Fixed-income strategy

A tour of inflation . . .. . .and why the world (& the UK) is not rosy

March 2011

Andrew Roberts

“The rise and fall of civilizations are linked to demographic trends” (Source: CIA)

CLIENT LOGO

RB

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2

Risky assets doing fine… on. Well, they were up to last week

55

60

65

70

75

80

85

90

Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11

AUD/JPY

-2000

-1500

-1000

-500

0

500

'91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11

RBS Risk appetite indicator

Risk-off

Risk-on

10

60

110

160

210

Feb-09 Aug-09 Feb-10 Aug-10 Feb-11

0

10

20

30

40

50

60

Treasury Option Volatility Estimate

VIX Index (rhs)

0

20

40

60

80

100

120

140

Jun-08 Jan-09 Aug-09 Mar-10 Oct-10

EUR FRA/OIS SPRD 3M,

4th future

GBP FRA/OIS SPRD 3M,

4th future

USD FRA/OIS SPRD 3M,

4th future

20

30

40

50

60

Feb-07 Nov-07 Aug-08May-09Feb-10 Nov-10

World Equity

0

200

400

600

800

1000

1200

1400

Feb-07 Dec-07 Oct-08 Aug-09 Jun-10

US Industrial 10-yr

Benchmark - US

Treasury 10-yr

B rated industrials

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3

Data surprises are already at all time highs. Worrying for equity bulls

Surprise

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Mar-02 Mar-04 Mar-06 Mar-08 Mar-10

RBS data surprise index, sample of USA & Germany front line data.

Normalised surprise indices, monthly data to end-Feb 2011

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4

What about the oil effect? About to hit

6

8

10

12

14

16

18

20

'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11

US CPI Urban Consumers Gasoline / US hourly wage

900

1000

1100

1200

1300

1400

1500

Feb-

06

Aug-

06

Feb-

07

Aug-

07

Feb-

08

Aug-

08

Feb-

09

Aug-

09

Feb-

10

Aug-

10

Feb-

11

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

EU27 gas oilpump priceindexGerman 2-yryield

Demand driven

Demand

driven: up to

now

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5

The rate of change can count . . . beware sharp rises

-75%

-55%

-35%

-15%

5%

25%

45%

65%

85%

105%

125%

Dec-

1961

May-

1967

Nov-

1972

May-

1978

Oct-1983 Apr-

1989

Oct-1994 Mar-

2000

Sep-

2005

-2

-1

0

1

2

3

4

5

6

7

Oil Price YoY % change World GDP growth YoY % change (rhs)

-75.00%

-25.00%

25.00%

75.00%

125.00%

175.00%

225.00%

275.00%

325.00%

375.00%

Dec-

1961

May-

1967

Nov-

1972

May-

1978

Oct-1983 Apr-1989 Oct-1994 Mar-

2000

Sep-

2005

Mar-

2011

-3

-2

-1

0

1

2

3

4

5

6

7

8

Oil Price 2yr change World GDP growth YoY % change (rhs)

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6

Real wages the key in H2. Already plunging, falling further in zones with spare labour

-3

-2

-1

0

1

2

3

4

5

6

7

Mar-

71

Mar-

74

Mar-

77

Mar-

80

Mar-

83

Mar-

86

Mar-

89

Mar-

92

Mar-

95

Mar-

98

Mar-

01

Mar-

04

Mar-

07

Mar-

10

Germany, Realcompensation rate,total economy, yoy

United States, Realcompensation rate,total economy, yoy

-6

-4

-2

0

2

4

6

8

10

Ma

r-7

1

Ma

r-7

4

Ma

r-7

7

Ma

r-8

0

Ma

r-8

3

Ma

r-8

6

Ma

r-8

9

Ma

r-9

2

Ma

r-9

5

Ma

r-9

8

Ma

r-0

1

Ma

r-0

4

Ma

r-0

7

Ma

r-1

0

United Kingdom, Real compensation rate,total economy, yoy

Sweden, Real compensation rate, totaleconomy, yoy

The big theme (even though no-one is discussing it). Spare labour capacity = no wage bargaining

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7

Eg US unemployment is high. Extraordinarily high in some measures

Source: Courtesy of ShadowStats.com

The augmented U-6 rate includes long-term discouraged workers (defined out of

existence in 1994). U-6 only includes short-term discouraged workers

Unemployment Rate

0

2

4

6

8

10

12

Jan-50 Jan-58 Jan-66 Jan-74 Jan-82 Jan-90 Jan-98 Jan-06

% Unemployed for >6m

0

10

20

30

40

50

Jan-48 Jan-57 Jan-66 Jan-75 Jan-84 Jan-93 Jan-02 Jan-11

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EMU: where is inflation going to come from? Wages low, demands high

– Negotiated wages outlook weak. Was at weakest ever last month

– Parts of EMU approaching deflation already

– Just popped up to due to fiscal tightening = higher VAT/taxes (notwithstanding oil)

Source: RBS Euro economics

0

0.5

1

1.5

2

2.5

3

3.5

4

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

EMU Negotiated Wages, % yoy EMU Core inflation, % yoy

97-10 avg

97-10 avg

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Ger, Fra, Ita, Neth, Bel, Aut, Fin, Lux

Spa, Gre, Por, Ire, Cyp, Mal, Svn, Svk

Taxes

7

7.5

8

8.5

9

9.5

10

10.5

11

Jan-91 Mar-95 Apr-99 May-03 Jul-07 Aug-11

0

1

2

3

4

5

Eurozone Unemployment Eurostat Harmonised Index of Consumer Prices

German wage claims in 2011

Sector demand

Construction industry 5.9%

Chemicals 6-7%

Deutsche Telekom 6.5%

Food and Catering 5-6%

Public services €50 + 3%

Coal industry Real wage rise

Textiles 5%

Insurance 6%

Volkswagan 6%

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What about the UK? In poor shape, according to balance sheet

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Mar-88 Nov-90 Aug-93 May-96 Feb-99 Nov-01 Aug-04 May-07 Jan-10

Government Households

Private non-financial corporations United Kingdom to rest of the world

Household

financial balance

is negative

35

40

45

50

55

60

65

Ma

r-

06

J

ul-

06

No

v-

06

Ma

r-

07

J

ul-

07

No

v-

07

Ma

r-

08

J

ul-

08

No

v-

08

Ma

r-

09

J

ul-

09

No

v-

09

Ma

r-

10

J

ul-

10

No

v-

10

US ISM Non-Manufacturing UK Services PMI

EMU Services PMI

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Risk assets are recovering, but UK production is not

UK production hardly bounced whatsoever, despite -26% sterling trade-weighted fall

Q307 to Q408

60

70

80

90

100

110

Mar-78 Mar-82 Mar-86 Mar-90 Mar-94 Mar-98 Mar-02 Mar-06 Mar-10

-15

-10

-5

0

5

10

15Industrial Production Change (YoY)

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What about the UK? Retail sales news mixed

Retail sales (ex. auto) - Change YoY

-8

-6

-4

-2

0

2

4

6

8

Feb-

05

Jul-

05

Dec-

05

May-

06

Oct-

06

Mar-

07

Aug-

07

Jan-

08

Jun-

08

Nov-

08

Apr-

09

Sep-

09

Feb-

10

Jul-

10

Dec-

10

UK EMU US

Better? No, with BRC retail sales at -0.4%yoy

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UK fiscal tightening set to bite

Government balances (% of GDP)

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

Austr

alia

Cana

da

Fran

ce

Germ

any

Greece Ita

ly

Netherlan

ds

Portu

gal

Spain

Swed

en

Switzerlan

d

Unite

d Kingd

om

Euro ar

ea

Total

OEC

D

2010 2011 2012

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Sticky UK inflation, yes … taxes & external influences

-1

0

1

2

3

4

5

6

2004 2005 2006 2007 2008 2009 2010 2011

UK

EMU

HICP constant tax, % y/y

85

90

95

100

105

110

Feb-06 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10

US Composite Leading Ind.

Total LeadingUK Composite Leading Ind.

Total LeadingEMU Composite Leading Ind.

Total LeadingJapan Composite Leading Ind.

Total Leading

Spot the odd man out: before the turmoil, UK was showing weaker momentum (data up to end-2010)

Source: OECD

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UK CPI forecasts

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Jan-

02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Jul-0

9

Jan-

10

Jul-1

0

Jan-

11

Jul-1

1

Jan-

12

Jul-1

2

RPI

RPI forecast

CPI

CPI forecast

il13s

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What are inflation options telling you? That the UK is seen to have an inflation problem

EMU

15

20

25

30

35

40

45

50

Feb-10

Mar-10

Apr-1

0

May-10

Jun-10

Jul-1

0

Aug-10

Sep-10

Oct-1

0

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

<1%Between 1% and 2%>3%

Probability of yoy inflation at various levels

in 10 years

UK

0

10

20

30

40

50

60

70

80

90

Feb-10

Mar-10

Apr-1

0

May-10

Jun-10

Jul-1

0

Aug-10

Sep-10

Oct-1

0

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

<1%

Between1% and 2%>3%

US

10

20

30

40

50

60

70

Feb-10

Mar-10

Apr-1

0

May-10

Jun-10

Jul-1

0

Aug-10

Sep-10

Oct-1

0

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

<1%

Between1% and 2%>3%

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Bank balance sheets not fixed. Credit to tighten for years

The knock-out punch that deleveraging delivers. 6 years of deleveraging?

Bank credit to the private sector (% of nominal GDP)

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No-one wants any credit when you are deleveraging . . .

UK: more credit available UK: that nobody wants

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UK rates already discounted a lot higher

UK rates already seen to rise significantly

0

1

2

3

4

5

6

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49

GBP USD EUR

1yr swap rates, starting at various forwards

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EMU debt sustainability

1.7

2.7 2.8 2.8 2.93.2

3.4 3.53.7 3.7

4.3

5.1

4.2

0

1

2

3

4

5

6

Gre

ece

Por

tuga

l

Hol

land

Ger

man

y

Spa

in

Italy

Fin

land

Bel

gium

Fra

nce

Aus

tria

Irel

and

US

A

UK

%

-5.9

-4.7 -4.7

-1.8-1.5

-1.1-0.8 -0.6 -0.6

-0.2 -0.1

0.5

-0.2

-7

-6

-5

-4

-3

-2

-1

0

1

Gre

ece

Spa

in

Irela

nd

Net

herla

nds

Por

tuga

l

Finl

and

Uni

ted

Sta

tes

Bel

gium Ita

ly

Fran

ce

Aus

tria

UK

Ger

man

y

%

Difference versus 2000-07IMF estimates of mean nominal GDP growth 2011-15

Growth is pivotal

Spain, Portugal & Ireland all suffer massive drops in nominal growth compared to the years 2000-2007

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20

Nominal growth minus long-term interest rates

-8

-6

-4

-2

0

2

4

6

Gre

ece

Ireland

Portu

gal

Spain

Italy

Finland

Net

herla

nds

Belgium

Franc

e

Ger

man

yUK

Unite

d Sta

tes

2000-2007 2008-2015

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21

A Fiscal Risk Index

Source: Maplecroft, February 2011

“…identify countries that will come under increasing economic pressure in

future years due to low birth rates, high life expectancy and state

commitments to look after ageing populations.

The index is calculated using eight indicators: child and old-age

dependency ratios between 2010 and 2050; labour rates of the over-65s;

GDP; debt; and public spending on pensions, health and education.”

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Uncomfortable bedfellows

Changes in public debt, 2008-2011, & 2008-2015

Source: IMF Fiscal Monitor, November 2010

Easy to differentiate between:

a) Countries that have gone beyond (?) or almost

reached the point of no return

b) Countries that have terrible metrics but are

doing what is necessary (UK)

c) Countries that are in the „bubbling under‟, next

countries to be hit category (Spain, Portugal,

France)

d) Countries that have done less easing and

should be less punished (Italy, Australia, EM)

Source: IMF World economic outlook, October 2010. Note: net debt for Japan

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UK funding needs coming down. From a high level, but falling

0

50

100

150

200

250

2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16

Gilt issuance/gross financing requirement

Gross Gilt sales

As of March Budget 2010: £187.3bn

As of April 2010 revision: £185.2bn

As of June 2010 emergency budget: £165.0bn

Current: £165.2 Gilt sales

Cumulative fall in gross financing requirement

announced in June 2010 emergency Budget:

-£106bn

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24

UK: logically, doing what it says on the tin

Gilts have just been on one big round trip (10-yr spread to bunds)

-80

-60

-40

-20

0

20

40

60

80

100

120

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11

(bps

)

UK 10y vs.France

UK 10y vs.Germany

The 7 Dec 2009

Budget give-

away, & capital

flight

The great Gilt reappraisal

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25

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