5 November 2009

Global Strategy
Weekly
www.sgresearch.socgen.com

Global Strategy Weekly

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

Albert Edwards One can almost see the stirrings of cyclical discontent within the market. Risk trades are
(44) 20 7762 5890
albert.edwards@sgcib.com looking increasingly vulnerable and correlations are beginning to break down. Investors
should focus on the nominal quantities, which continue to wither on the vine.

Q 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
Global asset allocation flabby male chests. The word was invented in 1985 meaning a sagging economy. It is
Index SG
% Index ‘boom’ spelt backwards – link.)
neutral Weight
Equities 30-80 60 35
Bonds 20-50 35 50 Q Now, I have to admit that I’ve been working in finance since the very start of the long bull
Cash 0-30 5 15 market in 1982. It’s been fun and I’ve met many very interesting people over the years. But
Source: SG Global Strategy 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).

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

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 Source: Daatastream

Macro 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 long-
term fundamentals (see chart below). Nominal quantities matter.

US nominal bond yields are driven by nominal GDP growth

16 16

14 14

12
10y bond yields 12

10 10

8 8

6 6

4 4

2 2
nominal GDP growth
0 0

-2 -2
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Source: Datastream

2 5 November 2009
 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

3.0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

US Europe

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

5 November 2009 3
 Global Strategy Weekly

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4 5 November 2009