First Quarter 2010 GTAA Macro

8/14/2019 First Quarter 2010 GTAA Macro

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o a ac casse oca on

GTAAMacro

First Quarter

First QuarterJanuary 9th, 2010

Damien Cleusix

Clue6 First Quarter 2010

am en c ue .com


2/38

1Quotes

Its frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by

people who have faith that they know exactly whats going on

A. Tversky

The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies

taking each particular riskS. Klarman

Risk means that more things can happen than will happen E. Dimson

The more you bet, the more you winwhen you win

Las Vegas saying



3/38

2Executive Summary

MacroThe collapse has been avoided thanks to the resolve of Central banks and governments around the world but we will still have

. ,

changing accounting rules and providing huge amount of emergency liquidity) and lower interest payments. This pushed the

overall debt to assets lower and improving interest coverage but they can not do this forever

The recession which has probably ended during the summer, was not a typical inventory-led one were more that 75% of the

decline is due to de-stocking. It was the beginning of a "balance sheet" recession which is going to haunt us for many years with

poor growth and intermittent relapses into recession (here we are talking about developed leveraged countries, financially

unleveraged developing countries will suffer because of their operating leverage but will end up as winners if they make the

right reforms and of course there is China which will have a very volatile path in the next 3-4 years)

The deleveraging process in unavoidable. Analysts have spent a great deal of time commenting on the collapse of credit

availability but we think the biggest problem for growth in the medium-term will be a lack of credit demand. Many households

and companies have realized that they could go under and they are going to build a buffer...

Nationalism and protectionism will gain in popularity while there is a big risk that regulators will go on a rampage (we see a

strong risk of this cyclical ERROR, like the commercial banks reserve increase in the 30s or the VTA hike in Japan in the 90s,

done by regulators) after doing too little for so many yearsPopulism will be a winning strategies for politicians, even morethan before

The current macro data has surprised on the upside with the success of the cash for clunkers schemes around the world (which

probably added up to 4% to US growth in the third quarter), various forms of help for first time home buyers, the socialization

of the credit market in the US and Europe or the credit explosion in China... We continue to see the current improvement as a


norma snap ac rom t e worst macro env ronment s nce t e s. t s ou not e con oun e w t a strong recovery.


4/38

3Executive Summary

The traditional swing factors I.e. inventories, residential investments and autos which have historically accounted for almost

all the volatility in GDP are not expected to have the same impact this time as in the past (and the autos part is probably

, .

Consumption should continue to be a drag in the developed world for some times. Aggregate disposable incomes and net

worth level influence on savings should be followed carefully as they will be the keys on how quickly the consumptionbehavior will chan e.

The fate of the current recovery hangs on the exit strategies for the monetary and fiscal stimuli , how the financial markets

will interpret them and the unavoidable errors which will be made

Fiscal Stimuli have been helpful but their long-term effects will be sub-optimal as long as they are considered as a short-

term fix and that they are not constructed to foster future productivity and labor market growth . Much more is needed as

they have, for the moment, only been able to compensate for the loss of other incomes in the US.

easing now that markets have normalized. They should do the same for the quantitative part. The QEs were legitimate (even

in our eyes...) to avoid a total freeze and collapse of the credit markets and a debt deflation dynamic to develop, but not

otherwise.

Deflation is still a real risk (we would even say a factand we are talking about price deflation including assets price

and not in the sense of money in circulationas the current inflation worries will pave the way for a new wave of

deflation) and we would thus like to see the quantitative part continuing a bit longer . Central Banks might even start

charging instead of paying interest on the reserves they hold on behalf of the commercial banks. This would encourage them to


put the money elsewhere into the economy. The Swedish Riksbank has started such a scheme and the BoE is discussing the

same...


5/38

4Executive Summary

Expect macro numbers to continue to move in the right direction (and in the next 3-6 months the rate of change is likely to be

increasingly positive as it will be calculated against 12 month old data...) until Q2 2010 at least.

After that we will remember that we are living in the aftermath of the biggest credit bubble in history. This does not

necessarily imply a double dip as much will depend on the behavior of households and the impact of fiscal and monetary

authorities policies or lack of policies...

Europe should be the focus of your attention as there is a high probability that the next crisis will have its epicenter there

In the next few years the world economy will be more volatile than in the 20 years pre-2007 with dramatic

consequences on assets valuation ratios (cheap tomorrow will be much cheaper than what was deemed cheap between

1990-2007)



6/38

5Macro: The Causes of the Current Crisis Another Repeat

We need to put the rest of the macro analysis into perspective

The NYT recently published an article by R.Shiller titled "An echo Chamber of Boom and Bust". He wrote:

"What happened? Economic analysts often turn to indicators like employment, housing starts or retail sales as causes of a recovery, when in fact

they are merely symptoms. For a fuller explanation, look beyond the traditional economic links and think of the world economy as driven by

social epidemics, contagion of ideas and huge feedback loops that gradually change world views . These social epidemics can travel as swiftly as

swine flu both spread from person to person and can reach every corner of the world in short order."

That's it... At turning points, markets trends change as the investors universal beliefs are proven wrong while during trends the markets

make the opinion... At turning points, the triggers are often hard to identify (in hindsight it always seems a self evidence). It is thus important to

try, as much as possible, to identify the potential triggers before they occur. One of the key is to see how the markets react when they occur to see if

they really are the turning point. Market perception is of utmost importance and the less it can discount the consequences the larger the

volatility

What did cause the current crisis?

Since the Spring of 2006 we have been warning that the credit build up the world economy (mainly US and Europe) was experiencing would lead

to a major shift in governments, banks, investors and consumers perceptions and behaviors. A shift that would be a generational event (so it

should last for approximately a generation). Regulators would wake up, banks behave like banks, investors rebalance, by reason or constraint, their

portfolio toward less risky assets and consumers spend less than what they earn.

The chain of events have unraveled as expected and should continue to do so. As with every trend, this development will not be linear and wewill have phases when investors will believe that the sky is the limit but they will be proved wrong. We will surely see some bubbles develop and

pop along the way but the wash out will take much more time than one thinks. (As we said some emerging economies will be able to do quite well

if they have the courage to make the necessary domestic reform and let Bretton Woods 2 die away)

This credit bubble was a bad bubble...It was mainly financed by banks and impacted unproductive assets, houses. The end result is that banks

can not lend while there has not been any addition to the productive capacity This bubble will also generate new regulations which will imperil


financial innovations in the future (some will be good and necessary, some bad) and lower banks capacity to lend. Money velocity will decline


7/38

6Macro: The Causes of the Current Crisis Another Repeat

The bubble was born out of the belief that Central Banks had tamed the business cycle and that they would use any means to prove it .

Yes, technological advances, the imagination of the investment banks and hedge fund quant desks or the semi-coma in which regulators seemed to

have fallen allowed it to reach unheard of proportions but without this deification of Central Banks it would not have reached such a monstrous

size. A arent believed stabilit led to too much risk bein taken and instabilit . A. Greens an called it the "Paradox of Credibilit .

The confidence in the system has now been eroded but not as much as one would have expected... Indeed, many believe that the Fed has saved the

day once more.

The bubble also submer ed a hi h number of countries enter rises and individuals with debt obli ations which can not be aid or onl b

living frugally and probably killed the consume now save later or never mentality which was prevalent in many developed economies ex-Japan.

Borrowing will be a dirty word and consumers will retrench to build up their savings.

Finally it led, by artificially lowering the cost of capital, to a global expansion of capacity which is going to haunt us for some time.

Overcapacity will dramatically reduce the earning power of the global economy, especially where the operating leverage is high. This will in all

likelihood encourage new protectionist measures around the world (not to be compared with the 30s but

The consequence will be what Pimcos B.Gross calls the New Normal I.e. deleveraging (both financial and operating), deglobalization and

reregulation

But now for the present and near future...

We continue to see the current phase as simple normalization from the panic experienced at the end of last year and earlier this year on the back ofan aggressive rise in excess money (monetary expansion over GDP growth or industrial production) and huge fiscal stimuli (even if beside China, a

big chunk of the announced stimuli is yet to be spent). The impact has been much stronger on non-financial leveraged economy were the

multiplication effect was in full swing (and was also helped by some government directives in less democratic countries like China). Trade was

frozen as letters of credits could not be emitted, companies panicked slashing down production (with industrial production falling much more

rapidly than sales) and laying off workers en masse. The latter point applies especially to the US.


So now let's look at the various elements in more details


8/38

7Macro: Leading Indicators

We are starting to see some divergences appear in

leading indicators (Chart 1). The Chicago Fed

US Leading IndicatorsSmrgasbord

Chart 1 Chart 2 Japan ,Euro and China LeadingIndicators

ISM Manufacturing New

Orders to Inventories Ratio

turned down. The same is true for the NFIB index

(and we will have more to say on small companies

latter...). The NFIB current level is consistent

with an ISM manufacturing Index of 44...

The non-manufacturing ISM is continuing to

print significant lower readings than the

manufacturing survey. This is an excellent

Source: Bloomberg, Clue

as noted last September and imply a continuing deterioration here...

The Conference Board leading indicator monetary and financial indicators remain strong while the

real economy indicators are rising much less vigorously...

Source: Bloomberg, Clue6

Chart 3 US Real-Time GDP Estimation

The Japan Economy Watchers Expectation survey has continued to deteriorate (Chart 2).

Remember that Japan is leveraged to the global cycle and has tended to lead other countries (note

that the Yen strength should also be taken into account... so maybe not as bearish as otherwise...).As an aside, the Topix correlation with this survey is extremely high so use it when looking at

your Japanese market exposure

All in all, growth expectation could be too low for Q4 2009 and Q1 2010 while the expectation for

Q3 2010 and forward are probably too high... but a lot depend on the evolution of the fiscal

stimuli, the Central Banks stance and, partly as a consequence, when the next shoe, probably


Europe, drops....


9/38


Let's call them the swing factors. They are inventories, residential investment and autos. They

might represent a low percentage of the overall GDP but believe it or not they have contributed to

all of the GDP decline in previous recession before the current one (without them we would not

US GDP and Swing FactorsChart 4

. ...

Inventories have less influence as they represent a smaller share of GDP and they remain

high (Chart 5). But one has to remember that it is the inventories quarterly rate of change which

counts so even if inventories continue to decline in Q4 they will only have to decline less than in3 to have a ositive contribution to GDP The will add u to 4.5% to the rowth announced

for Q4 2009 and Q1 2010. Note that ISM inventories indices are falling again (to 8 months low)

despite the fact that the supplier deliveries is above 50 Inventories are hard to finance which

leads to potential sales lost

For autos, the cash for clunkers scheme and similar ro rams in German and other countries

has, beside encouraging people to take on more debt (yes more...), pushed forward future

sales. This is the past, history and the only lasting mark is a relative increase in consumer

leverage and some auto manufacturer stocks slowly becoming attractive short again (Ford,

Fiat,)

Source: Morgan Stanley

Chart 5 Census Bureau BusineesInventory to Sales Ratio

Residential investment is not likely to be a major drag for future growth now that it

represents 2.3% of GDP from a 6% peak and a historical 4.5% average but the first time home

buyer tax credit has been extended both in time and scope which will be helpful. Previous

rebounds have been the result of short supply and as we will show later, supply is plentifuleven if the visible one has decreased substantially in the past few month, courtesy of the tax

credits...

Let's not forget that the last 2 factors are usually debt-financed and debt is harder to come by

these days (and actors not necessarily willing to borrow see balance sheet recession

later)...even if governments are directly or indirectly lending money.


,


10/38


It leaves us with government spending, private investments, consumption and export...

Government spending and consumption will be analyzed in more details later. We will show that

government spending will have a major positive impact in the short-term but then while

US Fixed Investment to GDP RatioChart 6

consumers spending, while it might continue to rebound in the medium-term, will slow again as

soon as their net worth starts to decline again

Private investment have been declining rapidly recently (Chart 6). This is a global phenomenonfor developed economies. Even in Japan, the perennial "over-invester", fixed capital investment

as a percentage of GDP have declined to 20% from 24% a year ago and a 32% peak in 1991.

In the US there are no net private investments (Chart 7)... despite the fact that companies

have a positive financing gap. This is typical of balance sheet recession where debt reduction is

more important than profit maximization...

Anyhow, we should witness increase capex in the quarters to come with the Conference BoardCEO Confidence index recently rising above 60 which is consistent with YoY 8% capex growth

in the quarters to come...


Chart 7 US Net Private Investments

For exports, we might have a positive surprise given the very low USD and the fact that the USlabor force has declined much more than the US GDP while it has only declined by 1% in

Europe and UK and 2% in Japan.

Higher productivity, lower currency and companies eager to find new market to compensate for

the sluggish domestic one, what more could you ask for...Source: Morgan Stanley



11/38

10Macro: Trade

Global trade has finally started to rebound with growth accelerating in the recent past

(Chart 8). It is still 14% below the April 2008 peaks but the September MoM increase was the

biggest on record

World Trade VolumeChart 8

trade late last year and that it would warrant at least a small snap back so far so good

Export growth in South Korea (more timeliness and strong correlation with the world trade data)

has continued to improve but the recent rebound into positive territory is mainly due to the base.

Manufacturing companies have been underperforming relative to the KOSPI for some time and

it has been a good leading indicator of deteriorating exports The underperformance has

accelerated recently

Protectionism has been again on the agenda recently (many fiscal stimuli had a buy domesticbias but this was not a bilateral measure so less likely to make the front page). We are also

seeing a lot of new capital control measures being instituted (Brazil, Indonesia, South Korea,

Taiwan, Russia) and some devaluation (Vietnam).

Source: Netherland Bureau for Economic Policy Analysis, Clue

Chart 9 South Korean exports

Expect this trend toward greater protectionism and/or competitive devaluations (even the SNB

does it nowadays) to continue going forward, especially when the growth cycle turns down

again...but do not expect a return to the 30s tariffs and trade wars

Remember that rotectionism is one of the five overnment cardinal sins accordin to

Charles Gave. The others are war, monetary policy mistakes, increase regulation and tax

hikes.

We will have more to say on them later


,


12/38

11Macro: Credit

Since last year, we have used R. Koo's "Balance

Sheet Recession" framework. Balance Sheet Recession

t was eve ope w en ana yz ng t e econom c

agents behavior following a credit bubble (see

"The Holy Grail of Macroeconomics: Lessons

from Japan's Great Recession by R.Koo).

n s env ronmen , ouse o an us ness

reduce their debt despite massive monetary

accommodation.

The economy relapses every time the

in Japan during the past 20 years

Stimuli can only been removed when the

deleveraging phase is completed and balance

but unfortunately government in the US,

Europe and Japan wont have the luxury to

wait The markets will force them (and the

feel the market pressure) to put their finance in

order (if it is possible which we doubt on a

longer-term perspective with the potential

exception of the US)

Source: The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession, R. Koo



13/38

12Macro: CreditThe west is overleveraged and it will take a lot

of time for leverage to normalize Welcome tothe balance sheet recession

There are many metrics one can look at as, for

Chart 10 Bank Credit to the Private Sector Chart 11 US Household Debt Burden

example, bank credit to the private sector as a

percentage of GDP (Chart 10) or the household debt

to total asset (stock) and personal disposable

income (flow) (Chart 11).

Note that households would have to pay back USD

Tn 4.35 to get back to their 1990-2000 average

leverage... and that is hard for them to lower their

leverage quickly except by using personal

bankruptcy so this will be a long story...

On Chart 12 and 13 one can see that the creditmarkets have mostly normalized from the panic

levels of late last year

Source: Morgan Stanley Source: Bloomberg, Clue

Chart 12 Chart 13 Moodys BAA SpreadsEuro and US Libor-OIS Spread

We are even seeing new issuances ofcov lite (few

conditions attached), pig toggle (debt principal and

interest paid with more debt) or dividend recaps

(debt to pay dividend) bonds and loans. We are also

seeing new CLO tranches being launched.

nvestors memory must ave s orten even more

than what we feared

As in 2007 look attentively when PE firms come

to the market to sell the shares they own or even


e er w en ey ecome pu c company some

have yet to do it)Blackstone marked the peak in2007

ource: oom erg, ueource: oom erg, ue


14/38

13Macro: Credit

Bank are still tightening credit standard in the US(Chart 14) and Europe (none are easing) while

demand remains low (Chart 15).

Chart 14 Chart 15 Fed Senior Loan Survey C&ICredit Demand Increasing as a % of

Total

Fed Senior Loan Survey C&I CreditStandard Tightening as a % of Total

Small companies are feeling especially hit. Did

you know that 82% of small companies

consider credit card has a vital form of

financing along with loans from local banks

Cre it car lines ave alrea y een cut from us

4.7 tn. to 3.5 tn. and they are expected to decline

by 1.5 tn. more in 2010

Local banks will be hardest hit by the coming

wave o e au t commerc a rea estate w c

represents up to 40% of the loans book, loans tocompanies,)

The NFIB credit condition index which measure

Source: Federal Reserve, Clue Source: Federal Reserve, Clue

Chart 16 NFIB Expected CreditConditions Chart 17Consumer Credit Outstanding

% Change YoY

oan ava a ty compare to mont s ago s at -

15 just 1 point away form the all time low of 16.

29% of companies said their borrowing needs

have been satisfied (one of the lowest reading in

the history of the dataset while 10% responded

a ey were no same eve as n arc

2009)

Consumer credit, revolving and non-revolving is

declining at a historic rate (Chart 17). Even the


... , ,


15/38

14Macro: Credit

Mortgage rates are kept down thanks to theorigination spree of government-backed entities

(with the FHA taking the lead) (Chart 18) and the

buying of the emitted paper by the Fed (which has

Chart 18 Chart 19

Investor Type Share of New Loan

Originations Scheduled Mortgage Resets

already bought more than usd 1 tn. of the usd 1.2

tn. it has said it would buy before the end of Q1

2010).

In the fourth quarter of 2006, approximately 10%

of originations in our sample were labeled by

originators as "subprime." For the entire universe

of mortgages, subprime loans are estimated to

have made up about 20% of originations in 2006.

By the first quarter of 2008, the subprime shareSource: Recent Developments in Mortgage Finance , J. Krainer ,

Source: Credit Suissewas e ec ve y zero. nce en, ncrease Federal Reserve Bank of San Francisco

Chart 20 US Loan Loss Reserve

lendingidentified here by Ginnie Mae's sharehas revived this segment of the market. he

share of borrowers with FICO credit scores lower than 660 has returned to just higher than 20%,

.

Delinquencies are still rising and we are entering in the second phase of exotic mortgage resets (Chart

19) which will have a dramatic impact (bank loss, increase in foreclosure,...).

A rela se is a ossibilit but not a certaint . In this re ard one has also to note that man reat

investors (D. Tepper, L. Ainslie) and some of the most prominent member of the "those who saw it

coming" group (J. Paulson...) are positive on the large bank stocks... So the jury is still out...

We will have to monitor carefully bank relative performance (stocks and CDS)...



16/38

15Macro: Credit 15

There are other risks one should keep in mind

Regulations imposing lower leverage on banks, minimum standard funding liquidity, counter

cyclical capital buffer or off balance sheet entities ban will lower lending capacity and could

Chart 21High Yield and Leveraged Loans

Refinancing Needs

.

FASB 166-167 which should start to apply during Q1 2010 will bring back more than usd 500

bio. off balance sheets assets into the "big 4" sponsoring entities balance sheet in the US

(and we now know that SIV assets can be of dubious quality...)

Basel II should also start to be implemented at the start of 2010. When one see that Japanese

banks can rise more than 10% on an article implying that the rules implementation might be

delayed, one can see that they won't be optimal on a bank profit maximization angle...

government assistance will only be junior to depositors would also increase banks funding

costs

There is also the refinancing risk with refinancing needs rising strongly just when government

and central banks will be forced to ti hten the ri b markets well overnment at least ...

Source: Barclays

Chart 22 Banks Debt Average Maturity

10% of the US high yield market will mature in 2011, 15% in 2012, 17% in 2013 and 20% in

2014. In 2014 alone usd 350 bio. of high yield and leverage loans will have to be refinanced in

the US and eur 60 bio. in Europe (Chart 21)

Some insiders are predicting that up to private equity owned companies, employing 3.75 mio.

workers, will go under between 2011-2015 (The Buyout of America, J. Koshman) as they

struggle to refinance the almost usd 1 tn. dollar that will come due...

Banks debt average maturity has also declined from 7.2 years 5 years ago to 4.2 years today.


Usd 7 tn. of their debt will mature by the end of 2012 (Chart 22)...


17/38

16Macro: Credit 16

Emerging markets refinancing needs will also be very important (especially in Eastern

Europe) (Chart 23). One has also to take into account the need to finance the budget deficits on

top of that and here again, Eastern Europe come into mind...

Chart 23 External Debt Refinancing Needs

On Chart 24, one can see that European banks are most exposed to this risk, with more than

75% of the total loans to emerging markets.

We have long argued that the next phase of the crisis will have its epicenter in Europe...

There are sovereign problems (Greece, Spain, Irland, Italy, Portugal, Austria), banks have been

much more timid to recognize their loss than their US or Japanese counterparts and are very

exposed to Eastern Europe (which will experience an Asia 97-98 like crisis... not a question of if

but when...).

Furthermore as we will see later, European government are likely to tighten their budget first,European companies are less competitive (high currency, not enough firing,...) and the housing

bubble has yet to pop.

Source: Source: World Economic Outlook , IMF, April 2009

Chart 24 Liabilities to Advanced EconomiesBanks (% GDP), 2007

e mar e s now s ar ng o rea ze e sovere gn pro em w reece u s us a

beginning) and the bankruptcy of Hypo Group Adria (HGAA) in Austria is putting European

Banks and their Eastern Europe exposure back on the table. Note that while HGAA might seem

small, for Austria it is equivalent to a bank with usd 2.5 tn. in assets...

...

in 1931...

As always, once we have identified potential risks, our role will be to monitor the indicators

which will show if they materialize...Source: IMF



18/38

17Macro: Inflation

Deflation... Inflation is low (Chart 25) and with the deleveraging induced fall in money velocity,

going to fall further. The ECRI future inflation gauge, unemployment momentum (Chart 20),

Chart 25

US Core CPI and Unemployment

Rate Momentum

.

Kondratieff's "fall from plateau" we described in the past...

With deflation nominal incomes are likely to decline or only grow slowly, increasing the need to

pay back debt. Real rates will also be positive even if nominal ones are at 0

But as J. Bullard, president of the St. Louis Fed, recently said, productive capacity might have

fallen (our no net investment graph before and the fact that many of the job losses are not cyclical

are confirming this hypothesis), the output gap might be much lower than what is currently

believed

Psychologically one should also take into account that the base effect will be negative in the

months to come (rapidly declining price 8-12 months ago). We could have 5-10% inflation rate on

a YoY basis in some emerging market countries (India,) Will be interesting to see how the

Central Banks and markets react Especially if food prices continue to rise (remember 2008

and the conse uence it had in emer in markets


But ultimately we still think that deflation will prevail when we relapse at the end of 2010

beginning of 2011 A potential scenario, as in 2008, would be an initial inflation scare, with

rising inflation expectation, which would pave the way to a new phase of deflation)



19/38

18Macro: Consumers Employmente roa unemp oyment rate a mprove

somehow (Chart 26) while job opening have, at

least for now, ceased to fall (Chart 27).

As said in our last 2 presentations, one should not

Chart 26 Chart 27Broad U6 Unemployment RateUS Job Openings By Industry Total

and Temporary Help Services

lagging. We prefer to look at the number of hours

worked and the temporary help index.

Indeed, firms will first move workers from part-- ,

increase labor hours and hire temporary workers

before hiring new workers. Both have been

improving recently (Chart 27). The Conference

Board Employment Trend Index has also turned

...

Nevertheless both the duration (Chart 28) and the

percentage of unemployed not on temporary layoff

(Chart 29) indicate that there is a fair amount of

Source: Bloomberg, Clue Source: Bloomberg, Clue

Chart 28 US Unemployment DurationOver 27 Weeks % of Total SA Chart 29 Percentage Of Unemployed Not OnTemporary Layoff SA

the boom are gone...)...

Did you know that there has not been any net

private job creation in the past 10 years in the...

if it ceased to be a major driver of growth (as we

expect... it has long cycle and we are near/at the

top)... In 2007 we wrote that the US potential

growth was overestimated... It still is... and we

refer not talkin about Euro e... while for Ja an it


is so low that we are almost certain that it will growquicker than estimated

, ,


20/38

19Macro: Consumers Employment

Small companies (less than 500 employees) are employing 65% of the US workforce (Table 1)...

Chart 30

Distribution of Net Gain in

Employment

In the past 18 months, the smaller companies (less than 50 employees, less than 30% workforce)

have accounted for 45% of the job losses while in the previous recession it lost only 9%...

Given the readings of the various NFIB survey components, they do not seem to be ready to hire...

This is a development to follow closely as it is different than previous cycles...

Nevertheless, the employment picture should improve in the medium-term (the models presented

in September is still indicating net job creation for Q1 2010). Do not forget that the government

will hire up to 1.5 mio. persons for the 2010 census (this could add up to 700'000 jobs to the May

nonfarm payroll), t ose jo s will e temporary ut sometimes t e mar et see only w at it wants...

Longer-term the job picture is grimmer...but we will analyze this in due time as it does not really

influence the near-term markets movement

Table 1 Employment Distribution

Source: BLS, x

Source: Clue6, BLS



21/38

20Macro: Consumers Disposable Incomes

The correlation between wages growth and consumption has been high historically (Chart 31).

Aggregate Income and

ConsumptionChart 31

contracted Aggregate paycheck should increase in the next quarter or 2 at least so this will

support at least some consumption (but note how depressed it is) Then the balance sheet

recession dynamic will prevail and consumption will grow less than aggregate income

incomes aggregate...

Indeed total personal disposable income is composed of: compensation of employees received

(~68%), Proprietor Incomes (~9%), Personal interest and dividend incomes (~16%), Personal

~

social insurance (~8%) less taxes which are less tan 10% today.

As one can see on chart 32, transfer and tax cuts have added more than usd 670 bio. (290 and

380 respectively). Without those contributions, disposable income would now be more than 5


Chart 32 Disposable Incomes GrowthComponents

...

that they are paying in taxes

It is doubtful that taxes and transfers contribution to total disposable income will continue

to have the same positive contribution going forward. They might stay where they are butwill not add usd 670 bio. more next ear Wa e rowth will thus be determinant as ro rietor

income and personal interest are likely to continue to fall while dividend incomes could rise

some but not much

But there are other elements impacting disposable income and its discretionary use...


,


22/38

21Macro: Consumers Disposable Incomes

On table 2, courtesy of Goldman Sachs, one can see the various elements which can impact

discretionary disposable income.

US Household Discretionary

Cash Flow SensitivitiesTable 2

ommo ty pr ces can ave a non-neg g e mpact. e ave ong sa t at ast year s nanc a

crisis masked the negative impact commodity prices had on global growth... We might have had

a commodity price induced recession even without the financial crisis... At usd 2.6 per gallon

unleaded gasoline is usd 1 higher than at the start of the year and much higher than the

level which were deemed to be impacting consumption negatively pre-2005. It has removedus o. ou o e consumer s poc e s.

Credit which we talked about earlier is removing usd 25 bio. for each % point of decline so

given the current 3.5% decline it has already removed usd 90 bio.

Source: Goldman Sachs

.

save more or not. If one regresses net worth to saving, savings seems to be were they should.

Our contention has been that the bursting of the credit bubble would change mentalities

for a generation at least. Never before have they seen what over-leverage could do. They might

Table 3GDP Change given Various Personal

Disposable Incomes and Saving Rate

...

So our most bullish guess is that saving will rise to 5-7% next year and disposable income

will fall 1-3%. The impact on GDP will be between 2.46-5.98%. One could add a 0.5-0.75%

impact from continued consumer credit fall for a grand total of 3-6%. If we were forced to-... , -

GDP components would have to add as much for GDP to be flat...

So going forward we will have to follow closely how total compensation evolves...

Source: Clue6


, , ...


23/38

22Macro: Consumers Wealthet wea t as r sen y us trn. ur ng t e past

quarter (Chart 33).

The net worth to GDP ratio is once again

hovering above 4... As we said this ratio is

Chart 33 Chart 34

US Household & Nonprofit

Organizations Net Worth

Ratio US One Family House Sold Annual

Median Price to Median Household Income

.

structural bull market can start... This implies a

>20% decline in net worth (depending on the

timing) to come or approximately usd 10 trn.

equities which represent approximately usd 23

trn and real estate with usd 17 trn... As we will

explain, we would expect real estate prices to fall

10-15% from current level so equities will have to

- ...

point before this cycle ends...

So why should housing decline more as the

downside momentum seems to be abating (Chart

Source: Bloomberg, Clue Source: Bloomberg, Clue

Chart 35

New Housing start and

NAHB Market Index Chart 36 US House Prices YoY

we are not there yet and with such an overshoot an

undershoot is likely (and at this time our 10-15%

decline would be too conservative)... Affordability

is at an all time high (fine for first time buyers,,

existing owners do not really care except if they

want to buy a more expensive house...)

Activity is failing to really pick up outside of

existin home sales Chart 35 The MBA


purchase index remains very depressed as are new

building permits

, ,


24/38


25/38

24Macro: Governments and Central Banks

Source: The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession, R. Koo



26/38

25Macro: Governments Fiscal Stimuli

ARRA Spent MoneyChart 39

The US has followed most of the remedies proposed by R. Koo both on the fiscal and monetary

side...

As we have said the fiscal stimuli should be oriented toward growth-enhancing investments and

should be temporary for the non-productivity enhancing reforms (need a new vote to be prolonged).

They should be temporary to limit the increase of the real interest rate which would decrease the

stimuli effect on the economy. Its main goal should be to increase productivity and encourage

people to work, the 2 motors of growth.

In the US, many reforms are permanent and as J. Hussman puts it:

our policy makers have aggressively crowded out private investment through this bailout

policy, which allocates good capital to the worst stewards, and they have done virtually nothing to

abate the housing downturn..

Furthermore the cash for clunkers and tax credit for first time home bu ers are encoura inSource: stimulus.org, Clue

present consumption at the cost of investments...

With regard to housing we repeat that we favor a debt to equity swaps where over-indebted

homeowners would give a participation to the future value of their house in exchange to a

diminution to their debt balance today. The more details we get from the moratorium on

Table 4

foreclosure and HAMP program instigated earlier this year, and the clearer it becomes that it is not

working...

Anyhow for the short-term it is the amount of money which is spent which count (unfortunately)

and there are plenty more to spend (Chart 39) and Table 4. Only a third of the ARRA has been

spent to ate w e t ere are a most us o. xten e prov s ons to come

And keep in mind that there is a lag between the fiscal thrust and the fiscal impact

When looking at the cyclically-adjusted budget balance (Chart 40, next page), one see that it is

v


Source: Stimulus.org, Clue6

,

the improvement is due to a rebound in tax revenues not caused by a rise in tax rates


27/38

26Macro: Governments Fiscal Stimuli

Cabinet Appointments: Prior

Private Sector ExperienceChart 41

The fate of the recovery later next year will depend on

the decision of the government. There are 3 main

scenarios:

The Liquidation Scenario: decreasing aggregate

demand and precipitating a major depression in order

Chart 40 Cyclicaly Adjusted Budeget Balance

to liquidate zombie companies and malinvestment. This

would cause a massive wave of defaults and decrease

debt burdens significantly through bankruptcy and debt

repudiation. or;

The Glide Path Solution: increasin a re ate demand

by maintaining government spending while trying to

liquidate zombie companies and malinvestment. This

would allow the private sector to decrease debt burdens

significantly over time through increased savings. It also

has the benefit of reducing dependency on foreign

Source: JP Morgan

Chart 42Japan GDP Real Chained Price Public

Demand SA YoY (lhs) and Topix

. Source: CBO Idea: A.Edwards

government debt, the specter of big government and a long muddle through.

The Hoover Status Quo: decreasing aggregate demand and precipitating a double dip recession in order to reduce

government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt

repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would

simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain

dependency on foreign sources of capital all without ending the spectre of big government. (E. Harisson)

We will see the fact that there are few in the current administration with a private sector experience (Chart 41)increase the risk that solution 1 and es eciall 3 will be chosen But then the market mi ht force their hand

Keep in mind what happened in Japan every time spending momentum faltered on a 12 months YoY basis(Chart

42) and spending will have to be cut and/or taxes be raised as soon as the economy show any sign of durable

growth. >3% real for 12-18 months)


,

obligations


28/38

27Macro: Governments States and Locals

Total States Budget ShortfallChart 43

Only 2 states have balanced budgets and 9 are in distress... One can almost read daily on

California woes in The Journal (and remember California is would be in the top 10 world GDP

if it was a country...).

Deficits are estimated to reach usd 180 bio. in 2011 and usd 120 bio. in 2012, if the economy

recover (Chart 43)...

One of our past concern was that part of the federal ARRA stimulus would be used to fill state

and local budget.

One can see that states and locals expenditure have yet to be cut (well once again if you do not

live in California...) because the federal government has been helping (Chart 44).Source: CBPP

Chart 44States and Locals Tax Revenue,

Expenditures and Federal Grant in AidAnd do not only look at the recession induced problems but the more structural cost structurewith extremely high health care and retirement benefits for public workers and as a

consequence the grossly underfunded pension and "other post employment benefits" (OPEB)

funds...

So this is not only an income statement problem but also a balance sheet problem...keep an

eyes on them...

Source: BEA, x



29/38

Macro: Governments Real Fiscal Burden 28

Table 5

Fiscal Imbalance as a Percentage

of GDP (2004)

Sometimes we know something is not sustainable, yet it continues in the same direction

unabated...

There are countless episode of bubbles in financial history and in political history...

It continues (and you hear " it has been so in the x past years and we did not have a problem so

why worry now...") until... it stops...

Could investors and the public start to price the real fiscal imbalance their countries are facing

(Table 5, note that this ratio is above 500% for the US too) sometimes in the next few years

now that the "traditional deficits" the press is always talking about are exploding?

This is a distinct ossibilit ...

The consequences will be a big increase in savings as citizens will slowly come to realize thatthey won't get what they were promised and increase in real rates as, even if the system is

reformed (increase pension age, lower pension. higher contribution...) ,it won't be sufficient to

avoid a fiscal crisis in man countries... Time to realize that the "ac uis sociaux" were not a

right but something which the state provided when they could... they can not anymore...

A risk to keep at the back of one's head (and as always the market will probably give clear

signal when to really worry about it as an investor... but as a citizen it is already too late...)Source: Measuring the Unfunded Obligations of European Countries J.

GokhaleAnother area were many emerging markets (ex Eastern Europe and some Latin American

countries) have a big comparative advantage...


M


30/38

29Macro: Central Banks A Repeat

Last year we said that Central Banks would have to become, temporarily, commercial banks in

order to avoid an extremely destructive debt deflation spiral. When the market literally closed,

spreads moved so high where even conservatively managed companies were facing bankruptcy as

Chart 45Fed and ECB vs. Japanese

Quantitative Easing

they could not access short-term financing. The Fed and the BOE have been exemplary in this

regard and have managed to restore some sort of calm to the market. This is not to say that

everything is rosy now but that only those who should will go under (another way to say it is that

it is OK for the Central Banks to deal with the confidence problem but that It should not forget

that there is also an important Solvency Problem. Spreads should be normalized but not pushedtoo low. The market should be given back its role of price fixer as soon as possible. The

deleveraging phase should start, debt reduced and not only socialized in government balance

sheet.

Central Banks are now facing a strong dilemma to decide when to normalize and how to

communicate it... Source: Bloomberg, Clue

Risky assets are rising strongly while the economic recovery is still in its infancy. By tightening too soon they risk killing a weak recovery. By

tightening too late they risk re-inflating the same kind of bubble which brought us where we were 6 months ago ... Furthermore they also must to

take into account that many unconventional measures have been implemented and that there are no prior record on how or when they should be

...

The exit should be coordinated with the government so that both fiscal and monetary stimuli are not exited at the same time. This adds another

layer of complexity where errors could be made

.

Central Banks. One part was active while the other was passive I.e. accessed at the private sectors discretion. The exit of the passive part should not be

considered as tightening but rather as a positive sign that the private sector feels strong enough not to need the Central Bank's hand. For the active part,

programs should be run down slowly and its impact on risky spreads analyzed carefully.


,

not be totally separated as the CB have also increased their balance sheet by buying "private" paper), should continue for now (but the mix should

M


31/38

30Macro: Central Banks

Chart 46Federal Reserve Balance

Sheet

slowly move toward only government bond paper...) (Chart 46) to fight deflation... This is

legitimate but here again the exit condition should be defined clearly. The risk is that it comes too

,

overshoots (but that is probably a risk Central Banks , in countries where indebtness is high, are

ready to take). Central Banks could also start to charge interest instead of paying it on reserve

held on behalf of commercial banks to force the money into the economy. The Riksbank is the

first one to have done so Short-term rates should be last to move...

As an aside, failure to communicate on the exit strategies, would be very detrimental to the

Central Bank national currency (but this might be something they aspire to but do not dare to

say).

Source: Federal Reserve Board


M


32/38

Macro: Rest of the World 31

Europe looks less leveraged but is it really? Its financial system is more leveraged (even aftercorrecting the difference between the IFRS and US-GAAP accounting rules) and holds more than

75% of the usd 4.7 trn. loans which have been made to emerging markets (see chart 24). Its

housin market has et to correct See later . The commercial side has corrected in some laces

Chart 47 Eastern Europe External Flows

notably in the UK but the residential market is still near bubble highs (with the exception of

Germany).

It is more dependant on export, its currency is overvalued and its central bank was rising rate late

last summer... It lacks the flexibilit and the culture of success defined as a failure bein an

experience and not a stigma) of the US. The labor force only declined by approximately 1%

compared to 5% in the US Guess who will be more competitive

The Eastern Part is on the brink and a crisis (Chart 47) much more severe than what happened in

South-East Asia will only be avoided if the IMF and the EU show strong resolve... Source: IMF

In Japan, the leverage problem has corrected during the last 20 years and if we do not take thehigh share of banks assets invested in equities, the situation looks better than in the US and

Europe. The Yen is too strong and as long as trade flows remain low do not expect a strong

recovery and this is what the Economy Watchers Expectation index (Chart 2) is confirming

Chart 48 Topix and Nominal GDP

Gross capital formation has slowed rapidly recently and this is a positive going forward as Japan

continued to overinvest long after the bubble burst in 1990

It should find a way to increase the number of people working (more women in the workforce and

more openness to immigration). We expect productivity to be a positive surprise in the next 5-10

years as the country slowly turns shareholder friendly.

The DPJ victory might be a catalyst but reforms will take time, lots of it to be implemented


ource: a wa

M


33/38

Macro: Rest of the World 32

South-East Asia has experienced its debt deflation approximately 10 years ago. Balance sheets at all levels are healthy. The problem remains toohigh a dependency on external demand. The big stimuli should be used to rebalance their economies toward less capital intensive industries and

toward labor intensive service, easier access to credit and improvement of welfare.

With regard to China, honestly, we do not know as we cant trust the data It is still a relatively young economy which is likely to experience

some booms/busts in the years to come. We are puzzled by the admiration many have for the influence the government has on the market and its

perceived proficiency Never confound luck with talent

The have rofited a lot from the lobal ex losion in li uidit as their bankin s stem was not officiall im aired low loan to de osit ratio

One should also keep in mind that J. Chanos has started to be a very vocal bear on China

We will write a chapter on it in the next quarterly were we will see if there is/are bubble(s) or not as a crisis would have enormous consequences on

many assets

Latin America remains dependant on commodities but one could have genuine hope that the region won't fall back to its ills of the 80's and 90's.

Their fiscal stimuli should have the same aims as the South-East Asian ones.

So, the US needs to save, Europe to revolt, Japans consumers to wake up and Asia/Lat Am to spend.

We would avoid large CA deficit countries with high need of foreign capital as foreign investors are in a lose/lose situation. Either they

devalue or they do nothing and the domestic economy collapse.

We would favor CA surplus countries with high domestic savings and low leverage. They will be long-term winners but are likely to suffer

greatly from the fallout of the above-mentioned.

It will be important to see which countries in this group will be making reforms that encourage the emergence of strong domestic-oriented

economies and ready to let their currencies appreciate. This group will be the big winners in the next 10-15 years


M S l S i


34/38

Macro: US Total Net Saving 33

One of the area which was identified as a potential growth engine in the future in the US was investments.

Investments need to be financed and while companies are saving a lots (but they have high absolute debt to equity level), the US total net saving has turned

negative for the first time


s s not goo or nvestments on a me um to onger-term as s, espec a y w en so muc o t e a t es are a rea y on ore gners an s

Time to axe future potential growth even more

Macro: H i


35/38

Macro: Housing 34

Source: IMFSource: OECD, Clue6

The housing bubble has bursed in the US but not elsewhere (except in Japan, Germany and Switzerland)

In many countries the initial loan to value ratio is similar as in the US and you often have the possibility to loan the rest at a higher rate

An important difference is that in the most affected US states mortgage are nonrecourse loans I.e. secured by a pledge on the real property but for which the borrower is not

personally liable, this encourage the lender to find a solution and, above all, limit both in time and length the impact of a housing decline on consumption (wealth effect is


lower)

The trigger for a correction in Europe are probably higher interest rate and/or fiscal tightening To observe attentively especially in Europe including the UK and Australia

Macro: C ti 35


36/38

Macro: Consumption 35

We saw this circulate on the web recently

Interesting to see that healthcare account for all of the increase I spending in the past 50 years

As the population grow older the proportion spend on healthcare is likely to rise, leaving less for the rest


Maybe the healthcare sector will be the victim of a witch hunt sometimes in the future


37/38

37Macro: Conclusions


38/38

37Macro: Conclusions

The fate of the current recovery hangs on the exit strategies for the monetary and fiscal stimuli, how the financial markets will interpret themand the unavoidable errors which will be made

Fiscal Stimuli have been hel ful but their lon -term effects will be sub-o timal as lon as the are considered as a short-term fix and that

they are not constructed to foster future productivity and labor market growth. Much more is needed as they have, for the moment, only been

able to compensate for the loss of other incomes in the US.

Central Banks will have to first give clear guidelines on how they are going first to exit the qualitative phase of their easing now that

markets have normalized. The should do the same for the uantitative art. The Es were le itimate even in our e es... to avoid a total freezeand collapse of the credit markets and a debt deflation dynamic to develop, but not otherwise.

Deflation is still a real risk (we would even say a factand we are talking about price deflation including assets price and not in the sense

of money in circulationas the current inflation worries will pave the way for a new wave of deflation) and we would thus like to see the

quantitative part continuing a bit longer. Central Banks might even start charging instead of paying interest on the reserves they hold on behalf

of the commercial banks. This would encourage them to put the money elsewhere into the economy. The Swedish Riksbank has started such a

scheme and the BoE is discussing the same...

Expect macro numbers to continue to move in the right direction (and in the next 3-6 months the rate of change is likely to be increasingly positive

as it will be calculated against 12 month old data...) until Q2 2010 at least.

After that we will remember that we are living in the aftermath of the biggest credit bubble in history. This does not necessarily imply a

double dip as much will depend on the behavior of households and the impact of fiscal and monetary authorities policies or lack of policies...

Europe should be the focus of your attention as there is a high probability that the next crisis will have its epicenter there

In the next few years the world economy will be more volatile than in the 20 years pre-2007 with dramatic consequences on assets

valuation ratios (cheap tomorrow will be much cheaper than what was deemed cheap between 1990-2007)


First Quarter 2010 GTAA Macro

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