310

310

300

seasonally unadj

300

290

290

seasonally adj 280

280

270

270

260

260

250

250

240

240 2005

2006

2007

2008

2009

IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS BEGINNING ON PAGE 4

Macro

Source: Daatastream

Commodities

Forex

Rates

Equity

Credit

Derivatives

Global Strategy Weekly

While I’m on the subject of gurus, I’ve come to the very sorry conclusion that many sell-side strategists purport to be financial gurus, yet strangely move from job to job as their employers find them to be empty vessels. There are very few in this business I would wrap my arms around, kiss on both cheeks and embrace as a true guru. One of the very few is my former colleague Peter Tasker. He is one of the foremost authorities on Japan as well as being a best-selling author of Japanese fiction – link. Anyway a MUST read is his sage like comments in the Financial Times Insight column (see China rushes towards a Japan-style bubble, 2 Nov). He compares the universal group-think on the Chinese situation now, with Japan two decades ago – what you think you see is decidedly not what you will get – link. If I serve no other purpose this week, flagging up Peter’s insights is a true honour. The fact that Peter’s analysis totally concurs with my colleague Dylan Grice’s recent thoughts on China (link) is surely just a coincidence. Trade-Weighted Dollar index: DXY breaking upwards?

Source: Datastream

The dollar may be breaking upwards (see chart above). If this is the start of a large upward move, driven in large part by huge short positions that might be forced to be unwound, this may crush correlated risk positions. In addition, the end of the $300bn Fed program of buying US Treasuries last week is causing jitters. Yet amid the noise one should focus on the longterm fundamentals (see chart below). Nominal quantities matter. US nominal bond yields are driven by nominal GDP growth 16

16

14

14

10y bond yields

12

12

10

10

8

8

6

6

4

4

2

2

nominal GDP growth

0

0

-2

-2 1955

Source: Datastream

2

5 November 2009

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Global Strategy Weekly

Although arithmetically, bond yields are a statistical artefact of short-term interest rate expectations, the above chart shows that trends in nominal GDP growth are the key driver. In the 1960s and 1970s, the continuous tendency of nominal GDP to grow well in excess of current bond yields provided an irresistible driver for higher yields. Conversely, the collapse in nominal GDP growth below bond yields in the early 1980s marked the start of the long bull market that continues to this day. Indeed, it is notable that nominal GDP growth is once again so far below bonds that a major move down in yields may be very close indeed. The continual ebbing of nominal quantities towards the deflationary Ice Age end is something we continue to bang on about in these pages. The charts below, for example, highlight what is happening to wage and benefits inflation. This cycle has ground wage inflation even closer to zero. And indeed the private sector data is even weaker than what you see below. US Employment Cost Index (all workers, yoy%) 7

7

6

6

total compensation

5

5

4

4

3

3

2

2

wages & salaries 1

1 82

84

86

88

90

92

94

96

98

00

02

04

06

08

Source: Datastream

Now a bull would say this is all jolly good news as company profits can be increased by continued cost cutting and margin expansion. But as Andrew Lapthorne pointed out in a recent note, with margins already so very high, it is impossible for companies to cost-cut their way to sustained profits growth - link. Hence nominal revenue growth will be the key driver to the profits outlook. In targeting margins, companies are currently driving the US economy to the very abyss of outright deflation - something we will all realise as this cycle soon stalls. What recession? Operating profit margins (ex financial & ex-energy) - and consensus expectations (%) 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0

US

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

3.0

Europe

Source: Factset, Company report and accounts & I/B/E/S

5 November 2009

3

Global Strategy Weekly

IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities and including any expression of opinion, has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness although Société Générale (“SG”) believe it to be clear, fair and not misleading. SG, and their affiliated companies in the SG Group, may from time to time deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or bankers in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document or be represented on the board of such persons, firms or entities. Employees of SG, and their affiliated companies in the SG Group, or individuals connected to then, other than the authors of this report, may from time to time have a position in or be holding any of the investments or related investments mentioned in this document. Each author of this report is not permitted to trade in or hold any of the investments or related investments which are the subject of this document. SG and their affiliated companies in the SG Group are under no obligation to disclose or take account of this document when advising or dealing with or for their customers. The views of SG reflected in this document may change without notice. To the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained herein. This research document is not intended for use by or targeted at retail customers. Should a retail customer obtain a copy of this report they should not base their investment decisions solely on the basis of this document but must seek independent financial advice. Important notice: The circumstances in which materials provided by SG Fixed & Forex Research, SG Commodity Research, SG Convertible Research, SG Technical Research and SG Equity Derivatives Research have been produced are such (for example because of reporting or remuneration structures or the physical location of the author of the material) that it is not appropriate to characterise it as independent investment research as referred to in European MIF directive and that it should be treated as a marketing material even if it contains a research recommendation (« recommandation d’investissement à caractère promotionnel »). However, it must be made clear that all publications issued by SG will be clear, fair, and not misleading. Analyst Certification: Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report. Notice to French Investors: This publication is issued in France by or through Société Générale ("SG") which is authorised by the CECEI and regulated by the AMF (Autorité des Marchés Financiers). Notice to UK investors: This publication is issued in the United Kingdom by or through Société Générale ("SG") London Branch which is regulated by the Financial Services Authority ("FSA") for the conduct of its UK business. Notice To US Investors: This report is intended only for major US institutional investors pursuant to SEC Rule 15a-6. Any US person wishing to discuss this report or effect transactions in any security discussed herein should do so with or through SG Americas Securities, LLC (“SGAS”) 1221 Avenue of the Americas, New York, NY 10020. (212)-278-6000. THIS RESEARCH REPORT IS PRODUCED BY SOCIETE GENERALE AND NOT SGAS. Notice to Japanese Investors: This report is distributed in Japan by Société Générale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated by the Financial Services Agency of Japan. The products mentioned in this report may not be eligible for sale in Japan and they may not be suitable for all types of investors. Notice to Australian Investors: Société Générale Australia Branch (ABN 71 092 516 286) (SG) takes responsibility for publishing this document. SG holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this newsletter is only directed to recipients who are wholesale clients as defined under the Act. IMPORTANT DISCLOSURES: Please refer to our website: http:\\www.sgresearch.socgen.com http://www.sgcib.com. Copyright: The Société Générale Group 2009. All rights reserved.

4

5 November 2009