Tide has turned in Favour of Risk

It is always darkest just before the day dawneth [Thomas Fuller 1650] When we wrote our annual UK Capital Market Outlook note (appositely entitled Gold and Other Commodities Hold the 2011 Capital Markets Key), last December, it was predicated on consensus forecasts being realistically based. As we have all discovered, the recession was deeper than previously calculated. This latter point is very important and goes a long way to explaining the lack of effective and demonstrable political policy action by most of the leading industrial nations and the resultant excessive volatility and the markets desperate focus upon historically minor indicators for a sense of direction. Nevertheless, Ben Bernankes speech at Jackson Hole, Wyoming addressed those concerns and, in hindsight, will have marked the turning point when investors turned their backs on so called safe haven investments and returned to risk assets. However, growth assumptions have yet to be fully rebased although the OECD and the IMF have led the way with their recently downgraded 2011 and 2012 expectations, which have also prompted other commentators to lower their expectations. Nevertheless, these are still too optimistic but will correct over the next 3 6 months. Prospective long-term growth rates in the US, UK and urozone are likely to be considerably less than historic trend rates while fiscal imbalances are corrected. Japans downward step change in GDP growth between 1986 1996 and 1997 2007 provides an indication of the delta of change that may occur [see Table: Real GDP (YoY % Change)]. Moreover, China and other developing economies will also exhibit a somewhat slower trend growth rate because their domestic economies are relatively immature and over reliant upon the developed industrial economies for growth. This slower prospective global growth trend eventually will manifest itself in lower corporate earnings, which for now are still benefiting from earlier carry momentum from the recessions now rapidly decelerating recovery phase that is wrong-footing equity analysts. Moreover, forward corporate earnings will also be increasingly constrained by capital inefficiency until and unless the global banking system is fully repaired and credit growth restored. Capital markets are generally efficient and although the above broad assumptions have not as yet been explicitly imputed into public expectations, these are increasingly being intuitively applied through higher risk assumptions. But it is now only a matter of time before economic realism reasserts itself upon both markets and more importantly politicians. Therefore, it does not matter whether there is a recession or not but what does matter, is investors having confidence in the official data supporting expectations, and if they do, this will permit a quick rebasing of market levels followed by a sustained recovery in investor appetite. Therefore, tactically investors, in the short term (i.e., next 1 3 months), should be selling (even shorting) the over inflated and generally illiquid safe haven assets of gold, silver, Swiss francs, etc. and moving into cash (i.e., the more liquid currencies of US$, Sterling, and the uro; the latter on further weakness). While in the medium term (i.e., 4 12 months), cash assets should be redeployed into equities and debt as the forward earnings correction takes place.

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Economic Activity
Leading independent forecasting agencies, such as the IMF and OECD, have confirmed that the recession was considerably deeper and less robust than earlier thought and that the recovery is now slowing, especially for the major industrial economies. Unfortunately, these earlier and overly optimistic economic assumptions led to political and fiscal complacency, particularly in the urozone, which established the basis for its Sovereign debt crisis. However, market pressure and economic reality are asserting increasingly positive pressure upon politicians and very soon a urozone solution will be developed and, more importantly, implemented. Generally, the underlying cause for the more recent slowing growth rate may be simply that developed economies are approaching, or have passed, their natural cyclical peaks; the US has already recorded 9 consecutive quarterly increases in GDP. This weakening demand from the industrialised economies is belatedly impacting upon the growth rates of the lesser developed economies (such as China, India, Vietnam, etc.) that are further exacerbating their domestic slowdown by using the blunt instrument of interest rates not only to strangle inflation from their economies but also starve their property markets of readily accessible credit to deflate a bubble before it bursts. Unfortunately, their policy decisions are probably too little and coming too late, which means that many Asian economies will suffer very painful hard landings. Table: Real GDP (YoY % Change)
France Germany uro area Japan UK USA Total OECD Source: OECD Average 1986-96 2.07 2.61 2.38 3.17 2.37 2.90 2.85 Average 1997-07 2.62 2.51 2.85 0.98 3.10 3.36 3.07 Average 1986-07 2.35 2.56 2.61 2.07 2.73 3.13 2.96 1997 2.20 1.85 2.62 1.56 3.31 4.46 3.68 1998 3.55 1.82 2.76 (2.05) 3.61 4.36 2.72 2006 2.42 3.57 3.17 2.04 2.79 2.67 3.15 2007 2.32 2.78 2.84 2.36 2.68 1.95 2.72 2008 0.09 0.70 0.31 (1.17) (0.07) 0.00 0.32 2009 (2.67) (4.67) (4.13) (6.28) (4.87) (2.63) (3.51) 2010 1.38 3.50 1.69 3.97 1.25 2.85 2.93 2011 2.23 3.44 2.05 (0.88) 1.38 2.57 2.33 2012 2.10 2.52 2.01 2.15 1.83 3.12 2.84

UK The UK addressed its budget deficit issue early but only because of a change in Government. The response was calculated and pragmatic and as such preserved the UKs AAA rating while deflecting attention elsewhere. However, the assumptions supporting an elimination of the budget deficit within one 5-year parliamentary term were overly optimistic. This means that the Government, if it is to keep the markets onside, has no choice ahead of an election in 2015 but to vigorously persue its commitment to shrink the public sector. However, it will need to either get its message across that the process will take longer to deliver due to weaker economic growth or grasp the poltical thistle and drastically squeeze the sacred cow budgets (e.g., NHS) from the start of the next tax year commencing 6 April 2012. In light of the current anaemic growth, this latter option may be too politically difficult, particularly as the real and major spending cutbacks occur during that fiscal year and unemployment rates will be soaring again. urozone Remaining closer to the UK (i.e., EU), the urozones, but particularly the uropean Central Banks (ECB), muddled policy decisions similarly appear to have been based upon overly optimistic assumptions concerning the strength and shape of the recovery leg of the recession, i.e., V-shaped and, more recently, talk of W-shaped. Indeed, Greece has confirmed that its austerity budget was based on more optimistic assumptions and that their recession was deeper than previously estimated. While the more recent lack of political resolve has more to do with politicians looking ahead to looming elections (2012 13) rather than properly addressing immediate economic issues, which has created and exacerbated the Sovereign debt crises within the region. Whether they like it or not, urozone politicians will be fighting their next elections on strong economic management and a

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commitment to eliminate budget deficits than tax give aways, which has already begun to emerge in France. As a brief aside, and bankers at the uropean Central Bank and their urozone politicians should take note that the uro could be likened to a Mk III version of the Gold Standard. The much cherished and well respected Mk I Gold Standard was managed and regulated by the worlds oldest and most respected central bank, the Bank of England, until the start of the First World War. The ill-fated Mk II Gold Standard was introduced after the First World War and was regulated by a newly constituted US Federal Reserve because the war had left the UK severely debilitated and its gold reserves significantly depleted while the US was, as is now, the worlds largest economy. However, the Fed made a succession of policy errors during the 1920s and 1930s that cumulatively led to the Great Depression. Interestingly, the ECB and their political masters because of Germanys inflation paranoia have already made some similar errors! urozone politicians and the ECB bankers should take greater heed of what Bernanke and the Fed has, and are doing, otherwise the consequences will be catastrophic for the urozone domestic economies. Nevertheless, a working urozone solution will more likely be found but it is likely to result in a change in the political landscape of each of the member nations concerned from but from which will emerge stronger economies and uro as these nations become more closely aligned to the German economic cycle. US The US embraced an expansionary domestic policy that was also more internationally supportive in approach than it may have been credited because of the Feds reasonable fear of creating the domestic and global conditions for another depression through inadequate and incorrect policy responses. The Fed Chairman, Ben Bernanke, as an economist majored on the Great Depression and as a result of his extensive research is an advocate that it is better to over stimulate than not The latest Bank of England Quarterly report stated that the UKs 200bn QE (Quantitative Easing) programme that began in early 2009 probably stimulated real GDP by 1.5% - 2.0%, which was broadly equivalent to a further cut in interest rates of 1.5% - 3%; by implication, the US economy should have received a comparably proportionate stimulus because of its two QE programmes. Currently, Bernanke, along with his fellow Fed Governors are watching not only the domestic but the global economy, especially those of the urozone and China. However, should the US economy require further stimulus this will be forthcoming, most probably in the form of a QE3 although the Fed will not be rushing to inject too much inflation into the economy. Also, we believe that any expansion of this accommodative approach will be conditional upon a more demanding but long term Government commitment to a demanding budget deficit rebalancing programme whether the politicians of all parties on Capitol Hill like it or not. Nevertheless, the Fed is taking deliberate and progressive actions to build a robust platform for a sustainable long-term recovery for which it is not yet being credited. For example, market commentators have chosen to miss the relevance of the US$400bn Operation Twist. This has been implemented to flatten the yield curve, which supports not only an earlier Fed commitment to low short-term interest rates but establish the necessary conditions to support a revival of the property credit market. In summary, our view remains unchanged - the global economic recovery will be l or Nike tickshaped (i.e., a long and slow recovery) while the fiscal imbalances in the leading economies are finally and specifically addressed. Moreover, this corrective period, at least 10 years, will result in the trend GDP growth rate falling well below that of earlier periods, which implies lower corporate earnings growth.

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Interest Rates
The overall trend will be downward where there is scope and unchanged where there is none. In the UK, the bank rate is likely to remain unchanged at 0.5% for at least the next 12, possibly 24 months and we would not rule out a UK twist programme to provide support to the property market. The Fed has already indicated that US rates will remain low for at least another couple of years due to the fragility of the economy and possibly longer because of its twist programme. The ECB will shortly begin to reverse its ill-conceived earlier rises that have exacerbated the issues for the problematic urozone states. Moreover, we anticipate that the ECB and EFSF will co-ordinate supportive programmes to assist urozone states through their painful long-term budget deficit reduction programmes. Table: Official Interest Rates
Country Rate US Fed Funds US Prime UK Repo uro Repo Japan Overnight Call Switzerland Libor target Source: ThomsonReuters Current 0.00% 0.25% 3.25% 0.50% 1.50% 0.00% - 0.10% 0.00% - 0.25% Since 16/12/2008 16/12/2008 5/3/2009 7/7/2011 5/10/2010 3/8/2011 Last 1.00% 4.00% 1.00% 1.25% 0.10% 0.00% - 0.75% -1 Month 0.00% - 0.25% 3.25% 0.50% 1.00% 0.10% 0.00% - 0.75% -1 Year 0.00% - 0.25% 3.25% 0.50% 1.00% 0.10% 0.00% - 0.75%

Exchange Rates
Exchange rates are perceived to be difficult to predict, which may be true for traders who are executing against short-term movements and attempting to interpret daily market noise to finesse trades. However, macro and global investors recognise that exchange rates are a relative reflection of the discounted perception of an economys strength and fiscal and monetary management, even if the currency is pegged to another. However, given that most industrialised economies are all broadly in the same place and that trend GDP growth rates are likely to adjust by the broadly similar deltas, then it should come as no surprise that we are not materially changing our forecasts. Last December 2010, we forecast that the /US$ would average $1.60 for 2011 but there could be brief excursions out to the extremes of 1.35 and 1.75. The only adjustment we would make here is to tighten up on the 1.35 part of the range and close this down to 1.50. In the case of the /uro, our view is, this will average 1.15 compared with an earlier expectation of 1.20; the wider trading range now appears, in rounded terms, to be 1.08 to 1.20 at the extremes. Moreover, we maintain our earlier opinion that the uro will emerge from this recession a stronger currency a bold call, given current circumstances. We previously did not look at the US$/uro but it looks as though it could average 1.43 for 2011 but with a wide trading range of 1.35 1.50 at the extremes. While the US$/en could close the year back up around 80 although, more recently, the US$ and en appear to be tracking each other at the current level.

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Chart: Currencies / US$

/ uro

US$ / uro

US$ / en

Source: Digitallook.com

Commodities
Oil Oil prices, irrespective of grade, extended the Q4 2010 rally and surged to a peak during Q2 2011, from which it has been progressively edging lower. The uncertainty created by the Arab Spring can largely account for this surge but as the year progressed it became clearer that underlying demand could not justifiably sustain the inflated levels. Moreover, major producers increased output to compensate for any temporary supply shortfalls and those producers will trim back their output as the affected offline producers go back online and so maintain the supply/demand balance. It should not be forgotten that OPEC has previously declared that an oil price trading between $70 and $90 per barrel was sustainable and its members, led by Saudi Arabia, have been managing supply to maintain that range. In terms of pricing, their balanced supply policy worked very successfully from broadly the end of Q2 2009 to the opening weeks of 2011. Thereafter, speculative th traders drove the price to the 11 April 2011 peak of $127.02 per barrel. However, slowing global demand together with a progressive easing of North African tensions following the regime changes has started to exert normal pricing discipline upon this commodity and prices have been steadily declining and we anticipate that this trend will be sustained until oil returns to the $70 - $90 range.

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Chart: Oil

Source: Digitallook.com

Gold When we wrote our report last December, we stated that gold (and other commodities) would be the highlight of this year but that the run was a final blowout. However, our view is that the gold bull run is heading into its final blow out, probably sometime within the next 3 9 months. The final blow out, depending upon momentum, may add another US$100 US$300 to current prices at best (US$1,388.50). While on 2nd September 2011 on CNBCs Investing Edge programme, we advised selling gold and other safe haven assets and look to deploy the proceeds into risk assets; (click on following link to see the video: http://video.cnbc.com/gallery/?video=3000043534). Our timing was just about right and only missed a slither in percentage points from the top but then only the very lucky ever call the precise top or bottom of a run! Gold and other perceived safe haven commodities, such as silver and more recently platinum and palladium (both of which are more generally influenced by automotive demand), have all begun to fall sharply although not exhibiting a bursting bubble, which suggests a controlled exit rather than a rush to the door. We believe that investors are implementing a tactical shift in asset allocation back into cash or more precisely near cash instruments, such as short dated US government debt.

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Charts: Gold, Silver, Platinum and Palladium Gold

Silver

Platinum

Palladium

Source: Digitallook.com

Debt Capital Markets

The debt market has endured a turbulent period since the global economy began to recover from the recession. But as the dust has settled, investors have been increasingly horrified by the severity of the damage to the financial system and the scale of the imbalances that need correcting, which has resulted in an almost wholesale reappraisal of credit ratings for all borrowers. Proactive borrowers, such as the UK Government, for now, have fared considerably better than the startled political rabbits within the urozone. While the US, which responded rapidly to shore up and, more importantly, lay down solid foundations for a sustained long-term recovery were punished with a credit downgrade because of the stupid political bickering on Capitol Hill. Nevertheless, there is a growing realisation that the major industrial economies are finally getting on top of, rather than fire-fighting, issues. And, once the debt capital markets can direct capital economically toward industrial applications rather than for the competitive refinancing of governments and financial institutions then the global growth engine will begin to build up momentum and reopen the M&A cash market. Nevertheless, we anticipate increasing demand across all debt asset classes as investors reallocate long-term capital back into risk assets.

Charts: Yield Curves Page 7 of 12 06 October 2011

US Yield Curve

UK Yield Curve

uro Yield Curve

Japan Yield Curve

Source: www.ft.com

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Equity Capital Markets

The media and short-term traders are fuelling an unnecessary frenzy about the possibility of a double dip recession. Yes the globally economy is slowing but there are several reasons and all are being addressed, admittedly in some areas naively, by policy makers. Do we believe the world and, more particularly the urozone, will re-enter recession? On balance no, but it will be very close. Global economies are all naturally slowing from the heady recovery phase of the synchronised global recession, an effect that was expected once the supply pipeline had refilled. However, demand is being more heavily dampened, particularly in the industrialised economies due to the cumulative impacts arising from rebalancing and shrinking the public or state sector. While the lesser developed economies, which remain overly dependent upon the increasingly sluggish industrialised economies, are chilling their economies to simultaneously squeeze out inflation while desperately deflating asset bubbles that have arisen due to cheap credit seepage from earlier western QE programmes. More importantly, governments and investors have been wrong-footed about the depth of the recession as well as the shape of the recovery. This has been compounded by the frequent downgrades to growth expectations, which have created uncertainty and undermined confidence in the underlying data. We re-iterate our earlier and long held view that the recovery will be long and anaemic (i.e., resembling an l). However, economists and forecasters are finally reaching their capitulation point and growth expectations will be cut to believable and achievable levels. While the banking industry, although financially stronger than when it entered the last recession, remains over extended and as a result continues to either refinance, shrink balance sheets or combinations of both. Until this process has been completed, credit will be restricted at a time when greater availability would be helpful. However, once markets fully adjust for the new low growth era and become less volatile, this calmer environment should encourage industry to again start investing for growth, which will encourage investors to further direct increasing levels of capital into all classes of cash equities. In turn, this will feed into corporate earnings expectations (i.e., a step change down) although, due to earlier recovery momentum, earnings will appear surprisingly robust. But this is no more than a timing issue and there are signs that this process is already underway. Once it does, equity markets will undergo a step change to fully discount the lower trend rate.

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Charts: Indices World

FTSE100

DJ Industrial

Source: www.ft.com

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Charts: Indices (continued) FTSE Eurofirst 300

Nikkei 225

Shanghai SE Composite

Source: www.ft.com

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Conclusion
The dust is finally settling following the ending of the 2008 2010 synchronised global recession and economic clarity (and reality!) re-emerging. In turn, this is resulting in a tactical reallocation of assets. Capital is shifting from the generally illiquid safe haven assets (e.g., gold, silver, Swiss Franc) and initially transiting into highly liquid cash pools of cash (e.g., short-dated US government debt) before being redeployed into cash equities and long-term debt. However, the pace of the tactical reallocation will be a function of rebuilding confidence in official data as well as the effective implementation of domestic fiscal policies but not whether there is a recession, which is no more than a market re-entry level. This final downward step change in global economic growth rates will result in a knee jerk adjustment to long-term corporate earnings expectations. But this new realism will enable corporates to plan for a resumption of growth, which will restart their capital investment programmes and M&A that in turn will lay the foundations for a sustainable IPO market.

Philip Morrish (philip.morrish@intellisys.uk.com)

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