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December
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Global Strategy
The investment opportunity of a generation
or the start of another lost decade?

Albert Edwards & Dylan Grice

December 2009

IMPORTANT: PLEASE READ DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT

Source : John Trever, Albuquerque Journal. Used by permission

3

The Premium Review 2 December 2009

 Inflation is always and everywhere a fiscal
phenomenon …
Official Net Debt, % GDP* Total net liabilities (funded and unfunded), % GDP**

750%

500%

250%

0%
Germany Spain France Italy UK EU US
* 2010 OECD projections
** 2005 estimates of total Fiscal Imbalance

Source: Gokhale (2009) 4

The last time China was about to take over …

Columbus’ ship next to Zheng He’s

Photograph by Lars Plougmann

5

The Premium Review 3 December 2009

 Pocket of value? Grain hasn’t participated in
the rally …
110 GSCI Grains Spot

GSCI Grains Excess Return

100
S&P500
90

80

70

60

50

40
30/06/08 30/08/08 30/10/08 30/12/08 28/02/09 30/04/09 30/06/09 30/08/09

Source: Datastream 6

Anatomy of a bubble: the Kindleberger-Minsky

model

Displacement

Revulsion Boom

Crisis Euphoria

Source: Kindleberger, SG Cross Asset Research

7

The Premium Review 4 December 2009

 Gold is cheap against USD: US monetary base
divided by gold held
1.60

1.40
Gold is expensive - USD overbacked by gold

1.20

1.00

0.80
Gold is inexpensive - USD underbacked by gold

0.60

0.40

0.20

-
Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4
1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: SG Cross Asset Research

8

Equities way behind government bonds

280 280

260 260

240 240

220 220

200 Bonds 200

180 180

160 160

140 140
Cash
120 120

100 100
Equities
80 80
97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Thomson Datastream 9

The Premium Review 5 December 2009

 S&P 10 year compound returns 1936-2008

Source: S&P
10

Phases of inflation & phases of investment:

relationship between US bond & equity market yields 16
16
Culting of the equity The dismal years The long bull market
14 Equity yields are an average 14
of Dividend & Earnings Yield

Interest rates are a weighted Interest rates 12

12 average of bond yields (2/3) &
short term interest rates (1/3)

10 10

8 8

6 6

4 4

2 Equity yield 2

0 0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Source: Thomson Datastream 11

The Premium Review 6 December 2009

 Ice Age derating of equities v bonds
8 8
The Ice Age
Bond yield
7 7
Bond yield

6 6

5 5

4 4

3 3
Equityyield
Equity yield
(avof
(av ofearnings
earnings&&dividend)
dividend)
2 2
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source : Thomson Datastream

Source: Thomson Datastream 12

Japanese bond/cash flow yield ratio derating

has led the US (strangely similar hey?)
1.20 1.20

1.00 1.00
US Ice Age derating…relatively
“cheap” US equities getting
0.80 0.80
cheaper and cheaper

0.60 0.60

0.40 0.40

0.20 0.20

Japan (led 10 years)

0 0
83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17

Source: Thomson Datastream 13

The Premium Review 7 December 2009

 Source: Datastream
14

The Great Moderation lie – back to volatility

Source: St Louis Fed 15

The Premium Review 8 December 2009

 Total US debt as % of GDP

Source: Lacy Hunt, Hoisington Investment Management 16

Leverage Ratios %

Source: San Fran Fed 17

The Premium Review 9 December 2009

 US domestic borrowing by sector ($bn)
6000 6000

5000 5000

4000 4000

3000 3000

2000 2000

1000 1000

0 0

-1000
federal + state & local government -1000
financial sector
-2000 non-financial domestic private sector -2000

total domestic
-3000 -3000
2005 2006 2007 2008 2009

Source: Thomson Datastream 18

Lessons from Japan: Equity markets became

highly cyclical with frequent +/-25% moves
100
90
Ice Age volatility
80
70
60
50
40
30
20
10
0
-10
-20
-30
-40
-50
Jan-64
Jan-65
Jan-66
Jan-67
Jan-68
Jan-69
Jan-70
Jan-71
Jan-72
Jan-73
Jan-74
Jan-75
Jan-76
Jan-77
Jan-78
Jan-79
Jan-80
Jan-81
Jan-82
Jan-83
Jan-84
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09

YoY change in the Nikkei 225 25% fall 25% rise

Source: SG Cross Asset Research 19

The Premium Review 10 December 2009

 Japanese Ice Age PE de-rating followed
80 the cycle
Cyclical lead indicator
90

(rhscale) 80
70

70
60

60
50

50
40
40

30
30

20 20

Forward PE
10 10
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: Thomson Datastream 20

Bubble, upon bubble, upon bubble!

"It will not be too bad this year. Both China and
America are addressing bubbles by creating
more bubbles and we're just taking advantage
of that. So we can't lose," he said.

Lou Jiwei, Chairman of China’s sovereign wealth fund, China

Investment Corp. Wealth Fund Muscles Up as Markets Recover: Reuters, August
28, 2009

21

The Premium Review 11 December 2009

 Is the Fed at it again?

Source: Zerohedge 22

US bank lending (ex securities yoy%)

20 20

15 15

10 10

5 5

0 0

-5 -5
74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: Thomson Datastream 23

The Premium Review 12 December 2009

 Deleveraging lasts well past end of the recession
14 20

12
loans to gov (treasuries)
15

10

8 10

5
4 total

2 0

-5
-2
recession
bank loans (private)
-4 -10
1989 1990 1991 1992 1993 1994 1995

Source: Thomson Datastream 24

Early 1990s stop/start recovery drove US bond

yields lower and lower
10.00 110

9.50

100
9.00

8.50
90

8.00

7.50 80

7.00

70
6.50

6.00
expectations 60

5.50 (rhscale)
10y yields
5.00 50
1989 1990 1991 1992 1993 1994

Source: Thomson Datastream 25

The Premium Review 13 December 2009

 Source: CSFB 26

27

The Premium Review 14 December 2009

 The unwind goes on and on and on

28

The Fed’s printers are already working flat out

Source: SG Cross Asset Research (A. Edwards) 29

The Premium Review 15 December 2009

 Have you forgotten how horrible things were
when inflation last exceeded 20%?

Source: SG Cross Asset Research (A. Edwards) 30

US 10y still in clear bull market

10 10

9 9

8 8

7 7

6 6

5 5

4 4

3 3

2 2
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source : Thomson Datastream

Source : Thomson Datastream 31

The Premium Review 16 December 2009

 US expectations ripe for correction
140 140

120 120

100 100

80 80

60 60

expectations
40 40

20 20
present situation
0 0
2002 2003 2004 2005 2006 2007 2008 2009

Source : Thomson Datastream 32

Watch the nominals (US GDP and wage bill)

12 12

10 10

8 8
nominal GDP
6 6

4 4

2 2

0 0

-2 -2

-4 -4

wage income
-6 -6
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source : Thomson Datastream 33

The Premium Review 17 December 2009

 US core CPI crashes in the recovery phase

35 6.00

headline ISM (inverted, 6mth mav) 5.50

40
5.00

4.50
45
4.00

50 3.50

3.00
55
2.50

2.00
60
1.50
core CPI (rhscale)
65 1.00
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source : Thomson Datastream 34

Spanish core CPI inflation heading to 0%

6 6

5 5

4 4

3 3

2 2

1 1
core
0 0

-1 -1
headline
-2 -2
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source : Thomson Datastream 35

The Premium Review 18 December 2009

 Australian annualised GDP growth – 2Q
14 14

12
nominal 12

10 10

8 8

6 6

4 4

2 2

0 0

-2 real -2

-4 -4

-6 -6
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source : Thomson Datastream 36

Hawley-Smoot here we come?

37

The Premium Review 19 December 2009

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The Premium Review 20 December 2009