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Double Dip?A review of the macro-economic scenarios for 2011

Brait Multi Strategy Fund Macro Economic Research May 2010

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Portfolio Manager Kevin Cousinstel +27 21 673 7831 email kcousins@brait.com

Brait South Africa LimitedAuthorised Financial Services Provider

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Risk asset prices anticipating a strong recovery

Global risk assets appear to have priced in a typical economicrecovery. The chart below, from Contrary Investor, compares theyear on year change of the S&P500 Index and US payrollemployment. Is a strong recovery in employment already in theprice? (Ref.1) It certainly looks that way. However, I believe theprobability of a different economic outcome is significant. Thispaper aims to explore a variety of possible economic scenarios, theevidence for and against each, and crucially their asset priceimplications, for both developed and emerging markets.

Economic scenarios for 2011

I will focus on the US economy initially, given its crucial role inasset prices globally. While it is possible to develop manyalternative scenarios, I believe the key outcomes can beadequately covered in just three.

2011 Scenario Characterization

Typical Recovery Above trend GDP growth

Big reduction in unemployment

Issue in due course becomes fully-utilised resourcesand inflation

New Normal Weaker recovery

Trend growth lower in future due to higher taxes, lessavailable and more costly leverage, back-tracking onglobalization and increased regulation (Ref.2)

Issue likely to be budget deficits

Double Dip Growth collapses once the fiscal stimulus ends

Deleveraging by household and Commercial RealEstate sectors continues for an extended periodimpacting consumer spending

Issue is deflation and the ineffectiveness of monetarypolicy

We have a behavioral tendency to put greater weight on evidencethat supports a favoured scenario, and to exclude or downplay

contrary evidence. I will use a tool that helps minimize thesebiases, the Analysis of Competing Hypothesis (ACH) process.The ACH process focuses on reviewing evidence against eachscenario, noting that evidence may be consistent with more thanone scenario, but in particular, documenting evidence thatcontradicts a scenario. Scenarios can then be ranked or assigneda probability on a more impartial basis. (Ref.3) The table below listskey items of evidence and their scenario consistencies.

Summary of Evidence

C= Consistent with Scenario

X = Contradicts Scenario

TypicalRe-

covery

NewNormal

DoubleDip

Leading Indicators show very strong YoY growthuniversally e.g. OECD G7 LI +10.2% in Feb 2010

C C X

GDP growth QoQ growing at a very rapid annualrate e.g. Q4 2009 at 5.7% in the USA C C X

Global growth in recent quarters is also strongand synchronized, with forecasts for 2010 and2011 being revised up

C C X

Impact of household and CRE sectordeleveraging in the US, UK and parts of Euroland X C C

Inappropriate policy response to attempt to lowerdeficits despite private sector deleveragingplanned from 2011

X C C

Secular trend towards of the Global economyleaves the Local economy as highly creditdependent and deeply cyclical. Local growthpotential poor.

X C C

The items of evidence that are shaded are, I believe, non-consensual and are reviewed in detail in this report. While the tableabove is of course fairly stylized, I believe it makes a crucial point.The probability of a Double Dip scenario in 2011 is significant.

Asset price implications of each scenario

The Typical Recovery appears consistent with current earningsforecasts, although of course forecast upgrades would also belikely. Rapid growth in tax revenues would enable governments toimprove finances reasonably quickly. The challenge for equity andbond markets would quickly become inflationary pressures and thenormalization of monetary policy. We would expect reasonableperformance of risk assets generally in this scenario, especially the

commodity complex.

The New Normal is a less favourable scenario for risk assets, inparticular the financial sector (most impacted by regulation). Globaleconomy exposed companies may benefit from consistently lowinterest rates, and I believe there is a significant chance of pricebubbles in Asian and other EM equities, in other wordsdecoupling.

The Double Dip will result in a dramatic risk aversion event similarto 2008. I doubt EM assets can successfully decouple in thisscenario. Safe haven assets (US treasuries and Bunds) do well.

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Double Dip?A review of the macro-economic scenarios for 2011

Brait Multi Strategy Fund Macro Economic Research May 2010

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Review of Key Non-Consensual Evidence

1 Deleveraging and GDP impact

Consumer spending has risen to more than 70% of US GDP. Anysecular change in consumer spending habits is hugely relevantwhen forecasting future GDP growth. The decade of the UShousing boom was characterized by households spending morethan their income (i.e. borrowing to consume). The FederalReserve Feb 2010 report of monthly consumer credit outstandingshows the biggest year on year decline in sixty years (chart below).Households are clearly still deleveraging.

In fact US households (together with those in the UK, Spain, SouthKorea and Canada) were specifically identified in a recentMcKinsey report on the credit bubble and its economicconsequences (Ref.5) as having a high likelihood of deleveraging.Also singled out were the commercial real estate (CRE) sectors inthe US, UK and Spain. McKinsey studied 45 episodes ofdeleveraging since the Great Depression, 32 of which followed afinancial crisis. Their conclusions were sobering. Deleveragingepisodes average 6 7 years after the end of the initial economicdownturn. They also have a significant cost to GDP growth. This issurely consistent with a New Normal scenario, and in additionraises the risk of the Double Dip.

2 Richard Koo and the Balance Sheet Recession

So why have we not seen the impact of this householddeleveraging on the current GDP growth numbers? In short, theshortfall in economic activity caused by the household and CREsectors new found thrift has been more than compensated for bythe governments fiscal spending programmes. Corporate inventoryrebuilding has also provided a sharp, although unfortunatelytemporary, boost to growth.

Richard Koo, the Chief Economist at the Nomura ResearchInstitute in Tokyo, has extensively studied periods of private sectordeleveraging (Ref.6). During these periods monetary policybecomes ineffective and the only effective tool for governments isfiscal policy. Despite near zero interest rates demand for loanscollapses and the private sector strives to repay debt. In his viewthe greatest risk faced by an economy undergoing what hedescribes as a balance sheet recession, is the prematurecurtailment of fiscal spending programmes before the private sectordeleveraging process has run its course. This has historically

happened when a recovery appears to have gathered momentum,and political pressure mounts to reduce the budget deficit. I believethat moment is fast approaching in the US, UK and Euroland.Ironically, Koo demonstrates that spending curbs duringdeleveraging episodes actually increase the deficit as tax revenuesfall even faster than the spending cuts themselves.

It is clear, and unsurprising, that high budget deficits are the currentpolitical obsession. The current 2010 estimates are as follows:US -11.1%, UK -12.8%, Euro area -7.2%, Spain -11.5%. Grimnumbers indeed. I fear that well-founded attempts to reduce thedeficits in the US, UK and Eurozone will have severe unintendedconsequences. While Richard Koos work is increasingly gainingcredibility (for example he was invited to testify together with theFederal Reserve Chairman to the House Financial ServicesCommittee in February) it is still not widely followed.

In fact there appears to be widespread political consensus on theneed for fiscal tightening, with only the means differing between leftand right wing (the left will primarily increase taxes and the right willprimarily slash spending). In a recent debate in the UK between theChancellor of the Exchequer and the two shadow chancellors fromthe Conservatives and Liberal Democrats, all three wereunanimous that a fiscal adjustment greater than that executed bythe Thatcher government in the 1980s was necessary. TheConservatives say that should they win the UK election next monththey will hold an emergency budget review within 60 days of takingoffice. Obama has frozen spending for most non-defense items,and the massive Bush era tax cuts are not to be renewed whenthey expire at the end of 2010. At a state level in the US sharpspending cuts and tax rate increases are the current norm. Overallforecasts expect fiscal spending to migrate from a substantial boostto US GDP in Q2 and Q3 2010 to a substantial headwind by Q42010 and throughout 2011.

Reducing spending or increasing taxes will have disastrousconsequences on the fragile, deleveraging economies like the UK,US and much of the Euro area over the medium term. As thesenations attempt to improve government finances I perverselyexpect budget deficits to actually widen, as their economies slipback into recession in 2011 and tax revenues evaporate.

3 The two-tier economy

I believe that the most important distinction for countries, sectorsand even individual firms is how they are positioned in the two-tiereconomy. Are they global or are they local? Global implies theability to benefit from globalization for example movingmanufacturing plants or service centres to lower cost jurisdictions(e.g. China and India respectively), selling product globally whereever there is growing demand and raising capital from globalfinancial markets rather than being beholden to the bankingsystem. Sectors that benefit from the Global economy alsoinclude basic materials, which has benefited from huge increases inEmerging Market demand given the resource-intensive nature ofChinas GDP growth in particular. The Global economy has strongsecular support and has thrived under the cheap and abundantliquidity regime brought about by the global financial crisis.

The Local economy is generally in far worse shape. Firstly Localeconomies have lost much of their diversification brought by export-

orientated manufacturing. The migration of manufacturing tocheaper locations (perhaps cynically described as a labourlegislation and environmental regulation arbitrage) has hollowedout economies as diverse as the US and SA. Local is more and

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Double Dip?A review of the macro-economic scenarios for 2011

Brait Multi Strategy Fund Macro Economic Research May 2010

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more dominated by the credit cycle consumer spending andrelated import, distribution and retailing, construction and propertydevelopment and of course financial services such as mortgageorigination. Smaller businesses are invariably Local. In the USsmall businesses employ 60% of the work force. The difference inhealth between Global and Local is well illustrated by the chartbelow (Ref.4).

The ISM surveys larger companies, the majority of which arebenefiting from the Global economy. The ISM diffusion indexabove is close to its all time high. In contrast, the NationalFederation of Independent Business (NFIB), Small BusinessSurvey is, while slightly above the lows of a year ago, is still

substantially below recession-era levels in 1991.

In addition, the US household and Commercial Real Estate sectorshave huge debt burdens. Large corporates that access marketsdirectly for funding have benefited from a normalization inborrowing availability and cost. For example the HSBC AAACorporate 5 Year Spread Index (HS3ASP5) is currently back to 117basis points from a crisis peak of 850 (chart below). In fact giventhe level of treasury yields, large corporates have been borrowingat or near all-time low rates. The recovery in equity markets hasenabled many large companies, most notably in the financialsector, to raise additional capital at reasonable prices.

Contrast this with the borrowing climate for small businesses. TheNFIB Small Business Survey index of credit availability, illustratedin the chart below (Ref. 4), is back to the all time low in the March2010 number.

The Local economy in the US is under immense secular pressure,and, as is shown by the afore-going charts, is still under cyclicalpressure. This is evidence in conflict with the Normal Recovery.

Conclusion

I believe there is a significant chance of a Double Dip in 2011. Thisis a non-consensual view and hence should this scenario eventuateit has dramatic asset price implications. Markets most effected willbe the UK, US and parts of Europe (e.g. Spain). SA will also be

severely effected, but has two key differentiating factors. Firstly oursignificant exposure to the Global economy via basic materialexports gives positive exposure to any decoupling of EM growth.Secondly the substantial cash economy or informal sector, isrelatively isolated from the credit cycle and global bouts of riskaversion.

I am not saying the Double Dip is the most likely scenario, rather,as the ACH process showed, it has a significant likelihood andgiven the severe asset price implications that is sufficient. Mystrategy will be to isolate sectors and companies fundamentallymost exposed to the double dip and the resulting bout of riskaversion. To that end I will also examine performances through the2008 downturn. Trade timing will most likely be only in Q4 2010and Q1 2011, however this could be accelerated by events inEurope and China.

References1. Contrary Investor, The Room to Consume?, ContraryInvestor.com, 15 April 2010

2. Bill Gross, On the course to a new normal, PIMCOInvestment Outlook, September 2009.

3. Richard J. Heuer, Psychology of Intelligence Analysis,Centre for the Study of Intelligence, Central Intelligence Agency,1999.

4. Contrary Investor, One Pill Makes You Larger And OnePill Makes You Small, Contrary Investor.com, 20 April 2010

5. McKinsey Global Institute, Debt and deleveraging: The

global credit bubble and its economic consequences, January2010.

6. Richard Koo, The Holy Grail of Macroeconomics:Lessons from Japans great recession John Wiley and Sons, 2009.