Thunderroad Report Q4.pdf

8/14/2019 Thunderroad Report Q4.pdf

http://slidepdf.com/reader/full/thunderroad-report-q4pdf 1/40

report

Thunder Road

Into a Bubble?

October 2013

Strategy

Buying Time in a Brought Forward World

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1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

S&P 500 - since 1996

Sectors/stocks: as pressure on consumers grows, companies

supplying essential goods & services will be relative benefciaries



Into a bubble?

Bubbling Up 3

Megaphones and Domed Houses 3

Polar Opposites - middle of a bull market or imminent peak? 5

Need a Plan B? 6

Trying to Make Sense of Bubbles 7

Buying Time in a Brought Forward World 11

Manipulating the Time Horizon 11

It Should Work Both Ways 11

Theme: Essential Goods & Services 12

Is the Cycle Slowing Again? 14

Slowdown versus 2004-05 Style Mid-Cycle Acceleration 14

The US Consumer 19

The Picture Outside the US 20

Ination Versus Deation: short-term resolution imminent? 31

Ambiguous Signals 31

Bigger Picture 34

Gibson’s Paradox 36

Interest rates and Interest Rates (Repos) 38

Research: Paul Mylchreest

+44 207190 7242

[email protected]

This is a marketing communication. It has not been prepared under the Independent Investment research regulatoryrequirements and accordingly there is no prohibition on dealing ahead of the dissemination of this research material.


http://slidepdf.com/reader/full/thunderroad-report-q4pdf 3/403October 2013

Bubbling Up

Megaphones and Domed Houses

Here we go again, creating another asset bubble for the third time in a decade and a half. This chart holds

particular signicance for us since our colleague, David McCreadie, has been writing about it in his daily

“Tactical Trader” emails for nearly 5 years.

Eckhart Tolle was voted the most spiritually inuential person in the world and teaches that:

“the primary cause of unhappiness is never the situation but your thoughts about it”

Which seems apt right now.

We noticed the immediate spike to an all-time high in the S&P 500 on the release of last week’s NFP data at

the same time that increasing doubts are surfacing over

• Whether the US economy will reach “escape velocity” and;

• The benet of QE on the real economy rather than asset prices.

It’s getting increasingly difcult to argue that we haven’t crossed the threshold into bubble territory in

equities.

Are we going to bounce off the upper resistance of the “megaphone” pattern in the chart above and fall

sharply?

Another near-perfect chart set up came and went. George Lindsay’s “Three Peaks and a Domed House” pattern

was forming through 2011-12, until the QE3-driven rally (pre and post the September 2012 announcement)

in equities ultimately “blew out” the last wall of the domed house - and the chart only shows the early stages.

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18000

1 9 9 6

1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Dow Jones Industrial Average - megaphone pattern since 1996

S o ur c e : Bl o om b e r g ,M o

n um e n t S e c ur i t i e s .



Which perhaps says something about the power of “unconventional” monetary policy?

Similarly, the widely used equity model - ISM manufacturing index versus the year-on-year change in the

S&P 500 – had an excellent long-term track record, but became almost redundant between mid-2012 and

mid-2013. Once again, it was the QE3-related rally which led to the correlation breaking down.

32.0

37.0

42.0

47.0

52.0

57.0

62.0

67.0

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

M a y - 9 9

S e p - 9 9

J a n - 0 0

M a y - 0 0

S e p - 0 0

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

S&P 500 v. ISM

S&P 500 yoy % ISM

S o ur c e : Bl o om b e r g ,M on um e n t S e c ur i t i e s .

S o ur c e : I S M ,Bl o om b e r g ,M on u

m e n t S e c ur i t i e s

S o ur c e : C a r l F u t i a

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1250

1300

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1400

1450

1500

1550

0 1 / 1 2 / 2 0 1 0

2 2 / 1 2 / 2 0 1 0

1 2 / 0 1 / 2 0 1 1

0 2 / 0 2 / 2 0 1 1

2 3 / 0 2 / 2 0 1 1

1 6 / 0 3 / 2 0 1 1

0 6 / 0 4 / 2 0 1 1

2 7 / 0 4 / 2 0 1 1

1 8 / 0 5 / 2 0 1 1

0 8 / 0 6 / 2 0 1 1

2 9 / 0 6 / 2 0 1 1

2 0 / 0 7 / 2 0 1 1

1 0 / 0 8 / 2 0 1 1

3 1 / 0 8 / 2 0 1 1

2 1 / 0 9 / 2 0 1 1

1 2 / 1 0 / 2 0 1 1

0 2 / 1 1 / 2 0 1 1

2 3 / 1 1 / 2 0 1 1

1 4 / 1 2 / 2 0 1 1

0 4 / 0 1 / 2 0 1 2

2 5 / 0 1 / 2 0 1 2

1 5 / 0 2 / 2 0 1 2

0 7 / 0 3 / 2 0 1 2

2 8 / 0 3 / 2 0 1 2

1 8 / 0 4 / 2 0 1 2

0 9 / 0 5 / 2 0 1 2

3 0 / 0 5 / 2 0 1 2

2 0 / 0 6 / 2 0 1 2

1 1 / 0 7 / 2 0 1 2

0 1 / 0 8 / 2 0 1 2

2 2 / 0 8 / 2 0 1 2

1 2 / 0 9 / 2 0 1 2

0 3 / 1 0 / 2 0 1 2

2 4 / 1 0 / 2 0 1 2

1 4 / 1 1 / 2 0 1 2

0 5 / 1 2 / 2 0 1 2

2 6 / 1 2 / 2 0 1 2

1 6 / 0 1 / 2 0 1 3

S&P 500: December 2010 - January 2013



The ISM/S&P 500 model is no longer suggesting that equities are signicantly overvalued. However, that is

thanks to the spike in the ISM which has likely reached its zenith and should roll over shortly (see below).

Polar Opposites - middle of a bull market or imminent peak?

We were intrigued recently how the same data in the form of the 2013 year-to-date chart pattern, were used

to justify polar opposite views for equities, i.e. continuation of a mega-bull market or an imminent crash.

This appealed because our gut feeling is that the reassessment of QE along with the tapering debate is an

important period in the post-Lehman recovery.

Just to illustrate...

The similarity between the US equity market’s performance in 1954 and 1995 with that in 2013 has been

cited by commentators on the bullish tack. 1954 was a great year for equities - not only did the Dow Jones

nally surpass the 1929 all-time high, but the index rose 44.0%.

This comment recently appeared on the Seeking Alpha markets forum.

“The two years that have the highest correlation to 2013 continue to be 1954 and 1995...In the

bigger picture, both 1954 and 1995 were right in the middle of the longest and strongest two

bull markets of the 20th Century. They came nowhere near the end of a bull market. In fact, they

marked the beginning of the longest and strongest growth legs of those two gigantic ‘El Toro

Grande’ bull markets.”

The Dow rose another 19% in 1955 and 24% in 1996 (after 33.3% in 1995).

Meanwhile, bearish commentators have pointed to similarities between the 2013 chart pattern with two

infamous crash years of 1929 and 1987. Despite the similarities, we seem to have avoided the 1987 scenario,

although the 1929 scenario is still “in play”, as Tom DeMark has highlighted recently. We’ve recreated his

chart here.

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0 1 / 0 1 / 1 9 5 4

1 5 / 0 1 / 1 9 5 4

2 9 / 0 1 / 1 9 5 4

1 2 / 0 2 / 1 9 5 4

2 6 / 0 2 / 1 9 5 4

1 2 / 0 3 / 1 9 5 4

2 6 / 0 3 / 1 9 5 4

0 9 / 0 4 / 1 9 5 4

2 3 / 0 4 / 1 9 5 4

0 7 / 0 5 / 1 9 5 4

2 1 / 0 5 / 1 9 5 4

0 4 / 0 6 / 1 9 5 4

1 8 / 0 6 / 1 9 5 4

0 2 / 0 7 / 1 9 5 4

1 6 / 0 7 / 1 9 5 4

3 0 / 0 7 / 1 9 5 4

1 3 / 0 8 / 1 9 5 4

2 7 / 0 8 / 1 9 5 4

1 0 / 0 9 / 1 9 5 4

2 4 / 0 9 / 1 9 5 4

0 8 / 1 0 / 1 9 5 4

2 2 / 1 0 / 1 9 5 4

0 5 / 1 1 / 1 9 5 4

1 9 / 1 1 / 1 9 5 4

0 3 / 1 2 / 1 9 5 4

1 7 / 1 2 / 1 9 5 4

3 1 / 1 2 / 1 9 5 4

Dow Jones Industrial Average: 1954 v. 2013

1954 2013 (sin ce 11 Dec 2012)




Policy makers are pushing monetary systems and experimental policies to their limit, so shouldn’t we

consider the possibility of correspondingly extreme outcomes in nancial markets in due course...

cause and effect?

No Plan B?

After Lehman, policy makers went “all-in” on bailouts/ZIRP/QE etc. This avoided an “all-out” collapse and

bought time in which a self-sustaining recovery could materialise. The Fed’s tapering threat showed that,

ve years on from Lehman, the recovery was still not self-sustaining. Our study of long-wave (Kondratieff)

cycles, however, leaves us concerned as to whether it ever will be. More commentators are having doubts,

e.g. Andrew Law of Caxton in the recent FT interview. The problem looming into view is that we might need

a new “plan.”

Does the incoming Fed Chairwoman have a new plan and, more importantly, one which could work? We have

our doubts, the default strategy being continued reliance on liquidity-driven asset bubbles, while hoping for

the best in terms of traction with the real economy. Our colleague, Andy Ash, commented last week.

“The biggest impact of QE1 was on metals and EM (emerging markets) indicating that the result

of QE was predicted to be growth. The three lowest beneciaries of QE3 have been Gold , Metals

and EM, all SIZEABLY NEGATIVE IN RETURNS. So QE3’s effect unlike QE1’s has been nothing to do

with global growth. The biggest return on QE3 was/is Western equities.”

If the US is locked into low growth for the foreseeable future, should the S&P 500 be trading on a 12-month

forward earnings multiple of 16.2x, slightly higher than the 15.5x long-term average? Let’s not forget that

Europe appears to be stuck in an even lower growth scenario and China’s growth rate is moderating. Moreover,

corporate margins are close to an all-time high and earnings forecasts are being progressively downgraded.

So higher and higher valuations for more distant, and (arguably) increasingly uncertain, cash ows.

With the temporary deal agreed in Washington, QE looks set to continue running at US$85bn until March

2014, maybe longer. We’ve written about the QE/repo linkage a lot in recent months and it’s our opinion that

the collateralisation of excess deposits created by QE has positively impacted equities via shadow bankingconduits, e.g. repos.

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0 3 / 0 1 / 1 9 2 8

0 3 / 0 2 / 1 9 2 8

0 3 / 0 3 / 1 9 2 8

0 3 / 0 4 / 1 9 2 8

0 3 / 0 5 / 1 9 2 8

0 3 / 0 6 / 1 9 2 8

0 3 / 0 7 / 1 9 2 8

0 3 / 0 8 / 1 9 2 8

0 3 / 0 9 / 1 9 2 8

0 3 / 1 0 / 1 9 2 8

0 3 / 1 1 / 1 9 2 8

0 3 / 1 2 / 1 9 2 8

0 3 / 0 1 / 1 9 2 9

0 3 / 0 2 / 1 9 2 9

0 3 / 0 3 / 1 9 2 9

0 3 / 0 4 / 1 9 2 9

0 3 / 0 5 / 1 9 2 9

0 3 / 0 6 / 1 9 2 9

0 3 / 0 7 / 1 9 2 9

0 3 / 0 8 / 1 9 2 9

0 3 / 0 9 / 1 9 2 9

0 3 / 1 0 / 1 9 2 9

0 3 / 1 1 / 1 9 2 9

0 3 / 1 2 / 1 9 2 9

0 3 / 0 1 / 1 9 3 0

0 3 / 0 2 / 1 9 3 0

0 3 / 0 3 / 1 9 3 0

0 3 / 0 4 / 1 9 3 0

Dow Jones Industrial Average: 1928-30 v. 2012-13

Jan 1928 - A pr 1930 May 2012 - Oc t 2013




Even the US Treasury (Treasury Borrowing Advisory Committee report for Q2 2013) noted the correlation

between weeks when QE exceeded US$5bn and strength in the S&P 500.

Have we really got to the point where it’s just about more and more QE, corralling more and more ow into

the equity market until it becomes (unsustainably) “top-heavy”?

Trying to Make Sense of Bubbles

If we are in a centrally-planned bubble (and it feels like it to us), we are reliant on second guessing policy-

makers, trying to gauge ows (positive for equities right now) and utilising any indicators which seem to be

showing good correlations. An example of the latter is the Summation Index. This is a measure of market

breadth, being a running total of Advance minus Decline values of the McClellan Oscillator. A pattern of

declining peaks had formed since the correction in late-May, but this reversed with the recent upward move.

S o ur c e : F

e d e r a l R e s e r v e ,M on um e n t S e c ur i t i e s

S o ur c e : T BA C

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M a r 0 9

A p r - 0 9

M a y - 0 9

J u n - 0 9

J u l - 0 9

A u g - 0 9

O c t - 0 9

N o v - 0 9

D e c - 0 9

J a n - 1 0

F e b - 1 0

M a r - 1 0

A p r - 1 0

J u n 1 0

J u l - 1 0

A u g - 1 0

S e p - 1 0

O c t - 1 0

N o v - 1 0

D e c - 1 0

F e b - 1 1

M a r - 1 1

A p r - 1 1

M a y - 1 1

J u n - 1 1

J u l - 1 1

S e p - 1 1

O c t - 1 1

N o v - 1 1

D e c - 1 1

J a n - 1 2

F e b - 1 2

M a r - 1 2

M a y - 1 2

J u n - 1 2

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

S&P 500 v. Deposits minus Loans ("deposit to loan gap" in banks from QE)

S&P 500 Deposits - Loans: All Commercial Banks (US$bn)



We are still in the biggest debt crisis in history and the banking sector will remain at the centre of its ebbs and

ows. The divergence of the sector’s performance from the broader market pre-empted the Lehman collapse

in 2008. In the US, we are keeping a close eye on the breakdown in the BKX.

There is a similar story in the UK.

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A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

S&P 500 v. Summation Index

S&P 500 Summation Index

0.030

0.032

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0.040

J a n - 1 2

F e b - 1 2

M a r - 1 2

A p r - 1 2

M a y - 1 2

J u n - 1 2

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

BKX Banks Index relative to S&P 500

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1.15

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J a n - 1 2

F e b - 1 2

M a r - 1 2

A p r - 1 2

M a y - 1 2

J u n - 1 2

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

FTSE Banks v. FTSE All Share



S o ur c e : Bl o om b e r g ,M on um

e n t S e c ur i t i e s .



In such extreme circumstances, we should also keep an idea of “crash patterns” in the back of our minds in

case. These often play out as a peak followed by a failure to make a new high and a subsequent break of

support. Here are some notable examples.

And we can compare these with the year-to-date chart for the S&P 500 (which is currently leading the Dow).

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1 0 /0 4 /1 9 29 1 0 /0 5 /1 92 9 1 0 /0 6 /1 9 29 1 0 /0 7 /1 9 29 1 0/ 08 /1 9 29 1 0/ 09 /1 92 9 1 0/ 10 /1 9 29 1 0 /1 1/ 19 2 9 1 0/ 12 /1 92 9

Dow Jones Industrial Average: 1929 (Apr-Dec)

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0 1/ 04 /1 9 87 0 1 /0 5 /1 9 87 0 1/ 06 /1 9 87 0 1 /0 7 /1 9 87 0 1/ 08 /1 9 87 0 1 /0 9 /1 98 7 0 1/ 10 /1 98 7 0 1 /1 1 /1 98 7 0 1/ 12 /1 98 7

Dow Jones Industrial Average: 1987 (Apr-Dec)

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0 1/ 09 /1 9 99 0 1/ 10 /1 9 99 0 1 /1 1 /1 99 9 0 1 /1 2/ 19 9 9 0 1/ 01 /2 0 00 0 1 /0 2 /2 00 0 0 1 /0 3 /2 0 00 0 1/ 04 /2 00 0 0 1/ 05 /2 0 00

NASDAQ Composite: 1999-2000 (Sept-May)

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0 3 /0 3 /2 0 0 8 0 3 /0 4 /2 0 0 8 0 3 /0 5 /2 0 0 8 0 3 /0 6 /2 0 0 8 0 3 /0 7 /2 0 0 8 0 3 /0 8 /2 0 0 8 0 3 /0 9 /2 0 0 8 0 3 /1 0 /2 0 0 8 0 3 /1 1 /2 0 0 8 0 3 /1 2 /2 0 0 8

Dow Jones Industrial Average: 2008 ( Mar-Dec)

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02/01/2013 02/02/2013 02/03/2013 02/04/2013 02/05/2013 02/06/2013 02/07/2013 02/08/2013 02/09/2013 02/10/2013

S&P 500: 2003 year-to-date

S o ur c e : Bl o om b e r g ,M

on um e n t S e c ur i t i e s .

S o ur c

e : Bl o om b e r g ,M on um e n t S e c ur i t i e s .



If there’s one market that makes us very nervous right now (hat tip to Ben Davies of Hinde Capital), it’s the

ChiNext...”a NASDAQ-type exchange for high-growth, high-tech start-ups” (Wikipedia). Besides the pattern,

it’s also risen by 110% since last November.

A nal word on equity market indicators. In our reports since May, we’ve been “road-testing” a model for the

US equity market (using the DJIA which has a longer history). It is based on cycles, not economic indicators,

but cycles in time. It is created from the interaction of 18 cycles in US equities. These vary in length from

just under 3 months to more than 30 years. Most of these cycles were discovered by the Foundation for the

Study of Cycles (FSC), which has published a vast body of work during the last 70 years. We’d like to make

contact with any readers who’ve also looked into this type of work, as trying to incorporate it into our research

is very much work in progress.

While in its very early days, the model has been a reasonably good predictor of market direction since the

beginning of 2009 (having also picked out most of the market peaks and troughs since 1905). We are slightly

alarmed because it’s predicting that the Dow should be rolling over now into the rst part of 2014.

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1500

01/03 /2013 01/04 /2013 01/0 5/201 3 01/0 6/2013 01/07/201 3 01/0 8/201 3 01/0 9/2013 01/10/201 3

ChiNext: 2013 (Mar-Oct)

0.973

0.978

0.983

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1.008

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2 0 0 9 - 0 1 - 0 2

2 0 0 9 - 0 3 - 0 2

2 0 0 9 - 0 5 - 0 2

2 0 0 9 - 0 7 - 0 2

2 0 0 9 - 0 9 - 0 2

2 0 0 9 - 1 1 - 0 2

2 0 1 0 - 0 1 - 0 2

2 0 1 0 - 0 3 - 0 2

2 0 1 0 - 0 5 - 0 2

2 0 1 0 - 0 7 - 0 2

2 0 1 0 - 0 9 - 0 2

2 0 1 0 - 1 1 - 0 2

2 0 1 1 - 0 1 - 0 2

2 0 1 1 - 0 3 - 0 2

2 0 1 1 - 0 5 - 0 2

2 0 1 1 - 0 7 - 0 2

2 0 1 1 - 0 9 - 0 2

2 0 1 1 - 1 1 - 0 2

2 0 1 2 - 0 1 - 0 2

2 0 1 2 - 0 3 - 0 2

2 0 1 2 - 0 5 - 0 2

2 0 1 2 - 0 7 - 0 2

2 0 1 2 - 0 9 - 0 2

2 0 1 2 - 1 1 - 0 2

2 0 1 3 - 0 1 - 0 2

2 0 1 3 - 0 3 - 0 2

2 0 1 3 - 0 5 - 0 2

2 0 1 3 - 0 7 - 0 2

2 0 1 3 - 0 9 - 0 2

2 0 1 3 - 1 1 - 0 2

2 0 1 4 - 0 1 - 0 2

Dow Jones Industrial Average: actual versus predicted 2009-13

Actual Predicted





While this ts with our current view of the fundamentals (see below), it obviously ies in the face of the trend,

“risk-on” sentiment and, most importantly perhaps, the continuation of US$85bn per month of QE for now.

Please note: the Y-axes on the above chart do not represent absolute levels for the Dow. Rather, the left

hand Y-axis represents the Dow Jones versus a moving average and the right hand Y-axis is a measure of the

amplitude in the predicted trend.

Buying time in a brought forward world

Manipulating the Time Horizon

We’ve been reecting on the idea that using unconventional monetary policies, i.e. QE at the long end of the

yield curve, central banks have “bought time” in a profound sense by manipulating the time horizon. This

leads to longer-term cash ows associated with nancial assets being discounted at articially low rates.

It has been crossing our minds as to how much equity investors have really considered this issue, even if (like

us) they are believers in equities overcoming bonds in the inationary endgame (see “Inationary Deation”

report from December 2012?

Fixed income investors are acutely aware that QE has forced them to extend duration. That comes with the

scary knowledge that they might all rush for the exit at the same time. While many nancial assets have long

duration, equities have very long “duration,” often reecting theoretical cash ows to innity.

Equity investors typically make detailed estimates for corporate cash ows, e.g. for 7-10 years. Beyond that,

cash ows to innity are capitalised (using long-term growth rate assumptions, ROIC fades, etc) in the form

of terminal values...or until analysts predict that the deposit/reservoir will be depleted in the case of mining/

energy stocks. QE obviously keeps rates lower than they would otherwise be and increases the value of these

capitalised cash ows - especially more distant ones.

When we think about long-term economic cycles, one of (if not) the biggest single driver is the growth in debt

(and, problematically, its eventual reduction at the end of the cycle). If we consider the US economy, the huge

increase in debt has brought forward consumption over an extended period of several decades. That process

has become increasingly “long in the tooth”, so it’s hardly surprising that credit and consumption growth is

currently subdued.

When so much consumption has already been “brought forward”, it might seem counter-intuitive that the

valuation of distant cash ows is being inated via PEs above their historic average AND articially suppressed

interest rates. When you also consider that corporate margins are close to a historic peak, the market takes

on the appearance of an athlete that is expected to continue performing at peak level almost indenitely.

Hmmm, as Grant (“Things That Make You Go Hmmm”) Williams might say.

It Should Work Both Ways

In a world of US$85bn per month QE, the corollary of the discussion above should be that the valuation of

long duration nancial assets should be unusually sensitive on the downside to anything that threatens this

current “buying time” and “brought forward” model for long-term nancial assets. The obvious candidates

are:

• A rise in interest rates; and/or

• An event which leads to a signicant contraction in the time horizon for investors, such as a sudden

deterioration in the macro outlook, or a geo-political shock.



The market turmoil induced by Bernanke and his colleagues with the taper threat (quickly watered down and

subsequently canned) seems entirely tting in this light. The consequence is that the Fed’s ability to taper

looks ever more serious with regard to asset prices. This is the two-way version of the “Stockholm syndrome”

between the Fed and markets we’ve highlighted before.

Boxed in?

In our July 2013 report, we noted the “spectacular irony” that Bernanke’s plan to taper directly contradicted

his criticism (in the “Money, Gold and the Great Depression” speech from March 2004) of the Federal Reserve

policy in the Great Depression era of the 1930s. We noted (with our emphasis).

“Each mistake Bernanke highlighted during 1928-33 involved a tightening of monetary policy,

exactly as the Fed has proposed recently. However, the real irony is the manner in which the Fed

tightened monetary policy in 1932 VIA THE REVERSAL OF OPEN-MARKET OPERATIONS, basically

reducing QE.”

Reversing the open market operations in 1932 caused interest rates to rise and Bernanke was scathing in his

criticism.

“These policymakers did not appear to appreciate that, even though nominal interest rates were

very low, the ongoing deation meant that the real cost of borrowing was very high because any

loans would have to be repaid in dollars of much greater value.”

Below is the trend in real long-term US rates (Barclays US Ination linked 7-10 years average real yield) –

which haven’t reversed all the increase since the possibility of tapering was oated and subsequently shelved.

Given the contradiction with Bernanke’s “doctrine”, we are slightly more sympathetic now with the view from

a “down the rabbit hole” source who explained that the reason for the Fed oating the idea of tapering was

to “test” the resilience of the nancial system. It appears to have failed that test. Boxed in?

Theme: Essential Goods & ServicesIf many long duration nancial assets are, indeed, moving into bubble territory, it’s been crossing our minds

to ask whether assets at the short end of the duration spectrum are becoming structurally undervalued?

-1.50

-1.00

-0.50

0.00

0.50

1.00

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

Barclays US Inflation linked 7-10 years real yield (%)




It’s amusing to turn over in your mind the idea that a 3-month German Treasury Bill, on a yield of 3 basis

points, could be “cheap”. The answer is obviously “yes” in an unfolding crisis (contraction in time horizon) and

these Bills traded on -20.5 basis points before Draghi threatened to do “whatever it takes” to save the Euro

(just as Spanish 10-year yields were spiking to 7.62%).

What about commodities which are both staples and perishable. Like the raw material for bread, for example?

Aside from “assets”, what about the idea of goods in terms of short “duration”?

This is Wikipedia on fast moving consumer goods (FMCG)...

“The term FMCGs refers to those retail goods that are generally replaced or fully used up over a

short period of days, weeks, or months, and within one year. Examples include non-durable goods

such as soft drinks, toiletries, etc, and grocery items...Fast-moving consumer electronics are atype of FMCG and are typically low priced, generic or easily substitutable consumer electronics,

including mobile phones, MP3 players, game players, and digital cameras...Global leaders in the

FMCG segment include Johnson & Johnson, Colgate-Palmolive, Anheuser-Busch InBev, Henkel,

-0.40

0.00

0.40

0.80

1.20

1.60

2.00

2.40

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Germany: 3-month Treasury Bill

300

400

500

600

700

800

900

1000

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Wheat (Active contract)





Kellogg’s, S.C. Johnson, Beiersdorf, Mars Inc., Heinz, Nestle, Reckitt Benckiser, Unilever, Procter

& Gamble, L’Oreal, Coca-Cola, General Mills Inc., PepsiCo, Mondelez and Kraft Foods.”

In the “Inationary Deation” report referred to earlier, we set out our long-term investment strategy. We

argued that as pressure on consumers intensies, equity portfolios should be progressively aligned towards

stocks which are relative beneciaries of the shifts in real disposable income. In general, we favour companies

supplying ESSENTIAL ITEMS AND SERVICES as we expect that these expenditures will account for a growing

share of the “economic pie” in future.

In thematic terms, many of the sectors we highlighted:

• Food/agriculture;

• Energy;

• Personal & household care;

• Healthcare;

• Mobile telephony & networking; and

• Defence (for governments).

Are, in fact, skewed towards faster moving consumer goods.

Some analysts seem to be thinking along similar lines. We were interested to read Sandeep Jaitly’s (of Fekete

Research and portfolio manager at First International) latest “Course of the Exchange” report in which he

argued in typically forceful fashion.

“When it comes to the picking of stocks going forward to capture this expected nominal rally

in the global equity exchanges – the concept of marketability must always be borne in mind.

Companies that produce the most marketable goods – such as Procter & Gamble, or Unilever –

will always have a ready market for their equity. However, it’s a question of the denomination of

this ready market as at squeezes such stocks into being hoarded just like gold. Some companies

which are just capitalised claims to at – such as banking or insurance shares – will lose all

relative exchange value at some point compared to the companies that produce marketable goods

of various shades.”

By “marketable”, he means acceptable. This brings gold to mind as a universally accepted currency and

store of wealth. Professor Fekete argues that the marginal utility of gold declines more slowly than any other

substance. I think this is relevant to the discussion about time horizons/duration but I need to think more

about it.

Is the cycle slowing again?

Slowdown versus 2004-05 style Mid-Cycle Acceleration

Sticking with our defensive theme, we are concerned that the rebound in global growth is about to level off

once again, likely driven by more subdued activity in the US and a stabilisation of the Eurozone recovery.

Our biggest fear is that the US consumer, so often the saviour of global growth, is really starting to struggle,

although pressure on real incomes is a much broader international theme.

We should preface this view by admitting how surprised we were by the strength of the ISM manufacturing

survey in recent months.



The ISM has risen by 7.2 points during the last four months (June to September 2013) from 49.0 to 56.2.

It’s worth putting such a strong rise in context. In the almost 24 years (285 months) since 1990, such a

strong (or stronger) rise has only happened on 15 occasions, or 5.2% of the time. Of these, 11 were within

six months of the ofcial end of a recession, i.e. when the economy was undoubtedly in recovery/bounce back

mode. Currently, we are more than four years away from the end of the last recession in June 2009.

The other four “mid-cycle” occasions were May 1992, June 1996, November 2003 and January 2004.

The key question is whether the ISM is signalling a “mid-cycle” acceleration in US growth this time? Let’s

consider the four previous occasions.

Within four months of May 1992, the ISM had fallen back by 6.0 points to 49.7. The month after June 1996,

the ISM was back below 50.0 at 49.7 and did not exceed the June 1996 level for six months. So on two of

these four occasions, things began to slow down shortly afterwards.

The exceptions were November 2003 and January 2004. The ISM peaked at 60.8 in January 2004 andremained remarkably strong (above 55.0) through to March 2005. The November 2003 and January 2004

ISM readings pre-empted the strongest period of US GDP growth between the 2001 and 2007-09 recessions

– a genuine mid-cycle acceleration.

30.0

35.0

40.0

45.0

50.0

55.0

60.0

65.0

J a n - 9 0

A u g - 9 0

M a r - 9 1

O c t - 9 1

M a y - 9 2

D e c - 9 2

J u l - 9 3

F e b - 9 4

S e p - 9 4

A p r - 9 5

N o v - 9 5

J u n - 9 6

J a n - 9 7

A u g - 9 7

M a r - 9 8

O c t - 9 8

M a y - 9 9

D e c - 9 9

J u l - 0 0

F e b - 0 1

S e p - 0 1

A p r - 0 2

N o v - 0 2

J u n - 0 3

J a n - 0 4

A u g - 0 4

M a r - 0 5

O c t - 0 5

M a y - 0 6

D e c - 0 6

J u l - 0 7

F e b - 0 8

S e p - 0 8

A p r - 0 9

N o v - 0 9

J u n - 1 0

J a n - 1 1

A u g - 1 1

M a r - 1 2

O c t - 1 2

M a y - 1 3

US: ISM Manufacturing Index (since 1990)

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

J a n - 9 0

A u g - 9 0

M a r - 9 1

O c t - 9 1

M a y - 9 2

D e c - 9 2

J u l - 9 3

F e b - 9 4

S e p - 9 4

A p r - 9 5

N o v - 9 5

J u n - 9 6

J a n - 9 7

A u g - 9 7

M a r - 9 8

O c t - 9 8

M a y - 9 9

D e c - 9 9

J u l - 0 0

F e b - 0 1

S e p - 0 1

A p r - 0 2

N o v - 0 2

J u n - 0 3

J a n - 0 4

A u g - 0 4

M a r - 0 5

O c t - 0 5

M a y - 0 6

D e c - 0 6

J u l - 0 7

F e b - 0 8

S e p - 0 8

A p r - 0 9

N o v - 0 9

J u n - 1 0

J a n - 1 1

A u g - 1 1

M a r - 1 2

O c t - 1 2

M a y - 1 3

US: 4-month change in ISM Manufacturing Index (since 1990)

S o ur c e : I S M ,M on um e n t S e c ur i t i e s

S o ur c e : I S M ,M on um e n t S e c ur i t i e s



Is a pick-up in growth like 2004-05 in store this time? We think it’s unlikely and it’s worth comparing current

trends with 2004-05. First, let’s highlight one issue which could have given the ISM a temporary boost. Some

keen observers noted a surge in aerospace orders in June as the supply chain geared up.

Surging aerospace orders did not only benet the US. We also saw a stronger-than-expected rebound in

German manufacturing orders in June following the Paris Air Show.

Alcoa led off the current earnings season and we were very interested in what the company said about trends

in aerospace. Here are a couple of quotes on the fourth quarter outlook from the results presentation:

“Aero plate shipments continue to be impacted by high OEM inventories”

And:

“Aerospace remains strong, temporarily impacted by engine market inventory realignment and

lower U.S. Defense spare parts demand”

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

US Real GDP growth (yoy %)

0

5000

10000

15000

20000

25000

30000

35000

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

US Durable Goods Orders - Aircraft & Parts (US$m)

S o ur c e : BE A

S o ur c e : U S C e n s u s B ur e a u



With something of a “softer spot” for aerospace coming in Q4, it looks like we should expect those strong ISM

numbers to roll over.

Aerospace aside, let’s consider other indicators of US economic strength and compare them (where possible)

with 2004-05 when we experienced a prolonged mid-cycle acceleration in growth. The current situation is

very different in our view.

The US is a credit-driven economy and household debt growth is non-existent right now, but was running at

double-digit rates during 2004-05.

Outstanding balances on credit cards tend to grow during buoyant economic periods. Current growth is non-

existent compared with the acceleration from c.2% in early 2004 to a peak of 12% in late-2006.

Growth in personal consumption expenditure is also in the doldrums compared with 6-7% growth during

much of 2004-05

-5%

0%

5%

10%

15%

20%

Q 1 1 9 6 1

Q 1 1 9 6 2

Q 1 1 9 6 3

Q 1 1 9 6 4

Q 1 1 9 6 5

Q 1 1 9 6 6

Q 1 1 9 6 7

Q 1 1 9 6 8

Q 1 1 9 6 9

Q 1 1 9 7 0

Q 1 1 9 7 1

Q 1 1 9 7 2

Q 1 1 9 7 3

Q 1 1 9 7 4

Q 1 1 9 7 5

Q 1 1 9 7 6

Q 1 1 9 7 7

Q 1 1 9 7 8

Q 1 1 9 7 9

Q 1 1 9 8 0

Q 1 1 9 8 1

Q 1 1 9 8 2

Q 1 1 9 8 3

Q 1 1 9 8 4

Q 1 1 9 8 5

Q 1 1 9 8 6

Q 1 1 9 8 7

Q 1 1 9 8 8

Q 1 1 9 8 9

Q 1 1 9 9 0

Q 1 1 9 9 1

Q 1 1 9 9 2

Q 1 1 9 9 3

Q 1 1 9 9 4

Q 1 1 9 9 5

Q 1 1 9 9 6

Q 1 1 9 9 7

Q 1 1 9 9 8

Q 1 1 9 9 9

Q 1 2 0 0 0

Q 1 2 0 0 1

Q 1 2 0 0 2

Q 1 2 0 0 3

Q 1 2 0 0 4

Q 1 2 0 0 5

Q 1 2 0 0 6

Q 1 2 0 0 7

Q 1 2 0 0 8

Q 1 2 0 0 9

Q 1 2 0 1 0

Q 1 2 0 1 1

Q 1 2 0 1 2

Q 1 2 0 1 3

Household debt growth yoy % (1961-2013)

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

J a n - 9 0

A u g - 9 0

M a r - 9 1

O c t - 9 1

M a y - 9 2

D e c - 9 2

J u l - 9 3

F e b - 9 4

S e p - 9 4

A p r - 9 5

N o v - 9 5

J u n - 9 6

J a n - 9 7

A u g - 9 7

M a r - 9 8

O c t - 9 8

M a y - 9 9

D e c - 9 9

J u l - 0 0

F e b - 0 1

S e p - 0 1

A p r - 0 2

N o v - 0 2

J u n - 0 3

J a n - 0 4

A u g - 0 4

M a r - 0 5

O c t - 0 5

M a y - 0 6

D e c - 0 6

J u l - 0 7

F e b - 0 8

S e p - 0 8

A p r - 0 9

N o v - 0 9

J u n - 1 0

J a n - 1 1

A u g - 1 1

M a r - 1 2

O c t - 1 2

M a y - 1 3

US revolving credit outstanding (yoy %)

S o ur c e : F e d e r a l R e s e r v e

S o ur c e : F e d e r a l R e s e r v e



The University of Michigan’s Consumer Condence survey remains below late-2003/early-2004 levels.

A thriving small business culture is usually associated with a vibrant economy. The NFIB Small Business

Optimism Index has recovered since the crisis but remains well below the peak levels reached in 2004-05.

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

US: Personal consumption expenditure (yoy %)

80

85

90

95

100

105

110

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

NFIB Small Business Optimism Index

50

60

70

80

90

100

110

120

J a n - 9 5

J u n - 9 5

N o v - 9 5

A p r - 9 6

S e p - 9 6

F e b - 9 7

J u l - 9 7

D e c - 9 7

M a y - 9 8

O c t - 9 8

M a r - 9 9

A u g - 9 9

J a n - 0 0

J u n - 0 0

N o v - 0 0

A p r - 0 1

S e p - 0 1

F e b - 0 2

J u l - 0 2

D e c - 0 2

M a y - 0 3

O c t - 0 3

M a r - 0 4

A u g - 0 4

J a n - 0 5

J u n - 0 5

N o v - 0 5

A p r - 0 6

S e p - 0 6

F e b - 0 7

J u l - 0 7

D e c - 0 7

M a y - 0 8

O c t - 0 8

M a r - 0 9

A u g - 0 9

J a n - 1 0

J u n - 1 0

N o v - 1 0

A p r - 1 1

S e p - 1 1

F e b - 1 2

J u l - 1 2

D e c - 1 2

M a y - 1 3

O c t - 1 3

US Consumer Confidence (UoM)

S o ur c e : BE A

S o ur c e : Uni v e r s i t y of Mi c h i g a n

S o ur c e : NF I B ,M on um e n t S e c ur i t i e s .



Then there’s the much vaunted housing recovery which appears to have slowed in response to the rates

spike. If it is in its early stages, which we doubt, it still has a long way to go before we return to the heady

days during the middle of the last decade.

If there is a catalyst out there which will drive a mid-cycle acceleration in US GDP growth, we are nding it

hard to see right now.

The US Consumer

The above discussion on US economic prospects makes us concerned about the prospects for the US

consumer...especially when consumer discretionary stocks have seen an almost unbroken ve-year run of

outperformance.

On the subject of the US economy and the health of US consumers, there’s an indicator (we wish we could

remember where we rst saw it - please contact us if you are the creator for delayed attribution) which is

ashing a RARE warning sign right now. This is shown in the chart below which shows a moving average of

Real Personal Income minus Current Transfer Payments (RPI-CTP).

100

150

200

250

300

350

400

450

500

550

0

500

1000

1500

2000

2500

J a n

- 0 1

M a y

- 0 1

S e p

- 0 1

J a n

- 0 2

M a y

- 0 2

S e p

- 0 2

J a n

- 0 3

M a y

- 0 3

S e p

- 0 3

J a n

- 0 4

M a y

- 0 4

S e p

- 0 4

J a n

- 0 5

M a y

- 0 5

S e p

- 0 5

J a n

- 0 6

M a y

- 0 6

S e p

- 0 6

J a n

- 0 7

M a y

- 0 7

S e p

- 0 7

J a n

- 0 8

M a y

- 0 8

S e p

- 0 8

J a n

- 0 9

M a y

- 0 9

S e p

- 0 9

J a n

- 1 0

M a y

- 1 0

S e p

- 1 0

J a n

- 1 1

M a y

- 1 1

S e p

- 1 1

J a n

- 1 2

M a y

- 1 2

S e p

- 1 2

J a n

- 1 3

M a y

- 1 3

S e p

- 1 3

Housing Starts and MBA Mortgage Purchase Index

Housing Starts (000s) MBA Mortgage Purchase Index

0.16

0.18

0.20

0.22

0.24

0.26

0.28

0.30

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

S&P Consumer Discretionary / S&P 500

S o ur c e : MBA ,M on um e n t S e c ur i t

i e s .

S o ur c e : Bl o om b e r g ,M on um e

n t S e c ur i t i e s .



Please note that recessions are marked with red boxes. Before now, there has only been one instance when

this indicator turned negative without the US being in recession since 1980.

Historically, RPI-CTI also correlated fairly well with S&P 500 Consumer Discretionary relative to S&P 500

Consumer Staples. In a directional sense, it broke down in 2011 as CD stocks continued to power ahead. This

trend is beginning to look very extended.

Time for a more defensively-oriented sector rotation?

The Picture Outside the US

If the US seems more subdued than the consensus believes, and a mid-cycle acceleration is questionable,

what about the global picture?

Although the global manufacturing PMI has picked up somewhat, the current reading is almost identical to

trough readings during 2004-05!

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

J a n - 8 0

O c t - 8 0

J u l - 8 1

A p r - 8 2

J a n - 8 3

O c t - 8 3

J u l - 8 4

A p r - 8 5

J a n - 8 6

O c t - 8 6

J u l - 8 7

A p r - 8 8

J a n - 8 9

O c t - 8 9

J u l - 9 0

A p r - 9 1

J a n - 9 2

O c t - 9 2

J u l - 9 3

A p r - 9 4

J a n - 9 5

O c t - 9 5

J u l - 9 6

A p r - 9 7

J a n - 9 8

O c t - 9 8

J u l - 9 9

A p r - 0 0

J a n - 0 1

O c t - 0 1

J u l - 0 2

A p r - 0 3

J a n - 0 4

O c t - 0 4

J u l - 0 5

A p r - 0 6

J a n - 0 7

O c t - 0 7

J u l - 0 8

A p r - 0 9

J a n - 1 0

O c t - 1 0

J u l - 1 1

A p r - 1 2

J a n - 1 3

Real personal income less current transfer receipts per capita (3m m.a.)

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

RPI - CTR v. S&P 500 Consumer Discretionary / Consumer Staples

Real Personal Income -Current Transfer Receipts S&P 500 Consumer Discretionary / Consumer Staples

S o ur c e : C onf e r e n c e B o a r d

S o ur c e : C onf e r e n c e B o a r d ,Bl o om b e r g



World trade was much stronger then.

In late-2003/early-2004, Dr Copper’s price was poised for a parabolic rise from US$2,300/tonne to US$8,800/

tonne in the rst half of 2006.

30

35

40

45

50

55

60

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

Global manufacturing PMI

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

Developed world imports & BRICS exports (% y-o-y)

Developed world impor ts BRIC S expor ts

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Copper LME (US$/tonne)

S o ur c e : M a r k i t . c om ,M on um e n t S e c ur i t i e s

S o ur c e : M on um e n t S e c ur i t i e s

S o ur c e : Bl o om b e r g ,M on um e n t S

e c ur i t i e s .



Chinese real GDP growth was ramping up into the 10-12% p.a. range, not stabilising in the 7-8% p.a. range.

When the Chinese government attempted to crack down on the shadow banking system in May/June 2013,

the economy seemed briey to go into freefall. Simon Hunt of Simon Hunt Strategic Services is the best

commentator on China that we’ve found. He noted recently.

“To stabilise the economy, government had to turn to the SOE sector in the process liquefying

many local governments with credit being issued directly by banks such as the China Development

Bank. We understand that these credit lines do not get captured in ofcial credit statistics. As a

result, the economy went from weakening to recovering in the space of a few weeks in July as

friends in the economic trenches told us.”

Year-on-year growth in iron ore imports rebounded sharply in July 2013 after the decline in June - these

months are highlighted in the chart below.

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

China Real GDP growth (yoy %)

50

55

60

65

70

75

J a n - 1 2

F e b - 1 2

M a r - 1 2

A p r - 1 2

M a y - 1 2

J u n - 1 2

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

China Iron Ore imports since January 2012 (m tonnes)

S o ur c e : C h i n a N a t i on a l B ur e a u of S t a t i s t i c s

S o

ur c e : C h i n a N a t i on a l B ur e a u of S t a t i s t i c s



After the May/June 2013 experience, we expect the Chinese authorities to adopt a more “softly softly”

approach to discourage excessive credit creation in shadow banking. The next chart puts the recent rise in

7-day repo rates in context.

In Simon Hunt’s view:

“The economy has stabilised; a cyclical recovery is underway but without structural reforms it is

unsustainable“

Fears about the ChiNext market aside, we subscribe to this view and see the likelihood of reasonable growth

continuing in China into the year-end and possibly early 2014. The HSBC/Markit Flash PMI for October

2013 showed another modest improvement to 50.9 from 50.2, while the latest ofcial PMI for new orders

(September 2013) showed the strongest reading since April 2012.

0.00

2.00

4.00

6.00

8.00

10.00

12.00

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

China Interbank 7-day Repo (%)

30

35

40

45

50

55

60

65

70

J a n - 0 6

M a r - 0 6

M a y - 0 6

J u l - 0 6

S e p - 0 6

N o v - 0 6

J a n - 0 7

M a r - 0 7

M a y - 0 7

J u l - 0 7

S e p - 0 7

N o v - 0 7

J a n - 0 8

M a r - 0 8

M a y - 0 8

J u l - 0 8

S e p - 0 8

N o v - 0 8

J a n - 0 9

M a r - 0 9

M a y - 0 9

J u l - 0 9

S e p - 0 9

N o v - 0 9

J a n - 1 0

M a r - 1 0

M a y - 1 0

J u l - 1 0

S e p - 1 0

N o v - 1 0

J a n - 1 1

M a r - 1 1

M a y - 1 1

J u l - 1 1

S e p - 1 1

N o v - 1 1

J a n - 1 2

M a r - 1 2

M a y - 1 2

J u l - 1 2

S e p - 1 2

N o v - 1 2

J a n - 1 3

M a r - 1 3

M a y - 1 3

J u l - 1 3

S e p - 1 3

China: Official PMI - new orders

S o ur c e : Bl o om b e r g ,M on um e n t S e c ur i t

i e s .

S o ur c e : C h i n a F L P



If the US looks set to weaken, while China should be okay for a few months, what about the other key

variable, i.e. Europe? We think that the strong rebound since the Spring will have levelled off by early 2014.

The Eurozone Composite Flash PMI fell marginally from 52.2 (27-month high) to 51.5 in October.

Our economist, Stephen Lewis, also noted that:

“In any case, the ‘hard’ data have started to lag the survey evidence of recovery. The euro zone’s

industrial production in July and August was, on average, marginally below the Q2 level, which

had been 0.7% higher than the Q1 average.”

We are still waiting for some signs of a pick-up in credit growth across the region as a whole - September

2013 was -0.1%.

The acceleration in Eurozone M1 growth which preceded this year’s rebound in GDP has attened off. Basedon the historic correlation, GDP growth itself should level off in January/February of 2014.

30

35

40

45

50

55

60

65

M a y - 0 5

A u g - 0 5

N o v - 0 5

F e b - 0 6

M a y - 0 6

A u g - 0 6

N o v - 0 6

F e b - 0 7

M a y - 0 7

A u g - 0 7

N o v - 0 7

F e b - 0 8

M a y - 0 8

A u g - 0 8

N o v - 0 8

F e b - 0 9

M a y - 0 9

A u g - 0 9

N o v - 0 9

F e b - 1 0

M a y - 1 0

A u g - 1 0

N o v - 1 0

F e b - 1 1

M a y - 1 1

A u g - 1 1

N o v - 1 1

F e b - 1 2

M a y - 1 2

A u g - 1 2

N o v - 1 2

F e b - 1 3

M a y - 1 3

A u g - 1 3

Eurozone Composite PMI

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

4600000

4700000

4800000

4900000

5000000

5100000

5200000

5300000

5400000

S e p - 0 8

N o v - 0 8

J a n - 0 9

M a r - 0 9

M a y - 0 9

J u l - 0 9

S e p - 0 9

N o v - 0 9

J a n - 1 0

M a r - 1 0

M a y - 1 0

J u l - 1 0

S e p - 1 0

N o v - 1 0

J a n - 1 1

M a r - 1 1

M a y - 1 1

J u l - 1 1

S e p - 1 1

N o v - 1 1

J a n - 1 2

M a r - 1 2

M a y - 1 2

J u l - 1 2

S e p - 1 2

N o v - 1 2

J a n - 1 3

M a r - 1 3

M a y - 1 3

J u l - 1 3

S e p - 1 3

Eurozone consumer credit

C onsumer c redit outstanding (E ur m) yoy %

S o ur c e : M a r k i t . c om ,M on um e n t S e c ur i t i e s

S o ur c e : E ur o s t a t



The CESI is worth keeping an eye on as it’s starting to rollover.

Looking at the periphery, the PMIs for Italy and Spain have both attened off recently.

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

O c t - 0 0

F e b - 0 1

J u n - 0 1

O c t - 0 1

F e b - 0 2

J u n - 0 2

O c t - 0 2

F e b - 0 3

J u n - 0 3

O c t - 0 3

F e b - 0 4

J u n - 0 4

O c t - 0 4

F e b - 0 5

J u n - 0 5

O c t - 0 5

F e b - 0 6

J u n - 0 6

O c t - 0 6

F e b - 0 7

J u n - 0 7

O c t - 0 7

F e b - 0 8

J u n - 0 8

O c t - 0 8

F e b - 0 9

J u n - 0 9

O c t - 0 9

F e b - 1 0

J u n - 1 0

O c t - 1 0

F e b - 1 1

J u n - 1 1

O c t - 1 1

F e b - 1 2

J u n - 1 2

O c t - 1 2

F e b - 1 3

J u n - 1 3

O c t - 1 3

F e b - 1 4

Eurozone: M1 (9 months forward) v. GDP growth

M 1 9-months forward (yoy %) GDP ( yoy %)

-100

-80

-60

-40

-20

0

20

40

60

80

J a n - 1 2

F e b - 1 2

M a r - 1 2

A p r - 1 2

M a y - 1 2

J u n e - 1 2

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n e - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

Eurozone: Citi Economic Surprise Index

40

42

44

46

48

50

52

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

Spain & Italy: PMI manufacturing 2013 (year-to-date)

Spain Italy

S o ur c e : E ur o s t a t

S o ur c e : C i t i ,M on um e n t S e c ur i t i e s

S o ur c e : M a r k i t . c om ,M on um e n

t S e c ur i t i e s



There is no sign of a pick-up in industrial production or consumer credit growth in Italy.

Export growth has turned negative.

Spain looks better than Italy. Retail sales have crossed into positive territory and consumer condence

continues to improve (although consumer credit growth was -5.0% year-on-year in September 2013).

-30%

-20%

-10%

0%

10%

20%

30%

J a n - 0 4

A p r - 0 4

J u l - 0 4

O c t - 0 4

J a n - 0 5

A p r - 0 5

J u l - 0 5

O c t - 0 5

J a n - 0 6

A p r - 0 6

J u l - 0 6

O c t - 0 6

J a n - 0 7

A p r - 0 7

J u l - 0 7

O c t - 0 7

J a n - 0 8

A p r - 0 8

J u l - 0 8

O c t - 0 8

J a n - 0 9

A p r - 0 9

J u l - 0 9

O c t - 0 9

J a n - 1 0

A p r - 1 0

J u l - 1 0

O c t - 1 0

J a n - 1 1

A p r - 1 1

J u l - 1 1

O c t - 1 1

J a n - 1 2

A p r - 1 2

J u l - 1 2

O c t - 1 2

J a n - 1 3

A p r - 1 3

J u l - 1 3

Italy: Industrial production & Consumer credit (yoy %)

Indust rial product ion Consumer credit

-30%

-20%

-10%

0%

10%

20%

30%

J a n - 9 9

M a y - 9 9

S e p - 9 9

J a n - 0 0

M a y - 0 0

S e p - 0 0

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

Italy: Exports (yoy %)

-50

-45

-40

-35

-30

-25

-20

-15

-10

-5

0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

Spain: Retail sales v. Consumer confidence

Reta il sa les ( yoy %) C onsumer c onfidenc e


S o ur c e : Bl o om b e r g ,M

on um e n t S e c ur i t i e s .

S o ur c e : Bl o om b e r g ,M on um e n t

S e c ur i t i e s .



Spanish imports are back on a declining trend.

In spite of its President, we had been a little more encouraged by trends in France recently. Both business

and consumer condence are rising.

Consumer credit is still in positive territory and has even accelerated during recent months.

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

J a n - 9 9

M a y - 9 9

S e p - 9 9

J a n - 0 0

M a y - 0 0

S e p - 0 0

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

Spain: Imports (yoy %)

60

70

80

90

100

110

120

130

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

France: Business & Consumer confidence

Business Confidence Composite Indicator Consumer Confidence

0%

2%

4%

6%

8%

10%

12%

14%

J a n - 0 4

A p r - 0 4

J u l - 0 4

O c t - 0 4

J a n - 0 5

A p r - 0 5

J u l - 0 5

O c t - 0 5

J a n - 0 6

A p r - 0 6

J u l - 0 6

O c t - 0 6

J a n - 0 7

A p r - 0 7

J u l - 0 7

O c t - 0 7

J a n - 0 8

A p r - 0 8

J u l - 0 8

O c t - 0 8

J a n - 0 9

A p r - 0 9

J u l - 0 9

O c t - 0 9

J a n - 1 0

A p r - 1 0

J u l - 1 0

O c t - 1 0

J a n - 1 1

A p r - 1 1

J u l - 1 1

O c t - 1 1

J a n - 1 2

A p r - 1 2

J u l - 1 2

O c t - 1 2

J a n - 1 3

A p r - 1 3

J u l - 1 3

France: Consumer credit outstanding (yoy %)



S o ur c e : E ur o s t a t ,M on um e n t S e c ur i t i e s .



Unfortunately, the most recent data has taken the edge off things a little. August 2013 had seen the rst

reduction in the number of jobseekers since April 2011, only for it to immediately rebound in September.

The Flash Eurozone PMI report commented that “France registered only a negligible expansion as its PMI

dipped closer toward neutrality.”

Both German IFO surveys (Climate and Expectations) were slightly down in October 2013 versus the previous

month, conrming the Flash PMI. The main drags were domestic, i.e. retail and services, while exports

remained resilient (China?).

So a plateau in activity seems to be on the horizon in the Eurozone, but we can’t help feeling that some of its

structural weaknesses have been brought sharply into focus again in recent weeks, although not assimilated

into current sentiment.

The rst relates to the banking system. The ECB is gearing up for direct oversight and new (improved?)stress tests, but what caught our eye were Draghi’s comments to the European Parliament after the German

election.

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

1800

2200

2600

3000

3400

J a n - 9 9

J u n - 9 9

N o v - 9 9

A p r - 0 0

S e p - 0 0

F e b - 0 1

J u l - 0 1

D e c - 0 1

M a y - 0 2

O c t - 0 2

M a r - 0 3

A u g - 0 3

J a n - 0 4

J u n - 0 4

N o v - 0 4

A p r - 0 5

S e p - 0 5

F e b - 0 6

J u l - 0 6

D e c - 0 6

M a y - 0 7

O c t - 0 7

M a r - 0 8

A u g - 0 8

J a n - 0 9

J u n - 0 9

N o v - 0 9

A p r - 1 0

S e p - 1 0

F e b - 1 1

J u l - 1 1

D e c - 1 1

M a y - 1 2

O c t - 1 2

M a r - 1 3

A u g - 1 3

France: Jobseekers v. Unemployment rate

Jobseekers (000s) Unemployment rate (%)

75

80

85

90

95

100

105

110

115

120

J a n - 0 1

M a y - 0 1

S e p - 0 1

J a n - 0 2

M a y - 0 2

S e p - 0 2

J a n - 0 3

M a y - 0 3

S e p - 0 3

J a n - 0 4

M a y - 0 4

S e p - 0 4

J a n - 0 5

M a y - 0 5

S e p - 0 5

J a n - 0 6

M a y - 0 6

S e p - 0 6

J a n - 0 7

M a y - 0 7

S e p - 0 7

J a n - 0 8

M a y - 0 8

S e p - 0 8

J a n - 0 9

M a y - 0 9

S e p - 0 9

J a n - 1 0

M a y - 1 0

S e p - 1 0

J a n - 1 1

M a y - 1 1

S e p - 1 1

J a n - 1 2

M a y - 1 2

S e p - 1 2

J a n - 1 3

M a y - 1 3

S e p - 1 3

Germany: IFO Business climate & Expectations

Bu si ness c li mat e Exp ec tat ion s


S o ur c e : I F OI n s t i t u t e



“We are ready to use any instrument, including another LTRO if needed, to maintain the short-

term money market rates at a level which is warranted by our assessment of ination in the

medium-term...While repayment of central bank credit is certainly a sign of normalisation, the

resulting reduction in excess liquidity can reinforce upward pressures on term money market

rates.”

So more LTROs are needed because earlier LTROs are being successfully REPAID – entirely logical!

We think that his comments emphasise the extreme fragility of the weaker European banks...and we wonder

if this includes one or two larger ones?

The comment about upward pressure on money market rates most likely refers to Eonia (Euro Over Night

Index Average). This is the weighted average rate for overnight unsecured loans in the European interbank

market. It is currently trading at 9.6bp - well below the 50bp for the ECB’s MRO (Main Renancing Operation)

policy rate. Prior to the 2008 crisis, Eonia traded at a small positive spread to the MRO as the latter is secured.

Since the 2008 crisis, the provision of excess liquidity by the ECB has pushed Eonia to a discount to MRO

in the Eurozone interest rate corridor. Draghi is clearly concerned that a sudden rise in Eonia – from the

extremely low level of 9.6bp - could threaten the banking system. The next chart shows EONIA in a longer-

term context.

European banks recovered from a 5-year low after Draghi’s “Whatever it takes” speech in July 2012. They

have been on a tear as condence in the Eurozone recovery emerged over the Summer - although the

outperformance has rolled over in the last couple of weeks.

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

EONIA (%)




This sector is for braver investors than us and we would avoid.

The other major structural aw in the Eurozone is obviously the excessive level of sovereign debt. This is not

lost on the “authorities” who are actively, it was clear from page 58 of the recent IMF report (Taxing Times,

October 2013), considering ways to address it. The key section, not discussed by any mainstream media

sources that we saw, is shown below without comment (although the emphasis is ours).

“The sharp deterioration of the public nances in many countries has revived interest in a capital

levy, a one-off tax on private wealth, as an exceptional measure to restore debt sustainability.

(1) The appeal is that such a tax, if it is implemented before avoidance is possible, and there is a

belief that it will never be repeated, does not distort behavior (and may be seen by some as fair).

There have been illustrious supporters, including Pigou, Ricardo, Schumpeter, and, until he changed

his mind, Keynes. The conditions for success are strong, but also need to be weighed against the

risks of the alternatives, which include repudiating public debt or inating it away (these, in turn,

are a particular form of wealth tax on bondholders that also falls on non-residents).

There is a surprisingly large amount of experience to draw on, as such levies were widely

adopted in Europe after World War I and in Germany and Japan after World War II. Reviewed in

Eichengreen (1990), this experience suggests that more notable than any loss of credibility was a

simple failure to achieve debt reduction, largely because the delay in introduction gave space for

extensive avoidance and capital ight, in turn spurring ination.

The tax rates needed to bring down public debt to pre-crisis levels, moreover, are sizable: reducing

debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) A TAX RATE

OF ABOUT 10% ON HOUSEHOLDS WITH POSITIVE NET WEALTH.”

0.030

0.032

0.034

0.036

0.038

0.040

0.042

0.044

0.046

0.048

0.050

J a n - 1 2

F e b - 1 2

M a r - 1 2

A p r - 1 2

M a y - 1 2

J u n - 1 2

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

Euro Stoxx Banks price relative




Ination Versus Deation: short-term resolution imminent?

Ambiguous Signals

The ght to the death between the forces of ination and deation continues. Obviously, whether the macro

trend is becoming more inationary or more deationary normally has consequences for asset allocation, so

the current lack of clarity is unhelpful. While our long-term conviction in the inationary endgame remains as

strong as ever, a shorter-term resolution of the conict seems close at hand.

One of our favourite charts right now is the divergence between US Treasury yields and breakeven ination

rates. Rising Treasury yields would typically be indicative of rising expectations for growth and ination, but

breakeven ination rates remain very subdued.

The world’s reserve currency (such as it is) is currently testing the 79.0-80.0 level, but a signicant break to

the downside could be inationary.

1.80

2.00

2.20

2.40

2.60

2.80

3.00

3.20

3.40

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

2.80

3.00

J u l - 1 2

A u g - 1 2

S e p - 1 2

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

10 year Treasury yield v. break even inflation

US 10-yr Treasury yield US 10-yr break even inflation

78

79

80

81

82

83

84

85

O c t - 1 2

N o v - 1 2

D e c - 1 2

J a n - 1 3

F e b - 1 3

M a r - 1 3

A p r - 1 3

M a y - 1 3

J u n - 1 3

J u l - 1 3

A u g - 1 3

S e p - 1 3

O c t - 1 3

US Dollar Index

S o ur c

e : Bl o om b e r g ,M on um e n t S e c ur i t i e s .




Our preferred index for commodity prices is the Thomson Reuters Continuous Commodity Index which is

composed of 17 equally weighted commodities. It recently put in a double bottom at the support level around

500, which could signal that the decline in commodity prices since 2011 is drawing to a close. The rebound

has been lacklustre, though, so far.

There are some slightly stronger signs in some of the agricultural commodities, like Wheat (shown above)

and others, like Live Cattle, remain in bull (!) markets.

Sugar has been a fairly good leading/coincident indicator for the Continuous Commodity Index and, having

broken out recently, is something we are watching.

300

350

400

450

500

550

600

650

700

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Continuous Commodity Index

70

80

90

100

110

120

130

140

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Live Cattle Contract (CME)


S o ur c e : Bl o om b e r g ,M on um e n t S e

c ur i t i e s .



It was notable that in the ination-prone UK economy, ination expectations have suddenly spiked upwards

thanks to increases in utility costs and rising house prices. This was our economist, Stephen Lewis, again.

“According to the latest Citi/YouGov survey, for October, prices were seen rising in the year ahead

by 3.2%, well above September’s 2.5% expectation. More alarming still, because it suggested the

public’s condence that price rises would be contained had started to erode, was the nding that

ination on a 5-10-year view was, this month, seen as high as 3.9%, up from 3.3% in September.”

The octogenarian, newsletter legend, Richard Russell, uses the gold/bond ratio, in the form of spot gold

versus the TLT (iShares 20+ year Treasury bond ETF) as his ination versus deation indicator. This does rely

on the assumption that both markets are “free”. Nonetheless, deationary forces remain in the ascendancy

on this basis.

A lesson for us since the announcement of open-ended QE last year has been the danger of under-estimating

the power of deationary forces during the biggest debt crisis in history. However, even if deationary forcestemporarily regain the ascendancy, it’s worth putting our current position in a much broader long-term

perspective.

350

400

450

500

550

600

650

700

750

10

15

20

25

30

35

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Sugar v. Continuous Commodity Index

S ug ar C on ti nu ous C ommo di ty I nd ex

6.0

8.0

10.0

12.0

14.0

16.0

18.0

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Gold v. TLT


S o ur c e : Bl o om

b e r g ,M on um e n t S e c ur i t i e s .



Bigger Picture

It strikes us that there is a major blind spot regarding the bigger picture “inationary mega-trend” in which

we nd ourselves. We like to put our current situation in the context of previous inationary waves, or

“Great Inations”, during the last millennium. We are currently in the fourth “Great Ination” of the last one

thousand years.

The rst took place during 1209-1317 - the price level is shown in the chart below. It’s noticeable how

ination increased sharply in its nal stages.

The second, during 1496-1650, was focused on the Spanish Empire – once again ination increased sharply

in its nal stages. The people who lived through this period christened it the “Price Revolution” on account of

the severity of the ination. The compound average growth rate in prices across this period was 1.5% p.a. – a

level which today’s central bankers would dene as “price stability.”

The third inationary mega-trend was slightly shorter at 80 years during 1733-1813, but once again there

was a surge in prices during its nal stages.

0

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200

250

300

350

400

450

1 2 0 9

1 2 1 1

1 2 1 3

1 2 1 5

1 2 1 7

1 2 1 9

1 2 2 1

1 2 2 3

1 2 2 5

1 2 2 7

1 2 2 9

1 2 3 1

1 2 3 3

1 2 3 5

1 2 3 7

1 2 3 9

1 2 4 1

1 2 4 3

1 2 4 5

1 2 4 7

1 2 4 9

1 2 5 1

1 2 5 3

1 2 5 5

1 2 5 7

1 2 5 9

1 2 6 1

1 2 6 3

1 2 6 5

1 2 6 7

1 2 6 9

1 2 7 1

1 2 7 3

1 2 7 5

1 2 7 7

1 2 7 9

1 2 8 1

1 2 8 3

1 2 8 5

1 2 8 7

1 2 8 9

1 2 9 1

1 2 9 3

1 2 9 5

1 2 9 7

1 2 9 9

1 3 0 1

1 3 0 3

1 3 0 5

1 3 0 7

1 3 0 9

1 3 1 1

1 3 1 3

1 3 1 5

1 3 1 7

First Price Inflation 1209 - 1317 (index 1209 = 100)

0

100

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300

400

500

600

700

1 4 9 6

1 4 9 9

1 5 0 2

1 5 0 5

1 5 0 8

1 5 1 1

1 5 1 4

1 5 1 7

1 5 2 0

1 5 2 3

1 5 2 6

1 5 2 9

1 5 3 2

1 5 3 5

1 5 3 8

1 5 4 1

1 5 4 4

1 5 4 7

1 5 5 0

1 5 5 3

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1 5 7 4

1 5 7 7

1 5 8 0

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1 5 9 2

1 5 9 5

1 5 9 8

1 6 0 1

1 6 0 4

1 6 0 7

1 6 1 0

1 6 1 3

1 6 1 6

1 6 1 9

1 6 2 2

1 6 2 5

1 6 2 8

1 6 3 1

1 6 3 4

1 6 3 7

1 6 4 0

1 6 4 3

1 6 4 6

1 6 4 9

Second Price Inflation 1496 - 1650 (index 1496 = 100)

S o ur c e : P r i c e Hi s t or y of E n gl i s h A gr i c ul t u

r e ,M e a s ur i n g W or t h

S o ur c e : P r i c e Hi s t or y of E n gl i s h A gr i c u

l t ur e ,M e a s ur i n g W or t h



The current one began in 1896 and accelerated (not surprisingly) after the collapse of Bretton Woods in 1971.

Will the trajectory of the current one increase in its nal stages like the other three? It’s almost comical to

put all four on the same axes. Earth to Alan Greenspan and Ben Bernanke...

0

50

100

150

200

250

300

350

1 7 3 3

1 7 3 5

1 7 3 7

1 7 3 9

1 7 4 1

1 7 4 3

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1 7 5 1

1 7 5 3

1 7 5 5

1 7 5 7

1 7 5 9

1 7 6 1

1 7 6 3

1 7 6 5

1 7 6 7

1 7 6 9

1 7 7 1

1 7 7 3

1 7 7 5

1 7 7 7

1 7 7 9

1 7 8 1

1 7 8 3

1 7 8 5

1 7 8 7

1 7 8 9

1 7 9 1

1 7 9 3

1 7 9 5

1 7 9 7

1 7 9 9

1 8 0 1

1 8 0 3

1 8 0 5

1 8 0 7

1 8 0 9

1 8 1 1

1 8 1 3

Third Price Inflation 1733 - 1813 (index 1733 = 100)

0

500

1,000

1,500

2,000

2,500

3,000

1 8 9 7

1 9 0 0

1 9 0 3

1 9 0 6

1 9 0 9

1 9 1 2

1 9 1 5

1 9 1 8

1 9 2 1

1 9 2 4

1 9 2 7

1 9 3 0

1 9 3 3

1 9 3 6

1 9 3 9

1 9 4 2

1 9 4 5

1 9 4 8

1 9 5 1

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1 9 6 0

1 9 6 3

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1 9 6 9

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1 9 7 8

1 9 8 1

1 9 8 4

1 9 8 7

1 9 9 0

1 9 9 3

1 9 9 6

1 9 9 9

2 0 0 2

2 0 0 5

2 0 0 8

2 0 1 1

Fourth Price Inflation 1897 onwards (index 1897 = 100)

0

500

1,000

1,500

2,000

2,500

3,000

1 4 7 1 0

1 3

1 6

1 9

2 2

2 5

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4 9

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7 9

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8 5

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9 4

9 7

1 0 0

1 0 3

1 0 6

1 0 9

1 1 2

1 1 5

1 1 8

1 2 1

1 2 4

1 2 7

1 3 0

1 3 3

1 3 6

1 3 9

1 4 2

1 4 5

1 4 8

1 5 1

1 5 4

Four Price Inflations Compared (y-axis = no. of years)

First (1209 - 1 317) Second (1496 - 1650) Third (1733 - 1813) Fourth (1897 onwards)

S o ur c e : P r i c e Hi s t or y of E n gl i s h A gr i c ul t ur e ,M e a s ur i n g W or t h

S o ur c e : P r i c e Hi s t or y of E n gl i s h A gr i c ul t u

r e ,M e a s ur i n g W or t h

S o ur c e : P r i c e Hi s t or y of E n gl i s h A gr i c ul t ur e ,M e a s

ur i n g W or t h



Gibson’s Paradox

Long-term data shows that consumer/wholesale prices and interest rates have tended to rise and fall together,

although the relationship has changed slightly (see below) since the collapse of Bretton Woods (BW) and the

permanent adoption of oating currencies.

The simultaneous rise in prices (N.B. the price level not the rate of ination) and interest rates is known as

“Gibson’s Paradox”. Wikipedia notes.

“Gibson’s Paradox is the observation that the rate of interest and the general level of prices are positively

correlated...The term was rst used by John Maynard Keynes, in his 1930 work, A Treatise on Money.”

In their academic paper, “Gibson’s Paradox and the Gold Standard”, Larry Summers (the one who nearly

became Fed Chairman) and Robert Barsky commented (with our emphasis).

“Monetary theory leads us to expect a correlation between nominal interest rates and the rate of

change, rather than the level, of prices. Yet, as emphasized by Keynes (1930), two centuries of

data do not conrm this expectation... Keynes referred to the strong positive correlation between

nominal interest rates and the price level, which he called ‘Gibson’s Paradox’ as ‘ONE OF THE

MOST COMPLETELY ESTABLISHED EMPIRICAL FACTS IN THE WHOLE FIELD OF QUANTITATIVE

ECONOMICS.”

We break down the last 230-odd years (since 1788) into four long economic (Kondratieff) cycles of which

the fourth is still to be completed, helped in no small way by the unconventional monetary policies of our

central banking friends. The most clear cut example of Gibson’s Paradox in operation was during the third

long economic (Kondratieff) wave, 1897-1933 as we dene it.

Please note: the above chart uses annual data.

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

6.00%

6.50%

7.0

9.0

11.0

13.0

15.0

17.0

19.0

21.0

1 8 9 7

1 8 9 8

1 8 9 9

1 9 0 0

1 9 0 1

1 9 0 2

1 9 0 3

1 9 0 4

1 9 0 5

1 9 0 6

1 9 0 7

1 9 0 8

1 9 0 9

1 9 1 0

1 9 1 1

1 9 1 2

1 9 1 3

1 9 1 4

1 9 1 5

1 9 1 6

1 9 1 7

1 9 1 8

1 9 1 9

1 9 2 0

1 9 2 1

1 9 2 2

1 9 2 3

1 9 2 4

1 9 2 5

1 9 2 6

1 9 2 7

1 9 2 8

1 9 2 9

1 9 3 0

1 9 3 1

1 9 3 2

1 9 3 3

Gibson's Paradox 1897 - 1933

Index of Consumer Prices Long-term Interest Rate (%)

S o ur c e : BL S , U S C e n s u s ,M e

a s ur i n g W or t h



However, as we noted, this relationship broke down with the collapse of BW as we transited from a Gold

Standard into today’s free oating US dollar. Here is the chart of the relationship since 1968, the year which

saw the collapse of the London Gold Pool, and prefaced BW’s subsequent demise.

However, the next chart shows that, while Gibson’s Paradox broke down, the relationship shifted from the

level of prices to its rst derivative, i.e. to the rate of ination itself...marking the end of the “Paradox.”

It’s interesting to look back to the biggest inationary spike during 1976-80 and see how interest rates lagged

the rise in ination for most of that period. It illustrates the monumental challenge facing today’s policy

-makers if (when!) ination does start to increase. Back then, total debt/GDP in the US was between 160-

170%. Today that gure is 350% and a rise in ination would put policymakers between the proverbial rock

and hard place. Allowing rates to rise sufciently quickly to temper rising ination would likely crash an over-

indebted economy, while doing nothing, or even trying to suppress rates further, would risk runaway ination.

Policymakers could lose control...

Back in 1976-80, the situation wasn’t made much more hazardous by an interest rate derivative mountain

and a vast shadow banking system either.

0.0

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250.0

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1 9 9 0

1 9 9 1

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1 9 9 7

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

Breakdown of Gibson's Paradox: CPI index v. interest rates since 1968

US CPI index (1982-84 = 100) US 10-year Treasury yield (%)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

-4.0

-2.0

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8.0

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16.0

1 9 6 8

1 9 6 9

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1 9 9 8

1 9 9 9

2 0 0 0

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2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

End of Gibson's Paradox: US CPI v. 10-yr Treasury yield (since 1968)

US CPI ( %) US 10-yr Tr easury yield ( %)





Interest Rates and Interest Rates (Repos)

If we asked you whether interest rates have been rising or falling since the announcement of QE3 last

September, what would your answer be?

Well, there are interest rates and interest rates...

10-year US Treasury yields had almost doubled by early-September 2013 - and are still nearly 60% higher. In

contrast, the growing shortage of collateral has caused rates in the large (and systemically important) US$4.6

trn repo market in the US to collapse - down almost 75% from 20 b.p. to about 5 b.p. in early-September

2013.

We have inverted the General Collateral Repo Rate in the chart below, which shows an almost perfect negative

correlation between 10-year Treasury yields and Repo Rates.

For much of the last 3-4 months, banks operating in the US were able to fund (leverage) their inventories of

securities at an average of 5-10 b.p. (General Collateral).

If it had been all about the underlying strength of the US economy, we don’t believe that tapering would

even have been considered. The unspoken benet from tapering would have been to free up the QE-driven

shortage of “high quality” collateral (i.e. Treasuries and MBS) in the repo market. In the words of the Oliver

Wyman consulting rm, the repo market is the “structural backbone of US nancial markets” and its primary

source of leverage.

The IMF, Bank for International Settlements, Bank of England, US Treasury (TBAC) and Janet Yellen have all

warned about the risks from the repo market in recent months. We also wonder whether Dallas Fed Governor,

Richard Fisher’s, post-FOMC quote...

“The largest nancial institutions are a dagger pointed at the heart of the economy.”

...was an oblique reference to repos?

0.00

0.05

0.10

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0.301.40

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1.80

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2.80

3.00

S e p - 1

2

O c t - 1 2

N o v - 1

2

D e c - 1

2

J a n - 1

3

F e

b - 1

3

M a r - 1 3

A p r - 1 3

M a y - 1

3

J u n - 1

3

J u l - 1 3

A u g - 1

3

S e p - 1

3

O c t - 1 3

10-year Treasury yield v. General Collateral Repo Rate (Inverted)

US 10-year Treasury Yield (%) General Collateral Repo Rate Inverted 20 day M.A. (%)




An aside: it has become noticeable in recent months how more and more equity investors are taking an

interest in shadow banking, and repos in particular. If you’d mentioned Long Term Capital Management, Bear

Stearns, Lehman and MF Global in the same sentence as repos only six months ago, you would probably have

received many confused looks.

Last month, more OTC derivative trades moved on exchange (requiring additional collateral) and some

Treasury repos went “special” implying collateral shortages. We are going to nd out whether, by not tapering,

the Fed makes the collateral issue worse in the short term, or whether it’s a problem which can stay on the

back burner for a while longer.

Given the increasing recognition of QE-driven collateral shortage, it might not be coincidental that the

possibility of xed rate overnight reverse repos with full allotment was proposed at the July 2013 FOMC

meeting and a pilot test authorised at last month’s meeting.

Reverse repos can drain excess cash held by banks AND (unlike the Fed Funds market) non-bank nancial

institutions and replace them with overnight loans of high quality collateral, e.g. Treasury securities, from the

Fed’s balance sheet. The Fed can set the rate on these reverse repos which will give it greater control over

overnight rates in money markets.

The ofcial reason for these “pilot” reverse repos is for the Fed to test its exit instruments, which it could

employ as part of its strategy to tighten monetary policy. When Bill Dudley of the FRBNY was asked why this

facility was being set up, one of the two reasons he gave (besides setting a oor for money market rates)

was that it would

“increase the availability of a risk-free asset, satisfying the demand when the appetite for safe

assets increases.”

Which sounds suspiciously like an acknowledgement that one of its purposes is to address collateral shortage.

The reverse repo test began during the week beginning 23 September with market participants limited to

US$500m at 1bp. The limit was doubled to US$1.0bn only three days later! On 30 September 2013, 87

bidders borrowed a very large US$58.2bn of Treasury collateral from the Fed. Does that really fall into the

denition of a “test” quantity. The so-called test runs until late-January 2014.

With US$3.47 trn of securities on the Fed’s balance sheet (US$2.06 trn Treasuries), the Fed has plenty of

ammunition with which to supply the repo market if nancial markets become “stressed”. This should provide

a substantial stability “buffer” in the early stages of a crisis in the US.

However, we are sceptical that it will be enough if there is a sharp deterioration in the global economy, or one

or more major nancial institutions get into trouble. For example:

• If the debt crisis erupts again, the natural instinct of lenders, including those in the repo market, will still

be to withdraw credit. This is a frightening prospect when the majority of repo loans are overnight; and

• The next crisis could be a sovereign debt crisis - which would put the valuation of the vast majority of the

collateral underpinning the repo market in question.

We spent quite a lot of time in this report talking about “duration” in one form or another. Then you stop tothink that there’s US$4.6 trn of leverage in US nancial markets which is largely OVERNIGHT.



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related investment menoned herein and may provide nancial services to the issuers or such investments.

MSL has put in place systems and controls mechanisms supported by appropriate procedures to idenfy and manage

any conicts of interest that may arise. A copy of our conict of interest policy is available on request. In relaon to this

content, we do not believe that any relaonships, circumstances, interests or potenal conicts of interest that would

require disclosure under the FSA Conduct of Business rules are likely to arise. In parcular no major shareholdings

or nancial interests exist between MSL and any relevant company. In the event that this situaon changes then

appropriate disclosures will be made.

All investments involve a degree of risk and may not be suitable for certain investors. All investors should make their

own investment decisions based on their circumstances, nancial objecves and resources and aer seeking any

appropriate professional advice.

Monument Securies Limited is authorised and regulated by the Financial Services Authority FCA Number 149028 in

the UK.

Documents

Thunderroad Report Q4.pdf