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16 March 2010

Global Strategy
Alternative view
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Global Strategy Weekly


Incroyable! French drinking habits seep into the UK CPI

Albert Edwards Recent data from the US Fed shows that the deleveraging of the economy continues apace.
(44) 20 7762 5890 These deflationary forces continue to act as a major restraint on activity which will surely suck
albert.edwards@sgcib.com
us back into outright deflation as the current stimulus wears off.

Q There are many pointless economic activities. Lord Turner, the Chairman of the UK’s
Financial Services Authority, caused a stir last year when, in a searing critique of the finance
industry, he described much of the City of London’s activities as "socially useless".

Q Now, I wouldn’t want to upset my French bosses with heretical talk, but surely one of the
most pointless industries must be the bottled water industry. I know there is huge demand
for it and in a free-market economy if people want the stuff why shouldn’t companies
provide it? But the closet-Stalinist in me has always thought that, in a world of limited
resources, especially when we are now worrying about global warming, isn’t it
Global asset allocation “environmental insanity” to be producing and transporting this stuff around the world - link?
Index SG
% Index
neutral Weight Q Anyway, my stand against this industry has suffered a blow as the UK’s ONS statistical
Equities 30-80 60 35 office has just decided to throw canned fizzy drinks out of the UK’s CPI basket and replace
Bonds 20-50 35 50
them with small bottles of mineral water – link. Personally, I’m sticking to my tap water,
Cash 0-30 5 15
Source: SG Cross Asset Research
despite the acknowledgement from the official “Visit London” website that “A drop of rain
falling into the Thames at its source in the Cotswolds will have been drunk by 8 people
before it reaches the sea.” – link. (Do they think that information will boost visitor numbers!)

Q Anyway, I digress, but only slightly. Last week’s Flow of Funds report from the Fed
showed that US total credit continued to disappear down the plughole, despite the
government’s best efforts to inflate us back to prosperity (see chart below). The current
recovery, based in very large part on the end of de-stocking, simply cannot be sustained
while credit is disappearing at this debilitating dehydrating rate.

US credit disappears down the plughole: borrowing by sector ($bn annual rate)
6000 6000

5000 5000

4000 4000

3000 3000

2000 2000

1000 1000

Global Strategy Team 0 0


Albert Edwards
(44) 20 7762 5890 Federal and local government
-1000 -1000

albert.edwards@sgcib.com
Financial Sector
financial sector
-2000 Non-financial
non-financialdomestic
domesticprivate
privatesector
sector -2000
federal
Total + state & local government
totaldomestic
Dylan Grice domestic
-3000 -3000
(44) 20 7762 5872 2005 2006 2007 2008 2009
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

The recently released Q4 Flow of Funds data allowed economists to get a full view of the 2009
data. It was ugly. Most shockingly, the household sector shrank its borrowing for the
seventh quarter in a row – with minimal signs of any abatement to the process.
Combined with continued rapid balance sheet shrinkage in both the corporate and financial
sectors, total domestic debt contracted for the fourth quarter in a row (see front page chart).
Now, we might be getting used to such news, but it is always worth remembering that, prior to
the global meltdown, even one quarter of total domestic debt shrinkage was like seeing a
black swan with some pink dots thrown in for good measure.

With nominal GDP actually managing to inch up some 0.8% in the year to Q4 2009, the
economy managed its first baby step along the long and winding road to normality, with US
debt dipping under 350% of GDP (see chart below). Household leverage has returned to 94%
from its peak of 96% in both 2007 and 2008. But consider this: at the peak of the Nasdaq
bubble, household leverage was just shy of 70%. There is a very, very long way to go.

US total domestic debt as % of GDP (end-year plots)

350%

300%
US Debt as % of US GDP

250%

200%

150%

100%

50%

0%
1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007
Household Business Financials Government

Source: Datastream, SG Cross Asset Research

Now, I’m the first to admit that I am a bear with very little brain and I struggle when asked by
clients if we are double counting when we include the financial sector (see charts below). I
seem to remember Dylan Grice and James Montier discussing this one lunchtime. I lost the
thread quite early on and decided to study the label on the bottle of wine we were drinking,
but I think the conclusion they reached was that it was not double-counting.

US total domestic debt/GDP US domestic non-financial debt/GDP

350
260

240
300
220

250 200

180
200
160

150 140

120
100 100
1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007

Source: Datastream, SG Cross Asset Research

2 16 March 2010
Global Strategy Weekly

In the case of the non-financial debt/GDP ratio (shown above), it remained at a record 240%
high at end-2009. We need to ‘lose’ some 60% of GDP worth of debt to get back to where we
were at the peak of the Nasdaq bubble (I use this reference point for no other reason than these
levels seem obscenely high relative to history at that time). Either way, investors should accept
we have a long hard slog ahead.

Many clients ask how we will know when the deleveraging process is over or whether there is a
‘right’ debt/income ratio. We will know when the deleveraging process has ended when we see
an end to the unprecedented pace of decline in bank lending (see chart below). This process
took three years in the early 1990s. Expect at least a decade of Japan-like Ice-Age pain.

US bank lending (yoy%)


18 18

15 15

total
10 10

5 5

0 0

-5 -5

loans and leases Y2K

-10 -10
73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07

Source: Datastream, SG Cross Asset Research

Ultimately, as my colleague Dylan Grice writes, I think we head back to double-digit inflation
rates as governments opt to default. I certainly again expect to see CPI inflation above 25% in
the UK and indeed in most developed nations in my lifetime – I have happy memories of the
three-day week and doing my homework by candlelight. In the near term, however, the
deflationary quicksand will suck us ever lower until we suffocate. A key driver for underlying
inflation remains unit labour costs. While unit labour costs decline at an unprecedented rate, they
are sucking us inevitably into a Fisherian, debt-deflation spiral. Only then will we see how far
policymakers are willing to go to debauch the currency. Last year saw them cross the Rubicon.
Monetisation is now the policy lever of first resort.

US Core CPI inflation to be driven lower by deep declines in unit labour costs
14 14

12 12

10 10

8 8
core CPI
6 6

4 4

2 2

0 0

-2 -2

unit labour costs


-4 -4

-6 -6
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Source: Datastream, SG Cross Asset Research

16 March 2010 3
Global Strategy Weekly

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4 16 March 2010

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