2 March 2010

Global Strategy
Alternative view
www.sgresearch.com

Global Strategy Weekly

As the 10th anniversary of the peak of the Tech bubble approaches, should we
really care what the market ‘thinks’ about sterling, or indeed much else?

Albert Edwards Much hand-wringing is accompanying sterling’s renewed slide. The market is reacting to the
(44) 20 7762 5890 rapidly falling odds of an outright Conservative victory in the forthcoming election, which will
albert.edwards@sgcib.com
probably mean the huge public sector deficit will stay larger for longer. But ultimately, in the
Ice Age, a weak currency is an escape route of choice from the deflationary quicksand. A look
at Japan shows the other extreme - a strong yen pushing Japan back into deep deflation.

Q Sterling’s latest slump contrasts markedly with the continued resilience in the yen (see
chart below). Should investors be as concerned about sterling as they so obviously are?
Perhaps not. Market participants are fickle creatures. I have previously likened them to
shoaling fish, heading as a group in one direction only to change direction for no particular
identifiable reason (perhaps headless chickens would be a better analogy). I read much
about market discipline forcing profligate governments into deep spending cutbacks.
Sterling’s plunge will be painted as one example of that market discipline and we will no
Global asset allocation doubt be told that that the market ‘wants’ deep public spending cutbacks.
Index SG
% Index Q I was left scratching my head after reading the FT’s currency comment last Saturday,
neutral Weight
Equities 30-80 60 35 “the yen pushed firmly higher yesterday as concerns about sovereign debt ratings in
Bonds 20-50 35 50 southern Europe sent investors scuttling for the relative safely seen to be provided by the
Cash 0-30 5 15 Japanese currency”. That is indeed the market’s perception. Except, as my colleague Dylan
Source: SG Cross Asset Research
Grice has shown, the Japanese fiscal situation is many times worse than almost anywhere
else! If any currency should be plunging at the moment, it is surely the yen!

Q It is an anathema to most commentators to suggest that Mr Market can possibly be

wrong. But the notion that it can somehow offer us some definitive wisdom about what is
the ‘correct’ course of action is surely nonsense. Investors can be totally and utterly wrong
for prolonged periods about what ultimately is ‘good’ for an individual stock or bond market,
or indeed a currency such as sterling.

Contrast the weakness of the trade weighted sterling to yen strength (JP Morgan narrow index)
115 115

110 110
Sterling
105 105

100 100

95 95

90 90

Global Strategy Team 85 85

Albert Edwards
(44) 20 7762 5890 80 80
albert.edwards@sgcib.com
75 Yen 75

Dylan Grice
(44) 20 7762 5872 70
2006 2007 2008 2009
70

dylan.grice@sgcib.com

Source: Datastream

Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
 Global Strategy Weekly

One nice example of why you shouldn’t listen to Mr Market was a story in the wake of the
sub-prime debacle from the FT’s John Authers. Writing back in September 2008, he said:

“WaMu on Friday became the biggest bank failure in US history (a title it will hopefully keep for
a while). Its decline, as has been amply documented, lay in its huge portfolio of mortgages and
mortgage-backed bonds. The last WaMu story I wrote covered a day when its share price fell
5 per cent in June 1999. It fell because investors were worried that it was retreating from its
policy of levering up by buying mortgage-backed securities. Analysts told me that retreating
from leverage would harm WaMu’s revenues in the short term, along with its earnings and its
share price. The implicit assumption was that leverage was good. Shareholders punished
companies and executives when they paid down their debt and took less risk. This should
remind us of the breadth of the failure of the global markets system that we are now
witnessing. Shareholders themselves egged on the lending binge in the US, and did so before
the stratospheric growth in the credit derivatives market.” – link.

This is a prime example that what the market thinks it wants in the short term may not be what
it really wants in the long term. In the case of the UK, there is no doubt in my mind that
premature tightening of fiscal policy after the election will send the economy back into
recession. And as we saw in the case of 1990s Japan, any premature return to recession
means the public sector deficit will end up even bigger than it already is now, the BoE would
have to resume aggressive monetisation and sterling would be even weaker than it is now.

Contrast the recent GDP recoveries in Japan and the UK, one suffering from a very strong
currency (perversely?) and the other enjoying a very weak one (see charts below).

Japanese real and nominal GDP (rebased Q1 2007=100) UK real and nominal GDP (rebased Q1 2007=100)
106 106 106 106

104 104 104

nominal 104

102 102 102 102

100 Real 100 100 100

98 98 98 98
real
96 Nominal 96 96 96

94 94 94 94

92 92 92 92

91 91 91 91
2007 2008 2009 2007 2008 2009

Source: Datastream, SG Cross Asset Research

Japan has seen a 2.4% bounce in real GDP from its depression-like GDP collapse, while the
UK has barely recovered. By way of contrast, nominal GDP shows the reverse. In the UK,
nominal GDP has enjoyed a heady 4% annualised surge over the last two quarters while
Japan has seen stagnation. The UK economy is ‘enjoying’ the benefits of the authorities
pulling the competitive devaluation lever, while Japan is still mired in deep deflation.

As we stated in our recent note, there is no easy way out of the mess we (globally) are in - link.
Either governments pursue the path of fiscal rectitude (although it is a bit late for that) and we
subside back into recession or we debauch the currency through deficits, the printing press
and devaluation. For many, the UK data suggests we are well on the road to debauchment.

2 2 March 2010
 Global Strategy Weekly

But certainly in a world where the private sector is trying to de-leverage, it is crucial to avoid a
Fisherian debt-deflation trap if one wants to avoid hurtling into a depression. There are no
easy answers. The simple fact is we shouldn’t be in this mess in the first place.

The certainties we once had as investors will be jolted sharply in other ways over the next few
months. One of the most interesting non-consensus calls last year was from our Asian
Economist Glenn Maguire, who forecast that the huge Chinese trade surplus would disappear
this year (see chart below). Glenn thinks that isn’t just going to be a temporary blip, but
something that the markets will really have to get used to. Given that grotesque external
imbalances were a feature of the build-up of the credit bubble, what will it mean if China
moves into sustained trade deficit?

China’s move into trade deficit will mean less dollars to recycle (USDbn)
50 250

40 200

30 150

20 100

10 50

0 0

-10 -50
Jun-2000 Jun-2002 Jun-2004 Jun-2006 Jun-2008 Jun-2010

China Trade Balance NSA LHS (including SG Forecast till Jun-10)

6 month change in China's US Treasury Holdings RHS

Source: SG Cross Asset Research, CEIC

Clearly to the extent that the rise in China’s official reserves depended on the size of its trade
deficit, there will be reduced purchases of US Treasuries. But China has, in part, merely been
swapping official dollar purchases of US Treasuries with surging imports of dollar-
denominated commodities on the trade account (see chart below). The emergence of a trade
deficit in Q2, together with Glenn’s view of a likely 5-10% yuan revaluation after the National
People’s Congress meets in March (see link), will do one very important thing however – it will
head off US protectionist sentiment ahead of the Congressional mid-term elections.

China total imports surge as commodity imports soar (yoy% change)

100 100

80 80

60 exports 60

40 40

20 20

0 0

-20 -20
imports
-40 -40

-60 -60
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Datastream, SG Cross Asset Research

2 March 2010 3
 Global Strategy Weekly

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4 2 March 2010