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Global Strategy

15 January 2009

Global Strategy Weekly

Technicals say it is time to bail out. Cut equity exposure and prepare for rout.
US depression looking likely. While China’s 2009 implosion could get ugly.

Albert Edwards After increasing our equity exposure at the end of October we believe that the market is set to
(44) 20 7762 5890
albert.edwards@sgcib.com quickly slide sharply towards our 500 target for the S&P. While economic data in developed
economies increasingly reflects depression rather than a deep recession, the real surprise in
2009 may lie elsewhere. It is becoming clear that the Chinese economy is imploding and this
raises the possibility of regime change. To prevent this, the authorities would likely devalue
the Yuan. A subsequent trade war could see a re-run of the Great Depression.

Q Economic data has been truly dreadful through the fourth quarter. Over a year ago we
forecast deep US recession. As it had not suffered one since the early 1980s, we thought
this outturn would shock. Yet recent data has been consistent with something far worse
than deep recession. There is no agreed definition of a “depression” as opposed to a deep
recession. But The Economist magazine is probably more qualified than many to take a
view. They consider a peak-to-trough decline in GDP in excess of 10% a reasonable
Global asset allocation definition – link. We had been thinking of deep GDP declines of the order of 5% peak to
Index SG
% Index trough but we are now thinking that this view might be too optimistic.
neutral Weight
Equities 30-80 60 35(50)
Q But, until yesterday, equity markets had been paddling quite happily sideways for most
Bonds 20-50 35 50(45)
of the last few months. They have been broadly flat since we increased our equity weighting
Cash 0-30 5 15(5)
Previous weighting in (brackets)
sharply on 23 October. Within that time the intra-day ‘peak’-to-trough’ rally in the S&P was
Source: SG Equity Research a creditable 28% from 740 low of Nov 21, but we do not claim to have captured that.
Nevertheless we feel very comfortable that the technicals at the end of October cried out to
Equity allocation close our extreme underweight equity exposure. They now tell us to cut exposure again.
Very Overweight
Q 2008 was a shock for investors. But 2009 could be an even bigger shock. There is
US
Overweight
UK evidence that the Chinese economy is imploding (see chart). Investors should consider what
Neutral Cont Europe would happen if China descends into social chaos. Yuan devaluation could spark a 1930’s-
Japan
Underweight style trade war. Do you really trust the politicians to “do the right thing”?
Emerging mkts
Very Underweight
Source: SG Equity Research Lead indicators say that Chinese GDP growth set to collapse
106
Chinese GDP growth 13

(yoy%, rhscale) 12
104

102
10

100

98 8

96

6
94
IMPORTANT: PLEASE READ OECD leading indicator
92
DISCLOSURES AND DISCLAIMERS 4

BEGINNING ON PAGE 8 90

88 2
96 97 98 99 00 01 02 03 04 05 06 07 08

www.sgresearch.socgen.com
Source: Datastream
 Global Strategy Weekly

After the savage slide in equity markets in October, it didn’t take a genius (just as well in my
case) to come to the conclusion the markets should enjoy some sort of technical bounce from
hugely oversold levels. We have repeatedly highlighted that during the 2001-03 bear market
there were four 25% bear market rallies before the market finally hit bottom. The same is true
for the 1930s bear market. Despite being structurally bearish I try to participate in the rallies,
while my colleague, James Montier, tut-tuts disapprovingly and tries to switch off the power to
my computer with his foot. At the end of October many technical indicators such as the % of
stocks above the 50-day moving average (see chart below - link), were so extreme we
increased our equity weighting from a rock bottom 30% to a still underweight 50%.

We remained underweight our benchmark because, unlike many strategists, we did not believe
we had seen the lows for this bear market. Our favoured valuation measures (such as the
cyclically adjusted PE), despite identifying Europe as cheap, called for further substantial
downside in the US market before it became similarly cheap. But once well known technical
indicators such as the MACD oscillator turned upwards at the end of October (see chart below),
we felt comfortable nearer to neutral. Two days ago we noticed that the MACD had turned back
downwards, and that the breadth indicators (see chart above) had peaked out.

Moving Average Convergence/Divergence (MACD) Oscillator for the S&P Composite

20

10

-10

-20

-30

-40

-50

-60

-70

-80
J F M A M J J A S O N D J

Source: Datastream

2 15 January 2009
 Global Strategy Weekly

Other technical indicators also now suggest it is time to bail out of equities. The CBOE put/call
ratio had moved down to the lowest level for twelve months at the turn of the year (see chart
below – this is typically used as a contrary indicator). That together with Vix appeared to be
bottoming out – link.

Another contrary technical indicator we watch closely is the balance of bulls relative to bears
(see chart below - Investors Intelligence survey 140 financial newsletters - link). This has now
bounced sharply from incredible lows at the end of October and is now back to neutral.
Individual investors (AAII survey) are also similarly more sanguine at the turn of the year with
the number of bulls comprising a surprisingly high 48.7%. This is a signal that the rally is over.

Investors Intelligence Bull-Bear Indicator (% gap)

50 50

40 40

30 30

20 20

10 10

0 0

-10 -10

-20 -20

-30 -30

-40 -40
2001 2002 2003 2004 2005 2006 2007 2008

Source: Datastream

We only ever saw our move back to a 50% equity exposure as temporary (see GSW 23 Oct –
link). The true awfulness of the economic data since the end of October has certainly limited
the ability of the market to enjoy a more heady technical bounce. But we always clearly stated
that we believed further dismal profits and economic data during H1 2009 would be sufficient
to catalyze a rout that would take the S&P down towards our 500 target – another 40% or so
downside. So with the oversoldness unwound and with the MACDs breaking downwards we
feel duty-bound to cut our exposure to equities aggressively.

15 January 2009 3
 Global Strategy Weekly

In some respects James and I do feel a lot more bullish than we did one year ago. The extent
of the economic implosion is now widely recognized, the equity market is far cheaper than it
was one year ago and the authorities are becoming increasingly aggressive in their stimulative
measures. I was discussing the deflation/inflation question the other day with my former
colleague Dylan Grice. We were both agreed that unlike Japan in the 1990s, current US policy
makers have a very pronounced bias towards inflation – see Dylan’s blog here. Although in the
near term (12-18 months) I believe we are sliding into a deflationary quagmire, I have a very
open mind on a 2-3 year time horizon. We should remain intellectually flexible in these times.

The year 2008 has surely taught investors to think the unthinkable. In 2009 it is not the
mounting risk of depression in developed economies that will come as a major surprise; it is
economic implosion in China and the global and geopolitical risk thereof. Unthinkable
you gasp! But you probably said the same thing about my forecasts at the start of 2008.
Chinese electric power output has been declining for the last three months (see chart below).
That is unusual.

Chinese electric power output (yoy %)

20 20

15 15

10 10

5 5

0 0

3mth mav

-5 -5
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Datastream

Normally electric power output and GDP move closely together (see chart below).

Annual data – Chinese electric power output and GDP (yoy %)

18 18

16 GDP 16

14 14

12 12

10 10

8 8

6 6

4 4

2 2

0 0

electric power
-2 -2
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: Datastream

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 Global Strategy Weekly

A decline in power output of this order of magnitude certainly should raise the possibility that
China is sliding into outright recession – no matter what the widely derided official GDP data
actually tells us. All the more interesting is that the collapse in electric power concurs with the
OECD leading indicator chart we put on our front page. The obvious conclusion is that the
electric power series is a dominating part of the OECD lead indicator. A little research on the
OECD website shows that this is not the case – link. Not only does it not dominate, it is not
even in it! For the geeks, the Chinese OECD lead indicator includes Cargo handled at ports
(tonnes), Enterprise deposits (CNY), Chemical fertilizer production (tonnes), Non ferrous metal
production (tonnes), Monetary aggregate M2 (CNY), and Imports from Asia (USD).

One reasonable explanation for the collapse in electric power output might relate to a switch
to oil-based power in the wake of the massive oil-price slump. That explanation is reasonable.
But it is concerning that in addition, much of Asia that has relied on rapid Chinese growth is
also declining at an unusually rapid pace (see chart below).

Japan and Taiwan industrial production (yoy%, Taiwan has 2 month mav)
25 25

20 Taiwan 20

15 15

10 10

5 5

0 0

-5 -5

-10 -10

-15 -15

-20 Japan -20

-25 -25
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Datastream

Developments in the Japanese trade are well known. Exports in November were down 25%
yoy, with exports to the US down 34%. But these have been weak for some time. The shock
is that in November exports to China were down 25% yoy compared with growth of 16% as
recently as July! The same trends are evident elsewhere in Asia, e.g. Taiwan (see chart below).

Taiwan’s exports to China collapse (yoy %) over last six months

60 60

Exports to China
40 40

20 20

0 0

-20 -20

Exports to the US
-40 -40

-60 -60
2006 2007 2008

Source: Datastream

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 Global Strategy Weekly

The same sudden collapse in Chinese demand for imports is also evident in the Korean data
(see chart below). Chinese data shows their exports contracting about 3% yoy in December
while imports fell by a massive 21% yoy (although clearly a proportion of the import decline
will relate to declining commodity prices – crude oil imports were down 33% yoy).

Korean exports to China (yoy%) also collapse over the last six months
40 40

30 30

20 20

10 10

0 0

-10 -10

-20 -20

Exports to the US
-30 -30
Exports to China
-40 -40
2006 2007 2008

Source: Datastream

Are Chinese imports slowing sharply due to the fact the economy processes many
components imported from the rest of Asia to be re-exported? Or to what extent is Chinese
import growth reflecting a slowdown in domestic demand? The export data from the US to
China is unlikely to be production line components in the value added chain. The US export
data suggest there is a problem with Chinese domestic demand (see chart below). Either way,
Chinese industrial production is slowing sharply (+7% yoy in November v +30% in July).

US export and imports with China (yoy%, 3m mav)

40 40

35 Exports to China 35

30 30

25 25

20 20

15 15

10 10

5 5

Imports from China

0 0

-5 -5
2006 2007 2008

Source: Datastream

We continue to emphasize our long-held view that emerging economies are particularly
vulnerable to a reversal in the global liquidity pump that has been reflected in an explosion of
global FX reserves over the last few years. Without full replication of the arguments here, a
burgeoning US current account deficit has been reflected in rampant global liquidity growth
via EM FX intervention. The collapse in the US trade deficit to only $40bn from $57bn in

6 15 January 2009
 Global Strategy Weekly

October was long overdue and the reflected declines in trade surpluses elsewhere (including
four trade deficits in a row in Japan), means that EM countries have started to see sharp
declines in their FX reserves. The liquidity pump for these economies has gone into
reverse and we described this as phase II of The Great Unwind – see Global Strategy
Weekly 18 September – link. In October it was notable that Chinese reserves began to decline.

In my view, China is still an export-led economy, underpinned by rapid (excessive) investment

growth. Consumption is still a relatively small part of GDP. Its relative resilience to date may
be due to nothing more than the fact it lags the export cycle which has only recently
collapsed. What is unambiguous however is that the authorities are very concerned about the
risk of an economic slowdown. The very survival of the regime depends on growth.

The Financial Times recently reported Prime Minister Wen saying, “We must be crystal-clear
that without a certain pace of economic growth, there will be difficulties with employment,
fiscal revenues and social development…factors damaging social stability will grow” – link. The
Wall Street Journal reports an increase in worker unrest as the economic situation deteriorates
– link. Crackdowns on dissidents are intensifying in the wake of the publication of the Charter
08 manifesto– link. The authorities face the toughest year since the economic malaise
two decades ago led to the crackdown on student/worker unrest in Tiananmen Square.

There is a touching faith that the authorities are still in control of events. The Chinese
authorities are no more or less fallible than anyone else. Could the economic situation become
so bad in China that it threatens the regime itself? Of course it could and clients should
consider the implications of such an event. But before the Communist Party accepts being
swept away in a tidal wave of worker unrest it has one key tool in its economic armoury it has
used before - mega-devaluation. China has a track record of such things. At the end of 1993
the authorities devalued the Yuan by 33%. Even the minimal recent slippage in the Yuan after
some three years of allowing it to appreciate, is causing the US authorities to twitch nervously.

But surely the authorities have learnt the lessons of the 1930s and we can rely on them to do
the right thing? It depends what the alternative is. A Yuan devaluation would undoubtedly be
likely if the alternative was the overthrow of the Communist Party. As The Economist pointed
out recently, economists and bankers begged President Hoover not to sign the 1930 Smoot-
Hawley Tariff Act – link. Amid confidence that the ongoing, massive, monetary and fiscal
stimulus will prevent a repeat of The Great Depression, will it instead be competitive
devaluation and an implosion of world trade that we should watch out for (see chart below)?

15 January 2009 7
 Global Strategy Weekly

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8 15 January 2009