21 May 2010

Global Strategy
Alternative view
www.sgresearch.com

Global Strategy Weekly

The US and eurozone now stand on the edge of a deflationary precipice

Albert Edwards Amid all the recent euro-related turbulence, the markets have not focused enough attention
(44) 20 7762 5890 on the rapidly vanishing core CPI inflation rates in the US and eurozone. With both moving
albert.edwards@sgcib.com
below 1%, we are now only one cyclical mishap from joining Japan in outright deflation. Given
our view that this cyclical recovery will end surprisingly early, slipping into the deflationary
mire will trigger further, more extreme rounds of Central Bank monetisation, inevitably driving
us towards our ultimate destination – 1970’s style 20-30% inflation will surely return.

Q Of all the inflation data released this week, the one that caught the markets’ attention was
the UK’s dramatically higher than expected 3.7% yoy rise for April. Even the core measure
of CPI managed to creep up above the 3% mark. Meanwhile the old RPI, to which most
state benefits are indexed, rose a heady 5.3% – the highest pace since July 1991. While
many commentators proceeded to berate the Bank of England for consistently under-
forecasting inflation in recent years, many also saw the first signs of the quantitatively eased
Global asset allocation pigeons coming home to roost.
Index SG
% Index Q But I would argue that in a year or so, we will see the UK’s relatively high inflation rate as
neutral Weight
Equities 30-80 60 35 a godsend. For elsewhere, it went almost unnoticed this week that core CPI inflation rates in
Bonds 20-50 35 50 the US and eurozone continue to slip-slide their way down towards zero (see chart below).
Cash 0-30 5 15
Although this is seen as buoying bond prices at the margin, it is a pernicious development
Source: SG Cross Asset Research
that investors will focus on when this cycle starts to fail. Regular readers will know that I
believe that in a post-bubble world, recession follows recession with surprising rapidity. We
are now only one cyclical failure away from Japanese-style outright deflation in the US and
the eurozone at a time when de-leveraging still has years to run (falling prices bring the risk
of a classic debt deflation trap). Impending cyclical failure and a deflation scare will trigger
new lows in equities as the valuation bear market finally plays itself out with the S&P falling
below 500. We therefore maintain our long-standing target of sub-2% US 10y bond yields –
and that is the point when QE will really begin to get serious.

US and eurozone core CPI inflation

3.00 3.00

US

2.50 2.50

2.00 2.00

1.50 1.50
Global Strategy Team
Albert Edwards
(44) 20 7762 5890 1.00 1.00
albert.edwards@sgcib.com
Eurozone
Dylan Grice
(44) 20 7762 5872 0.50 0.50
dylan.grice@sgcib.com 2002 2003 2004 2005 2006 2007 2008 2009

Source: Datastream

Macro Commodities Forex Rates Equity Credit Derivatives

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

Dylan Grice has shown us clearly over the past few months that governments are insolvent. At
some point, as can be seen most vividly along the periphery of the eurozone, the market
demands action. And amid renewed zeal for fiscal retrenchment within the new UK
government, it is worth repeating one key point – namely, premature fiscal retrenchment was
one of the key policy errors Japan made in a post-bubble, de-leveraging economy (see GSW
12 Feb, To cut or not to cut? Actually it doesn’t really matter. We’re stuffed anyway! – link).

I remain persuaded by Richard Koo’s book about the lessons from Japan’s balance sheet
recession. The crux of his analysis is that governments have no option but to stimulate
aggressively all the while the private sector is de-leveraging. ANY attempt at fiscal cuts simply
results in renewed recession and a further loss of confidence, thus making it even harder and
more costly to sustain any subsequent recovery – and hence the budget deficit ends up
bigger than before (see chart below). A repeat of Japan’s mistakes is exactly the outcome I
expect. Renewed recession awaits and with the eurozone and the US core CPI inflation less
than 1%, the icy tentacles of outright deflation are now just within reach. (Attached is a link to
an interview by welling@weeden with Mr. Koo. It is well worth a read – link.).

Richard Koo says premature fiscal tightening in Japan 1997 and 2001 weakened the economy,
reduced tax revenue and ultimately made the fiscal deficit even bigger

Source: Welling@Weedon

Competitive devaluation is one way to try and wriggle free from the deflationary quicksand.

OECD real effective exchange rate indices (using CPI, indexed to 2000=100)
131 131
130 130

Eurozone
120 120

110 110

100 100

90 90

UK
80 80
US
70 70
2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Datastream, SG Cross Asset Research

2 21 May 2010
 Global Strategy Weekly

The UK has clearly embraced this option with gusto and is enjoying the benefits of a relatively
high inflation rate. This resembles closely the UK’s experience of the 1930s when it was
ejected from the Gold Standard, only to devalue aggressively and so suffer a relatively mild
“depression” compared to those who remained on gold. The eurozone clearly needs to
devalue and the Greek crisis is allowing that much needed adjustment to occur. Competitive
devaluation might allow the eurozone overall to escape the deflationary fate of some of its
most vulnerable members (see chart below) and export its deflation elsewhere.

Spain slips into outright deflation (joining Portugal and Ireland). Eurozone next?
4.00 4.00

3.50
Spain 3.50

3.00 3.00

2.50 2.50

2.00 2.00

1.50 1.50

1.00 1.00
Eurozone
0.50 0.50

0 0

-0.50 -0.50
2002 2003 2004 2005 2006 2007 2008 2009

Source: Datastream, SG Cross Asset Research

But as my old friend Jim Saft pointed out in his Reuters opinion piece yesterday, it won’t just
be deflation the eurozone will be exporting but also trade tensions as the dollar rises– link. Jim
makes the very good point that “the US primary elections on Tuesday showed voter anger is
focused on incumbents in general and Washington in specific. It would not be a surprise for
the administration to try and focus that anger outside of the country.” A renewed global
downturn with rising trade tensions is exactly the environment that will see the shock Chinese
yuan devaluation. I continue to remain of the view that a global downturn is close. Too many
are focusing on the buoyant economic data that is entirely consistent with continued strength
of the coincident indicators, yet all the while the leading indicators continue to slow (see chart
below). Renewed recession will never be forecast until after we are back in one!

US Economic Cycle Research Institute leading and coincident indicator (yoy%)

30.0 coincident indicator (rhscale) 8.0

6.0
20.0
4.0

10.0 2.0

0.0
0.0
-2.0

-10.0 -4.0

-6.0
-20.0 leading indicator
-8.0

-30.0 -10.0
1/1/1999 1/1/2001 1/1/2003 1/1/2005 1/1/2007 1/1/2009

Source: ECRI

21 May 2010 3
 Global Strategy Weekly

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4 21 May 2010