EFTA00612097.pdf

www.variantperception.com May 10 VARIANT PERCEPTION Variant Perception — May 2010 PIIGS Get Slaughtered; Asia Drowns in Liquidity The European periphery highlights the dwindling belief in sovereign guarantees and the return of the bond vigilantes. The periphery will struggle in a debt deflationary spiral, while Asia will continue to be overwhelmed by loose liquidity from the developed world. We anticipate bubbles in Asia, and particularly India, given its easy money policies and negative real interest rates. THEMES > Greece will eventually default and the periphery will remain under pressure — While the EU and the IMF may help in the short run, Greece will likely seek debt restructuring and avoid technical default, but the result is the same. We continue to prefer spread widening in the periphery and CDS trades rather than being short the Euro. The European periphery has all the hallmarks of Asia in 1997 besides a foreign exchange asseVliability mismatch. All periphery countries are very reliant on foreign funding. We believe the European periphery will experience painful deflation and sovereign and private defaults. The crisis in Eastern and Southern Europe is ahead of us, not behind. > Government bonds are the only obvious existing bubble — We have highlighted many countries that are ripe for asset bubbles. However, the one asset class that is truly in the final stages of a multi-decade bubble is government bonds. Currently government bonds are universally hated, so tactically we would not short them, but structurally, we see very little way most governments will be able to reduce the size of their debts given profligate promises and little political will to reduce spending. We view inflation or default as most likely outcomes. > Sovereign debt to GDP ratios of developed nations will prove exceedingly difficult to reduce — Countries can try to reduce their debt burdens by stimulating growth or stoking inflation. The most effective way, though, is to reduce the cyclically-adjusted primary deficit. However, this involves unpopular cost cutting measures and tax rises. If governments choose this route, this will act as further structural resistance on global growth. > The upcoming UK election will likely be positive for sterling volatility — The outcome of the UK election on the 6In of May is very uncertain. There are several possibilities and the degree of uncertainty, we believe, will persist in the weeks or months after the election. With the UK's enormous fiscal problems, we believe this will prove positive for sterling volatility. 01 EFTA00612097 www.variantperception.com May 10 > Potential for black swan "Credit Anstalt" type event - It is not our base case that we have another financial crash so soon, but we are vigilant to any extreme contagion events in the European periphery. We have flagged before that sovereign defaults typically follow banking crises by two or three years. The main event that lead to banking failures in the Great Depression was not the 1929 crash but the 1931 financial crisis that began in Austria because of Credit Anstalt. > Inflation is being underpriced globally, but central banks will not respond the same way — India already has 11% inflation, and within nine months, we think Chinese inflation will surprise very strongly to the upside and reach 8-10%. Other emerging markets will also experience rapidly rising inflation. We favour EM yield curve flatteners and being short the front end of EM yield curves. We believe India will become a large importer of agriculture going forward, exerting the same effects on grains and softs that China has exerted on base metals. > Real interest rates already negative in many emerging markets — Rising CPI and accommodative central banks is causing real interest rates to be negative. Negative real interest rates fuel excess lending, which is the clearest precursor to financial bubbles. Investors are focused on a Chinese bubble, while we believe India will experience the extremely expansionary lagged consequence of negative real rates. We recommend Asian flatteners. > Asian currency appreciation key to determining when the party will end — As long as Asian countries keep their currencies from appreciating, the massive reserve accumulation will continue and will lead to expansive domestic monetary policies. We anticipate continued Asian currency appreciation. Substantial Asian currency appreciation would represent significant global liquidity tightening. We recommend being long a basket of Asian currencies. > Lower trend growth and greater macroeconomic volatility ahead are important structural breaks from the past — We have seen a secular decline over the last four cycles in trend growth across GDP. We also anticipate greater volatility in the business cycle going forward. The net effect is growth in the US will dip more frequently below zero and recessions will be more frequent. We believe this has very important implications for equity and bond investors across asset classes. > There is more than one unemployment rate in the US — We believe the disparity in unemployment levels between high education and lower educational levels is part of a profound structural change in the labour market. As employment and wages stagnate at the lower end, any reflationary monetary policy will reduce real incomes of the poor. Consumer staples and high end discretionary spending will remain robust. > Sovereign risk underlines the need to hedge currency debasement — Countries that can "print" their currencies will, and we believe questions of sovereign solvency and inflation highlight the need to own gold as a hedge. Gold has recently formed an inverted head and shoulders pattern, and fears about government solvency in the European periphery underline the fear of sovereign crises spreading. Please do not forward this publication. Variant Perception has a limited subscriber base, and forwarding on compromises the exclusivity of the product and the service we provide to our clients. 02 EFTA00612098 www.variantperception.com May 10 ASIAN LIQUIDITY ABUNDANT; INFLATION AHEAD Inflation in many Asian economies is rising quickly. Fiscal and monetary stimuli will soon be exerting their full effects and this will put further upward pressure on prices. India CPI -5% rm- 8 $ 5.1 $ $ $ $ $ 2 2 2 2 2 2 2 2 2 2 2 2 2 —Urten workers —Urban non-manual workers —Agricultural Inflation rates in India are about 14% across most measures and food inflation is running at about 20%. We would note that the inflation is not solely restricted to food, and we believe inflation will remain higher than the Reserve Bank of India would like. India Food Inflation. Ye? (3m average) 5.) 3 1 3 3 3 3 3 3 3 1111 3 The result of high inflation and loose monetary policy is that real mortgage rates in India are now deeply negative. In fact, India has the highest inflation rate and the most accommodative monetary policy in the world currently. 03 EFTA00612099 www.variantperception.com May 10 India Mortgage Rates 10 o$ o o$ o o 8 8 0$ Ia o ^ q 6̀' $ $ $5t ? TaikeTA:tU*TAkUg 0 o —Mortgage Rate —Real Mortgage Rate We have written before that one of the most certain precursors to financial bubbles are negative real interest rates. The following chart shows what negative real interest rates did in Ireland. Effectively customers were being "paid" to borrow money as inflation outstripped interest and mortgage rates. ECB Rate vs Ireland Real Interest Rate a 7 7 6 6 5 5 4 jz fTh , 3 • 3 2 . 2 I I -2 I 2 1 2 1 2 I II/ cn cn cn cn 2 cn 2 o 2 to cn —Iceland Real Meted Rates —ECB Rate The very accommodative stance of the RBI is particularly odd given very high inflation and surging industrial production. Indeed, the three month moving average of industrial production never went negative during the Great Recession. India was one of the few global exceptions to the downturn. Now growth is surging at a higher pace than at any point in the last decade. We believe the RBI is being very complacent. 04 EFTA00612100 1,vww.variantperception.com May 10 India industrial Production YoY (3m average) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 8 Fp O 8 aoccocco aocco As the following chart shows, despite the global downturn, credit growth never turned negative in India. Indeed, commercial credit has turned positive once again. India Private Sector and Commercial Credit YoY 40% 30% 20% 10'0 0% -10% - zit & 'I .3 1 2 2 2 —Primate Sector —Commercial The Indian Rupee has appreciated recently, and the prospect of further appreciation will only fuel increases in the Indian Sensex stock index. 05 EFTA00612101 WWW variant perception COm May 10 USD/INR and Sense,' 22403 20.000 15.000 10.000 5.000 0 9 I 1 3 3 —Sensex —11300A Our base case is that absent aggressive hiking by the RBI (and the recent 25bps hike rather than the expected 50bps supports this), India is a prime candidate for a large property and stock market bubble as negative real rates drive credit growth and mortgage lending. This has happened in almost all countries that have had negative real rates. We believe India will become bigger buyer internationally of foodstuffs. India will do for agriculture, what China has done for copper, iron ore, coal, and most rare metals. As the following chart shows. India's growing food needs in some agricultural commodities dwarf global trade in food. Indian v Global Food Demand (mns ton) 140 1 120 1 100 So se so 2o 0 Rice Wheal Sugar Milk and totaled products ■ India Consumption a Global Trade Source: Credit Suisse 06 EFTA00612102 www.variantperception.com May 10 Even in the United States, our own forecasts are for higher food prices ahead. One of our key themes for 2010 is higher food inflation, and we believe that we will soon start to see a rise in food prices based on the correlation of crude and intermediate foodstuffs in PPI. US PPI Points to Rise in Food Prices 40% 12% 30% 10% 8% 20% 6% 10% 4% 0% . 2% -10% 0% -20% .2% -30% .4% 8 g 4 s 8 s s 4 4 4 4 4 0 A A A A A A A A A A A 5 5 - FF1Crude Foodstuffs (pushed golly! d) (LHS) — PPI ntelniethate Foodsrfeeds (pushed 3M f won (RIC) — CFI Food at Home (RHS) We believe markets are being very complacent about the potential for increases in food prices and pass through inflation outside of headline inflation. CHINA AND HONG KONG UPDATE We wrote earlier this year that we anticipated higher inflation in China based on the lagged effects of extremely accommodative monetary policy and the surge in lending. We are beginning to see an strong increase in inflation in China. We anticipate that inflation will rise throughout the rest of the year. China M2 growth and CPI 30% • 12% 28% 10% 26% 8% 24% • 22% • 6% 20% • • 4% 18% • • 2% 16% 0% 14% 12% 10% I C Z I O Z I C Z I O Z I Z I Z • Iz• I z• z• z -CFI (RHS) _M2 growth (9m brwarth As inflation rises, policymakers of most Asian countries will move to try and contain it. Rising prices, especially food prices, are a huge problem in many developing countries. Pakistan, where CPI is over 12% YoY, has recently faced a spate of strikes and riots triggered by an almost 20% rise in food prices over the last year. 07 EFTA00612103 www.variantperception.com May 10 Mindful of such risks, Chinese authorities have begun to sterilize their money supply. The chart below shows the steady increase of net issuance of bills and repos. helping to soak up some of the excess liquidity. PBOC Bills and Repo Issuance 2500 400 300 2000 203 1500 'KO 0 tf I 1000 -100 203 -300 0 ;assts I$$$$§$$$S!$ $$$ 9 9 9 9 4 1 2 - 77 6i,gi 7 W-11n1Wit imiWettly Issuance imWeekiy Redemption: —Curntlatne Net Issuance 'Prom Mat 20010 Hong Kong's monetary base continues its rapid expansion, driven by the dollar peg and the US's maintenance of very loose monetary policy. On a YoY basis, it is still rising at almost 90%. Mortgage lending, too, is now expanding at a rapid pace, over 125% YoY. We believe Hong Kong's housing market is in bubble territory. Hong Kong Monetary Base 14% 150% 12% 125% 10% 100% 8% 75% 6% 50% 4% 25% 2% 0% 0% -2% -25% -4% -50% N9 u,9 $ 8 8 8 s 6-6- 6-essss ass $i O 4<₹ int 4 n< 2 LU I 4 int 4 —HK Mortgage Lending YoY (L8S) —HK Monetary Base YoY GLOBAL EXCESS LIQUIDITY AND ASIAN STOCK MARKET VALUATIONS We believe that many Asian stock markets will continue to outperform on the back of excess global liquidity. However, many have already enjoyed very robust rallies. While this does not preclude them running further (we reiterate what we have said on several occasions, i.e. that excess liquidity is a very powerful force and can drive prices far, far beyond any notion of 'fair value), it is worthwhile taking a closer look to see a more nuanced picture. 08 EFTA00612104  vana nlperception.com May 10 Asia EM Equity Indices (MSC!) •10% C • c • •C 03 -5% 44 0. 2 9 a • Z 03 a a • 2 U T3 YOY YTD Perolrmance (RI4S) One measure to help get an idea of where valuations are is to look at the size of the stock market in relation to the size of the overall market, i.e. the market cap / GDP ratio. Warren Buffet has referred to this measure in the US as "probably the best single measure of where valuations stand at any given moment". A rule of thumb is that when the market cap / GDP ratio is in the range 75%-90% the market is fairly valued; from 90% up to 115% it is modestly overvalued: and at over 115% it is very overvalued. On this basis, two markets in Asia-ex Japan stand out as being in very overvalued territory: Taiwan and Malaysia. Malaysia Market Ca prGDP Ratio Taiwan Market Cap:GDP Ratio 10.000 190% r 9.000 licos 9.000 160% 130% 5.000 110% 60, ‘ 5.000 sox 50% 4 000 "% 111¢ 111;111¢ I 1 11111111111111111111 &Mewl CapG0P5bbo Average .136%— FTSE a. SA kblasso bees o w oop Ra10 — Average . 122% —TM( hoes Malaysia's ratio is approaching 140%, near its average (although we only have data back to 2006 so this is a very short average). In Taiwan the ratio is straight through its 10 year average and heading to 170%. Taiwan has by far the highest market cap / GDP ratio in emerging Asia and looks significantly overvalued. And also in very overvalued territory, by a smidgen but rising fast, is China with a market cap / GDP ratio of 118%. However, China is way below the peak this ratio reached of over 200% in 2007. 09 EFTA00612105  www.variantperception.com May 10 China Market Cap/GDP Ratio 250% 200% 150% 100% 60% 0 0% 4$14 1 $1$ —Shenzhen Index — Nbrkel CaptOP — Ave age - 83% Nevertheless, although some short-term caution may be warranted in these markets, we remind our readers of the powerful combination huge excess global liquidity, strong fundamental stories, and market sizes that are still very small relative to those of developed countries. The two charts below give some idea of how the US dominates world equity market capitalizations, and how miniscule emerging markets are in comparison. Wald Stoa Varuis a World Ma Cap World Stock Markets % et World Mkt Cap 35% Is% 3tr. 09% 0 8% 20% 5n 2 0 6% 0 5% l 04% .I.1,1, ! ION IIIII CI% 5% 024 01 1,1,1 1 1 1,1,..• • • • • c'S:a WY. I I 1 1 I 1 • W2161127;9 tt3ja i l'ar d ccAris t e i nil 111 1 ?, c Fa 1111/1111101 - Z W % el Mild LUMBICOldlialeri •% el World Merkel Ceiatilitedion To further highlight the point, we compared the size of some EM equity markets to several US blue- chip companies. For instance, Microsoft's market cap is about 80% of the Malaysia stock market's total market cap, and it is bigger than Indonesia's market cap. The Philippines' market cap is smaller than that of Apple, GE. Google and Wells Fargo. Vietnam's market cap is smaller than that of Research in Motion's. 10 EFTA00612106 www.variantperception.com May 10 Woad Stock Markets vs Large US Companies 350.000 300.000 250.000 200.000 150.000 100.000 50000 I I 5 3 5 .1 a Regardless of any measures of valuation — which may or may not prove to be prescient — small emerging markets could be overwhelmed by excess liquidity emanating mainly from Europe, the US and Japan. As ongoing problems with Greece signal, it is unlikely monetary policy — certainly in Europe, but also likely the US and Japan as well — will be tightened significantly in the near future. We have previously used the simile "like a fire hose through a stray( to describe the effects of loose developed market monetary policy on emerging countries with small asset markets. We think this remains a most apt description for the outlook today. UPDATE ON THE US: MOMENTUM HAS PEAKED In the US we do not forecast a double dip downturn in the next 12 months. Our base case is for robust growth. Indeed, the Leading Economic Indicators are at multi-decade highs. We view the chances of a double dip recession in the next twelve months as being close to zero. Leading Economic Indicators (VoV) 6% $ $ $ $ $ $ $ $ $ $ $ r§E§E§ r§ r§ r§r§E§E§E§ r§r§ r§r§ r§ r§ r§ r§r§ However, we would caution that various measures which do a very good job of forecasting the Leading Economic Indicators have now started to roll over. Growth will be positive, but momentum has peaked. 11 EFTA00612107  www.variantperception.com May 10 LEI vrilkortgage Sprss0 6 Months Fr:wwar0 LEI vs Early- Lae Sectors 9 ntnlM forward 0.7 N O3 0.0 0A 05 - 03 04 03 - Ox 02 - JO 01 - is 00 - is 42 - 20 .03 - 23 4.4 4% - - 24 45 $ $$$$$$$$doda dad $ $ aaaaakaaaaaaaaaa / 3 3 / 3 * 3 3 3 $ 4 3 4 $ 3 3 4 $ 4 4 3 3 $ 4 —LEIY0Y — M0moa00 Sprea0 6 MOr609 FOrveld —LEI Ye? — Early Lale &Delors 9 months formed ECRI's leading index, which moves faster than the Leading Economic Index of the Conference Board. has turned over decisively, showing that growth will still be strongly positive, but momentum has peaked. ECRI Growth Index 30 20 - 10 o -10 - -20 're 72 c7p O co co 01 01 01 EURO PERIPHERY: GREEK DEFAULT CERTAIN, SPANISH ROLLOVER RISK SUBSTANTIAL Every day brings new headlines of a potential rescue of Greece. We believe any rescue faces many obstacles and will ultimately fail in its aims. National governments could scupper any deal, particularly in Germany, where there is little political will to bail out Greece, and even if Greece were to comply with draconian cuts, a debt deflationary spiral would only make further bailouts necessary. Our base case is that Greece will ultimately experience a practical, as opposed to technical, default. Most likely we will see a voluntary restructuring of Greek debt involving a substantial haircut that will simply formalize what is already happening in the financial markets. It is a matter of when, not if. The ECB will do what it can, as the recent suspension of the application of a minimum credit rating threshold to collateral eligibility shows. Once the bond vigilantes have moved on from Greece, the rest of the periphery will be in their sites. This is the way every international crisis evolves, whether it be Asia in 1997 or the banking crisis of 2008. 12 EFTA00612108 www.variantperception.com May 10 European Bond Spreads 700 600 • 500 400 300 200 100 0 0 0 1; — 2 a a. Z 2a• Spain-Germany 10y 8 8 — if! 2 Greece-Germany 124 — taly-Getmany 10y — Greece-Spain 10y Greece has a government debt to GDP level of 120%. Portugal of 90% and Spain 54%. It is worth remembering that Argentina's debt to GDP ratio was 64% in 2001, one year before default. Most countries in the world are now running above the debt level at which Argentina defaulted, but European periphery countries look most like Argentina with large debts in a currency they cannot print. We continue to prefer Spain and Portugal spread wideners rather than EURUSD shorts. We recommend initiating or adding to positions on any short covering rallies. We have yet to speak to a client who likes the euro, while in November we couldn't find anyone who liked the dollar and that proved to be the low in the dollar. As the following chart shows, we are near historic extremes in positioning and sentiment of the Commitment of Traders (COT), and we doubt there is a single currency trader out there who is unaware of the problems in Greece. EUR Traders Speculative Position tas 124003 "a • 100003 Las ISO 145 140 1.35 Ida 125 0 120 Ile 1.10 LOG IMO age 050 "" nlf ; 42 I - ; 1 1;;;;;;Ii;;;;;;;;;;:i a. /44 tons . .EURLISO Cony Paradoxically, we believe any default will be good for the Euro in the long run. The Euro can be a "hard" currency like the Deutschemark or a "soft- currency like the Drachma. A debt restructuring would fall into the hard category; while a profligate rescue would raise the stakes in the moral 13 EFTA00612109  www.variantperception.com May 10 hazard game and would make the Euro more like the drachma. We will ultimately take our cue from national governments and the ECB. The real danger to the Euro area is large scale contagion to European banks holding the bag of defaulted Greek paper and distressed Spanish and Portuguese debt. 10 Largest Foreign Claims of Reporting Banks to PIIGS Countries (in S bns) 1.000 8C0 6C0 4C0 200 cP e te. cit ">te 4 t•b • ate ,stte, Ponugal Ireland -Italy MB Greece Spain —.—Total (RHS) Source: BIS We think Spain is the greater problem than Greece, while Portugal's economy is even smaller and less significant than Greece's. As we have written before, Greece is less than 2% of Euro area GDP. while Spain is almost 12%. In relative terms. Greece defaulting would be like Arkansas or Mississippi defaulting for the US. In absolute terms. Greece's economy is about the size of Massachusetts, while Spain's economy is almost the size of California. Our base case is not a Spanish default, but we believe investors are not being adequately compensated for rollover risk in Spain or the cost of upcoming banking bailouts that we expect in Spain. Spain's leverage problem is concentrated in its household and corporate sector, and we have yet to see any meaningful deleveraging. Indeed loan growth to the construction sector, astonishingly, has not even declined, proving that a rolling loan gathers no loss. One of the reasons why Greece has been pushed into the limelight now is it had large upcoming debt refinancing (and new issuance) to deal with. Spain is not substantially different. The two charts below capture the similarities between Greek and Spanish debt repayment profiles. Greece Debt Repayment Schedule (In E mns) Spanish Debt Repayment Schedule (In C mns) 45.DCO ro cc* 40.0(0 404)0 35.0(0 SOS® 00.D:0 25.3:0 40.(00 20.0:0 15.0:0 100:0 5.1):0 0 ; R ;;;IIIIIIIIIII% Parcips a110MB IIIPMCIpi • 11140131 Source: Bloomberg 14 EFTA00612110 www.variantperception.com May 10 As of now. Spain needs to pay back 40% of all its outstanding principal and interest payments over the next five years, compared to a 50% figure for Greece. This is before taking into account disbursement of emergency loans from the EU and the IMF. Over the next ten years, Greece is due to pay back a sum equivalent to 60% of all its outstanding principal and interest, whereas for Spain it is 75%. More immediately, Spain has to issue new debt plus roll existing debt this year to the tune of €225 billion, roughly a quarter of Spanish GDP. Spain's debt to GDP level is 54%, which is below the EU average, but Spain is showing the highest velocity of increase, and we believe it will reach 85% of GDP by 2014. Worryingly, more than half last years increase in borrowing was financed by foreigners. Simply put, Spain is dependent on the kindness of strangers. The following chart shows the total stock of bonds (this does not include short term Letras del Tesoro). Spanish Government Borrowing (% of total) 90% 80% 70% 60% SO% 40% 30% 20% 10% 0% 1996 1999 2000 2001 WV 2003 2004 2006 2006 2007 2006 2009 —Spanish Reskients —Foreigners It is likely that foreign buyers will be fickle and could switch their holdings of Spanish debt into what they perceive to be safer assets very quickly. For Spain, the ingredients are there for a rout with much higher bond yields, should investors take fright. Furthermore, as the following charts of net international investment position, external debt and current account deficit show, Spain's cash flow situation remains terrible. Spain. Net International Invesitren1 Position 4. of GDP Spam Gross Ea vernal Dab, ...of GDP