GMI August

Issue No.
66 August 2010

Jave a, Spain

August 2010- Monthly

In this edition:

• Introduction - The Future Recession In an Ongoing Depression ...

• Trade Recommendation - Sell to Close US 2-Yr notes, Buy to Close Blackrock, Buy to Close PPR

• The Business Cycle

• Charts to make you go 'Hmmm ... • o Wheat

o South African Rand

o Iranian Stock Market

o The Dollar

o The Euro

o The Chinese Stock Market

o European Banks and US Confidence

o The Yen

o Japanese Yield Curve History

• Positions (both open and closed out)

~ The Global Macro Investor 2010

e Monthly Publ;o";on No.66 A'g'" 2010

Introduction

The Future Recession in an Ongoing Depression ...

Well instead of getting a crash as the markets broke the necklines of their respective headand-shoulders tops, we got a sharp bounce.

He-hum ... that is the way of summer markets.

However, nothing that has happened in the last four weeks has changed the risk of some significant downside to come. Chart patterns across major markets still look like large distribution tops.

Still slip-sliding away ...

You can see the new downtrend rather clearly if we add regression lines to the chart of the SPX. It's not as flashy as a crash, but a downtrend it is. Expect the upside to be capped near here ...

tQ The Global Macro Investor 2010

2

e Monthly Publ;oafion No.66 Augu," 2010

Go nowhere fast (and slowly)

Most major markets are now roughly where they were during the summer or autumn of 2009. China and Japan are the worst markets with zero returns since May 2009. Europe has managed zero returns since August 2008 and the SPX since September 2008. Looking farther out, the SPX and Eurostoxx have now produced zero returns since March 1998, the Nikkei since September 2001 and China since 2006.

By any yardstick these are lousy markets indeed and we have to expect them to worsen again as the economy weakens.

The worst recovery in history

While we are on the subject of how lousy things are; this is the worst economic recovery out of a recession in recorded history - and this comes after the second worst recession in 100 years.

The breakdown of GDP shows that pretty much the entire bounce in the economy was driven by government spending and an inventory rebuild, both of which look to be topping out.

I've shown the following chart a few times but it speaks volumes. GDP would be a disaster if the Government hadn't spent so much on stimulus - and thus we have to fear what will happen when stimulus is withdrawn. The Keynesian aim of stimulating until the private sector gains traction, has thus so far failed ...

Prlval. So~tor GOP: Wllh No Govomrnom lipQntllng GDP I. Subduod

14000000

1<4500

13500000

1~000

noooooo

13000

12500000

12500

lZ000000

12000

11.500000

'1500

11000000

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All the signs are now pointing to an economic contraction beginning in the latter part of the year (more on this shortly). This matters because equity market returns are very much linked to the economic cycle. And in a secular bear market, which we are without a doubt in, equities are almost entirely cyclical with a bias towards PE contraction over time, as opposed to expansion, thus giving the markets their secular downward trend.


3

Monthly Publication NO.66 August 2010

The Business Cycle matters for equities

These next two charts illustrate how closely the SPX is now following the ISM, not only in its YoY% change version but now in outright prices too ...

ISM VI. SPX Y"VfJ.

20

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..,. .. ... .. ... C Q .. .... .. .... '" '" ... '" C> ISM Vs. SPX

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'" .. ... C> 0 0 ~ The Global Macro Investor 2010

65

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e Monthly Pu.II,"loo No. 66 Au,"" 2010

The initial read from the charts above suggests that it is very difficult for the equity markets to make new lows unless the economy weakens even more than it did in 2008. But still, if the ISM weakens as expected to the recessionary level of 42, then the SPX will go to around 800, a fall of some 27%. If you also account for a bit of PIE contraction, as is common in a secular bear market, then you may see a possible 40% decline.

But imagine if we get the full sovereign mess too ...

Thus, we have to take what is happening in the economy rather seriously. And god forbid if we get the expected sovereign debt crisis because then we will see a potentially massive economic contraction and equity markets Will very likely make significant new lows.

All I know is that yet again bulls outweigh bears, and to me, with the backdrop of a weakening economy, that is a sure way of losing money.

You can see this clearly on the chart of the Mil Bull Bear Index. We are getting close to major resistance ...

Also, the recent sell-off has only caused a small increase of cash holdings at mutual funds. They have very little buying power left. Such low cash balances always lead to major bear markets... (see overleaf)


5

Monthly Publication No.66 August 2010

r---------------------------------------------------------------------_, ·12

-- SPX Log Sale

-Mutual FWld& Poreontago Of Cash Holdings

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13

Bond World is the real world

Meanwhile over in Bond World, markets are predicting a vastly different outlook. 10-Year bond yields Year-on-Year are suggesting that ISM is going to come down to 50, tout de suite. This makes much more sense and highlights just how precarious the equity market is ...

15,------------------------------------------------------------------------,

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-us 10 YrYlo'lds YOY'Y.

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Bond markets are usually removed from the excessive speculation and Panglossian outlook that equities have the tendency to suffer, thus I take what bonds say very seriously indeed.

The wider credit market is also suggesting that the ISM is going lower and at these levels also suggests ISM should be sub 50 ...

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The evidence for a recession

What makes me concemed is that there is rapidly mounting evidence that the US economy will be back in recession within the next two quarters. Let's examine the evidence:

Exhibit 1 - 011 Prices

Oil price rises are always a precursor to recessions. We hit the magic 100% YoY rise in November 2009 and went on to hit the third highest YoY% rise in the history of the oil markets ...

(!;) The Global Macro Investor 2010

7


011 Up +100% YoY14 Ha. porr.ct Probability or Predicting R.c ... lon •....•

150

125

75

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·50
·75
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~ <.. <.. <.. .... <.. <.. c, <.. <.. c, .... <.. <.. <.. <.. <.. .... .... <.. L. L. ....
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~ t: ;;: '" j;: " i;: ~ ~ 1: t: ~ ~ ~ :i: :l: g ~ ~ g ~ 1;
.... .. The magic 100% level in the YoY% change in the price of oil gives us a 100% chance of a recession in the succeeding twelve months. This indicator suggests that the ISM will fall to 40, or even 35, in the coming months before recovering ...

011 Up +100% YoYI4 rak .. ISM Down To About 40._

75r--------------------------------------------------------------------------------------r·'25

30

-ISM LaggDd' Months
-011 YoY% InvOBD Valuo
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8

e Monthly P""Ii,at;o" No.66 A"g"" 2010

Exhibit 2 - The ECRI Weekly Indicator

Every time we head into a recession people refute the evidence. This time is no exception. So much bullishly biased, bullshit economic research time has been wasted on explaining why the ECRI is useless. Maybe it is the analysts who are useless?

Not only has this been the fastest fall in the history of the ECRI, but we are now well below levels that forecast a recession. This indicator has a 100% success rate in forecasting recessions.

It is currently forecasting a recession deeper than 1990 and around the same as 2001 - but has not yet stopped falling. Here is the chart ...


9


When we put the ECRI against GOP you can see it is at levels suggesting -2.5% GOP ...

40 r-------------------------------------------------------------------------,

-ECRI

-us GOP: QoQ Annualized

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e Exhibit 3 - The Consumer Metrics Index

The Consumer Metrics Index, which measures point of sales data on consumer discretionary goods and services, completely backs up what the ERCI is telling us but is computed entirely differently. It forecasts GOP rather well and is suggesting that GOP by next year will be

-3.8% ...

8r--------------------------------------------------------------------------. $

-Conaumor MlttriQ Indo.

-us GOP qoq Annuallzod: La

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.!.. ~ The Global Macro Investor 2010

10


exhibit 4 - Per Capita Auto Sales

Per Capita Auto Sales in the US are at levels only ever seen in recessions. They strongly suggest that ISM will come back to around 35 ...

7S
70
6S
- --
~ 60
55
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4S
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-Per Capito US Aulo S~lo.

-ISM

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... CD '" ... '" '" '" '" . ... co ... en exhibit 5 - University of Michigan Consumer Sentiment Index

Much like Auto Sales, this indicator has rolled over and, like Auto Sales, it suggests that the ISM should be back down at 35, which roughly equates to -2% to -3% GOP ...

125.--------------------------------------------------------------------,

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-u or M Co"sumor Sentlmo"1 Indox

115

-ISM

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w .. ~ The Global Macro Investor 2010

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e Month,y P"b"",'~" No 66 A"9"" 2010

Exhibit 6 - The Baltic Dry Index

This is another index that too many people have wasted time trying to disprove. It has been collapsing at an alarming rate. This should not be happening, regardless of the supply of new ships etc ...

The fall has been so rapid that, other than the previous recession in 2008, this is the sharpest QoQ fall in history ...


12


I-Bal~lC Ory Indene: coo%l

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150

100 ~-------------------------------------------Ar-

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.100L---~~--~--~~--~~----------------~----------~~--------~------_J

And it is the second equal largest YoY% fall, equal with the recession in 2002 ...

Bailie Dry Indox: YaY'A

500 r---------------------------------~------------------------------------_.

450

- ----- - ----- --- - -- --- ----- ----

350

300

250

(!:) The Global Macro Investor 2010

13


Exhibit 7 - Housing

After a brief recovery caused by the tax credits, Housing has rolled over again to levels only seen at the depths of the last recession. Housing starts have collapsed ...

As have New Home Prices ...

- us Now Homo Price US OS

Homo Buyon Ta. Credit< FAILI

300000.---------------------------------,

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~ The Global Macro Investor 2010 14 e Moo,"ly P,bl"""oo No. 66 A'g'" 2010

The NAHB Index tells us that the ISM should hit 43 by early next year. which is a full recession ...

~----------~-.--~------------~~--------~----~----~----~.801

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43
46
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30 The evidence for an ongoing Depression

What is more concerning is that behind the data that is suggesting that we will be in a recession in short order. we have a huge amount of data that suggests that we are still in the middle of a depression.

Essentially. normal recessions see economic activity recover fully and surpass the previous economic peak.

Only in a depression does economic activity not regain its previous peak. Forget all the talk of a double-dip. A double-dip is a low peak in economic activity. as shown by the ISM. This time around we have had a full ISM up-cycle. thus this cannot be a mid-cycle slowdown or a double-dip.

It will be a separate recession in its own right. but it will be part of an ongoing depression.

Exhibit 1 - GOP

Except during a depression. GOP always makes a new peak before the next recession. This time GOP will see a new contraction instead of a new peak Depression.


15


Exhibit 2 - Industrial Production

Industrial is showing the same thing. We are so far away from making up lost production that it is almost impossible not to label this a depression ...

Indu5111al Production

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~ ;r l ~ ;r l ~ d' J' J' d' J' ~ -n "TI ~ -n
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., ~ ~ ~ ~ rr ., ., rr ~ ., rr ~ ~ rr
~ .. ~ ~ e ~ c " "
.. '" ... ~ The Global Macro Investor 2010

16


Exhibit 3 - Consumption

Real Retail Sales have had a miserable recovery. It's actually rather shocking ... this is not an economic recovery. This is an ongoing depression ...

Roal Rolall Salo.

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-Roa' Rotan Salo.
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... .. ... ... ... '" '" ... 0 0 0 Exhibit 4 - Unemployment

This chart of the Duration of Unemployment pretty much says it all. Never before will we have entered a recession with it so hard to find a job.

Duration Of Uncmpl Dyment: Weoks

-Duntlon OfUncmploymonl: WQOks

3DI-------==================~--------------

20

15

1D


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fa Monthly Publ"'ion No.66 August 20'0

exhibit 5 - Durable Goods

This economy is badly mis-firing and Durable Good's orders are at risk of forming a headand-shoulders top!

Summary

The overwhelming evidence suggests that the US economy is headed into a recession by Q4 2010 or Q1 2011, and this will be against a backdrop of an ongoing depression. It is far too early to tell how deep the recession will be. In the normal course of events it would be expected to be relatively mild, but we are not in the normal course of events so we need to anticipate a wider error in forecasting.

Issues for the next recession

We are going to have to spend some time thinking about the potential issues that might arise during the next recession. These will have the capacity to strongly affect the economic outcome.

QE - The Only Bullet In the Gun

If we analyse every recession within the last 40 years or so, we can see that there was an increased reliance on lowering interest rates to stimulate the economy. The main focus was lowering the Fed Funds rate to allow consumers to step up borrowing in order to cushion the shortfall caused by the recession.


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e Moot"" P,blioatioo No. 66 A'g'st 2010

The next recession will not have that cushion. What does that mean for the downside in the economy? As yet we just don't know. This will be the first recession without a movement at the short end to stimulate the economy.

Thus, the Fed is left with one bullet and that is QE. Recent noises from the Fed have suggested that the bullet is being primed to be loaded into the gun. QE II is the whisper amongst market participants and "off the record" officials.

Well, in the myopic, under-researched, panqlosslan world that is customary in investment bank research, we can expect a lot of banner waving to say that the Fed will save the day.

Maybe QE will prove to be the next economic miracle but I think the odds are not in its favour. Firstly, QE is not new. It has been tried and tested by Japan and however much I dig into the data I cannot find ANY evidence at all that it works. There is next to no evidence that it worked in 2008. By all accounts it was the fiscal package that gave the bang for the buck The idea behind QE is that it lowers the long-term financing rate thus encouraging banks to borrow money to lend out and encourage savers to spend.

However, one thing we absolutely know is that lending has never recovered since the last recession and nor has borrowing or spending. The evidence suggests that outcome from QE was sweet Fanny Adams.

In fact, as a tool for fighting deflation, I am not sure it doesn't actually do the opposite.

When an economy is suffering a balance sheet recession, people are more inclined to save as opposed to spend. When you lower the yield on bonds then you force people to save more money to generate the same income. More saving equals more deflation.

I'm just not sure that policy makers understand the balance sheet recession. QE might work but it is highly unlikely.

Fiscal Stimulus - The end of the road

The next issue that we will face in the coming recession is that most governments do not have the ability to fiscally stimulate. Fiscal stimulus does work in generating short-term GOP growth just by the mathematical calculation of GOP alone, but the Keynesian ideal is that the private sector will pick up once the stimulus starts to fade. We have seen time and time again in Japan that this is not the case.

In fact the end result is more volatile GOP and an increasingly indebted government.

In an age when most major governments around the world, from the US to China and from Japan to the UK are all choking on debt, then extra fiscal stimulus risks sparking the chain of sovereign default that, in the end, is the only way to clear up this huge mess and move on.

Taxes

Another thing we need to throw into the mix are taxes. Governments are trying to raise tax revenues to help payoff debt. That in itself can cause the economy to tilt into recession as happened in Japan in 1997, but the bigger problem lies with existing tax revenues when economies go into recession.


19

e Monthly Publ;oat;on No.66 August 2{) 10

Much like the fiscal stimulus issue above, government debt becomes a bigger issue when the economy enters a recession. In the case of taxes, a recession usually means that tax revenues fall. Every single austerity package out there assumes continued GDP growth to reduce deficits, but if we get a recession we increase the risk that tax revenues evaporate, thus massively increasing the risk of sovereign default.

Unemployment

Another problematical reality is that if we do go into recession in 2011, we will enter it with the highest-ever level of unemployment.

Never before have we started a recession with near 10% unemployment, and if you take into account that on average a recession increases unemployment by between 3% and 5%, then it is possible that we could see 15% unemployment in the US. That would be truly staggering ...

Thow out the rule book and the text books

It is this point above that will make a future recession something that we have not had to deal with since the 1930's. The entire economic rule book will get thrown out of the window and the chances are that default, restructuring and a new, much more economically conservative future lies ahead.


20

e Monthly ""Ol""tlon NO.66 August 2010

The Fourth Turning

If you've read the book The Fourth Turning by William Strauss and Neil Howe, you'll note that this is almost exactly as they predicted. At the end of The Fourth Turning, we start the entire process again, returning to where the super-cycle began. In this case we would be returning to a society much more like the 1950's which was a time of economic and social conservatism, shunning of debt, economic isolationism and a whole heap of insecurity and paranoia.

However, we only start again at the first turning once the fourth turning has played out and in that case it means default (and often war ... but I won't go that far!) and a complete shift in societal and political values.

But remember, little did the average man in the 1950's (the last first turning) know that he could look forward to the 50 best years to come. The authors have identified this social, political and economic cycle back over the last 500 years. I've only just come across the book and I pretty much agree with it. We are in the midst of the fourth turning and it's likely to take at least another decade to work through - if not longer - and then we can start again.

It's almost Austrian in its theory of creative destruction and for me, it makes a lot of sense.

I am often asked what I think is the solution to the current economic problems, but I actually don't believe there is an easy solution.

History tells us time and time again, over the millenia, that these super-cycles inevitably end badly, and it's the bad outcome that proves to be the best outcome because we can begin again with a clean slate.

The UK Economy and the Hope Trade

I have noticed that since the Cameron Government came to power and unveiled its new austerity plan, that markets have greeted it with glee.

By most accounts analysts and market participants have lauded the measures, and markets have rewarded the UK with a stronger currency and lower CDS prices.

See the chart overleaf of UK CDS; since the election the markets have halved the risk of the UK defaulting on its debts.

There is a lot of hope riding on the UK ...


21


But let's not forget that the UK is the single most indebted major nation on earth if we take into account total debt. It is in fact 475% of GOP in debt.

Never, ever gonna happen

I have never in my life heard, read about or dreamt about a country that can reign In that kind of debt via austerity measures.

Mathematically, it's simply next to impossible.

But markets are bloody lousy students of history and it will be left to me to be the lone voice yet again pointing out the Insanity of what people are expecting ...

The UK will eventually default.

There is no other achievable option.

A default would be the best thing, and although the short-term outcome would be horrific, it would at least mean that the future would not be quite so bleak.

I know I am hardly consensus in this view but I think it's tough to prove that I'm wrong at this juncture.

Anyway, let's look at the assumptions that the UK has made for Its budget and revenues. The numbers don't seem to bear up to much scrutiny even though most people seem to accept them at face value (which is not something I would do ... ).

I!;) The Global Macro Investor 2010

22


Historically the UK has achieved tax revenues as a percentage of GDP no greater than 38.2% since 1964. And since the previous crisis in 1992, taxes represented about 36.5% of GDP at the peak ...

UK Tnx FlGvenuo M A % Of GOP

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1- l.uK Tax RovontJeAsA·" 01 Gopl
--- - ~ -- - - - -

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The projections below show that the treasury expects to be at its peak taxing point again by 2014 ...

39

I~ UK Tax Rovonue As A '4 Of GOP I
• UK Traasurlcs Proj+cllons
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DO to '" CD "' "" But if you look at their assumptions, you will realise that they need a very strong dose of inflation in order to make this projection work


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e Moot." Publ;,atioo No. 66 August 2010

Since the previous big economic shock in 1991, the UK has averaged 4.96% nominal GOP growth per annum. If we take a look at HM's Treasuries projections, they are in fact, pencilling in a continuation of this nominal GOP growth rate ...

lHopp'Y o.~ Are H.". Again?
25
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~wo~ A '" ~PIJ~ "'en ..... ~C~N~A~~~~~O~~u~~~~O~O~~w~~~ The major problem with this projection lies not with the average of nominal GOP but with the components of nominal GOP (Real GDP + Inflation).

Real GDP has averaged about 2.25% since 1964 (during the great baby-boomer era) and about 2% since 1991 ...

UK Ro-aIIGOP: Yo Y'Y.

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• UK !t.ol G·OP: ¥oY% ~

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~ ... "' .. Cb) The Global Macro Investor 2010

24


So, if we assume that happy days are here again in the UK, then we will assume that real GDP will rise by 2% per year. That leaves the other half of the nominal GDP equation to figure out.

Since 1991, the UK Price Deflator has averaged a shade under 2.93%. The Treasury has effectively forecast in a 3.17% price deflator for each of the next five years on average. (See chart below.)

Happy DOY50 Me H~rG A'!Iall\?

18

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II\cn ..... t;D Q~ Q W U'lcn ..... ,,""g .. ... The estimates are look very much like they Will be hopelessly unrealistic.

The reasons? Well there are two main levers for UK CPI. The first is loan growth. Loan growth to individuals was off the charts before the last recession, hitting 25% YoY! It has since gone massively negative.

If the UK couldn't get +3% CPI with a 25% jump in loans then how will it achieve a consistent 3% CPI with -6% loan growth? (See chart overleaf.)

tQ The Global Macro Investor 2010

25


35

-UIK Total Prlv3t·o Loan Growth

30

25

20 t-------------------------------~:

15

10

·5

·10 .,
g> ;: L. 0 51: 0 3: » ... c.. Z ,.. !C ... "- 01 a: 0 51:> L. L :z > '" ." L 0 51: ~ 3: l '- L. Z ,.. ~
~ . ~ ~ " "' .. " 0 .., .. " .. ~ It e: " .. e 0 ,. .. .. e .. !; II .. e 0 '0
'Y ~ I' but i' " ~ .. "i' ... ± s b'" i' " 6 i' "i' ~ ~ I' ! ~ "i' !. !. ~ 1 ~
'" ~ ID -0 C> ~ .~ 0 6 0 '" ~ b c:> ... g '" 6 '" C> '" s:
0) ... ID 0 '" N N '" ... "" .. '" VI .... ... ... co <a '" '" 0 .. ~ ,. .. '" '" ... The other major component is import prices. And this means oil. The GBP price of oil has tracked CPI YoY with good accuracy.

That's the reason for the large UK trade deficit. Although they produce a good amount of oil, they have been in deficit for the last six years in net trade of crude. The huge drop in production and exports has been very damaging to the UK's trade balance ...

150 r------r----------------------------------------------------------------,6

·50

·100 .,
go ;r L.. g 1£ 0 ;;: }> g '- z > ¥' : c.. c ;;: ~ 1£> '- <- z > .... .,. '- Q 1£ ~ ;;: > ~ '- > ""
" 1: II U OJ ~ " 0 '0 " " ~ ~ S .. " ~ ... ... " " 0 " l: c " '0 .,
.... rr T 1 c i' $ ~ ; " b t :> ~ .,. -g rr § ~'1 "i' ~ !. l "i'
t '" ... ~ .:. s e '" ~ .... '" .,. . '" e .~ eo .:..
'" ... C> 0 ~ '" s :;: II> "'~ .... ._, !!: '" '" C> 0 ~ :! '" ... ~ The Global Macro Investor 2010

5

4

2

4

2

o

26


The secular shift of UK Oil Production means that they need a cheaper currency in order to compete in the global export market. The trade balance will continue to get worse if this is not the case. As you can see, the UK trade balance has trekked south since about 2000 because of the peak in UK Oil Production ...

UK 011 Stota: 000' Tons

160,000 .,------------------------------------------ ....

140.000

120,000

100,000

80.000

60,000

40.000

20.000


27

e Monthly P,blioat~n No.66 A'9"t 2010

One thing that is important to consider is that the YoY% change in the price of oil is falling, and due to the mathematical relationship between UK CPI and oil we would have to see prices of $150 a barrel in a year's time for CPI to stay this high.

However, there is a risk that sterling will continue to weaken over time, and that means that the GBP price of oil will remain elevated, but not cause a YoY% spike. This will take away from consumption of other goods, since loan growth is negative.

This is all rather deflationary.

So, the two most important variables in gauging potential CPI over the next five years are both in dire straights. Loan growth is negative and oil prices are set to go higher based on a probable drop in GBP, based on larger oil imports (larger trade deficit).

There are other structural headwinds we have to keep in mind:

The decline in the number of people employed in financial services in the UK is dramatic. We don't know if it has bottomed yet, but even if we mimic 1991 we can see that it will be at least five years until we get back to record finaricial sector employment That's important because this is the industry that has been the consistent money-spinner for tax collectors and has elevated personal consumption (which boosts GOP handsomely).

The chart below shows the drop in the financial sector workforce. My view is that this will continue to fall over time as opposed to recover. ..

The other head-wind industry is Housing. Housing has been a free lunch for the treasury for the last decade. But now that the bubble has popped the Treasury will have to give back much of its revenues as tax loss carryforward as investors and homebuyers take a hit.


28

e Mon'hly Publioa'jon No.66 Aug", 2010

Not just that but the Halifax Home Price Index looks like it is heading back down! Which is typical in a debt-deflation. Looks similar to the GMI Crash Pattern in fact...

So who is going to invest in the UK going forwards? You would be crazy to jump in headfirst in this environment. One day there will be a great chance to make money in the UK, but the system hasn't finished cleansing itself yet and businesses know that. Business investment, as shown on the following chart, is very subdued ...

Q The Global Macro Investor 2010

29

e Monthly Pc.I"allon No.66 Augu" 2OtO

With an overvalued currency, rising taxes, curbed demand, negative credit growth and no business investment, is it any wonder that UK Industrial Production is still at 1988 levels? Things are not going to change until the system has cleaned out the debt and the imbalances ...


30

e Monthly PuOI;"";on No.66 Aug"" 2010

This is all very deflationary, but for the sake of being conservative let's assume prices simply average 0.5% over the next five years, rather than the immaculate conception-like 3.17% HMT is expecting.

That would mean that nominal GOP would average about 2.5% per annum for the next five years.

Also, don't forget that the "tax revenues as a % of GOP" estimate of 36.5% is based on tax loss carryforward finally wearing off over the next two years. That assumes that UK housing prices start to rise in value and that everything is back to normal.

So, we will assume a tax rate of 35.5%. This should prove to be more accurate unless they raise taxes again, which would likely scare most of the investment banks and hedge funds to NY, Hong Kong, Singapore and Switzerland.

Tax revenue is likely to be well below estimates.

Hence, with our 2.5% nominal GOP assumption going forward it's easy to see why the UK will likely fall into trouble.

Might Not Look Uko Much Of A Dlrroronco BUIlt Add~ Up To A GBP5S0.5 Billion Shon1all.

&00
TOO
SOD
500
400
~OO
200
100
0
.... ib tt
'"
~ '" '"
.,. '1"
'" ~ :::
... -UK Treasury lReci.,.pls

- -Trca;su,) Projecliol15

-.our Cons,erva1lve ProJocllolls

Over the next five years, tax revenues will be short by GBP 590.5 billion!

You can see from the next chart that the UK's debt-to-GOP would explode if our conservative scenario were to play out.

Oebt-to-GOP would be well above 100%, the first time since 1954 and well Into the levels usually triggering sovereign defaults ...

lSI The Global Macro Investor 2010

31


UK GOlltrl1lmcnt Go!)! To GOPI5 SetTo Explode To .100 ....

1.2

1.1

-UK Gross Gov~mmQmtlOf)btTo GOP Rallo

-UK Tre-as'ury Eltimalos

--GMI's Conservatlyo Estlmatos

0.9

0.8

0.7 -- - --- ---

0.6

Not a record by any means, but still going in the wrong direction ...

UK Gove~IIIMnt Hl·norleftl Debt To GOP: With Eltlm3;OS

I -IUK Gov~mMonl HIsI(),ieallDabtTo GDP,Wijth E~t1m!l.l.JlI

2

o ...... ..--~-


32

e Monthly Publ"olion No.66 Augu," 2010

Thus, I think you can see from the foregoing that we need to be a little more focused on the Government's assumptions.

The UK still seems to be headed for a disaster, and that's without factoring in another bout of global recession.

Another recession would see the UK default sooner rather than later ... the CDS are at the wrong price.

Hungary

Another potential flashpoint for the Global Sovereign Debt Crisis is Hungary. Hungary, if you remember, was one of the first countries to run into trouble and needed I MF loans to help them through. But as in a textbook sovereign crisis, they have become fed up with austerity measures and have expressed a desire to walk away from the IMF/EU and go it alone.

This is the usual route to a default so I thOUght I'd take a little look at the situation so you can monitor it too.

Hungary has been effectively bankrupted. The only reason they haven't gone to the wall yet is because of the rebound in trade. The Forint has been extremely week since the crisis first hit.

This boost to exports has meant that the trade balance has gone decisively positive for the first time ever! This is the only thing keeping Hungary alive ...


33


Basically the global stimulus and a weakening Forint has saved Hungary for the last eighteen months, but the second round will be more painful as global stimulus and trade tail off again.

Despite a likely further weakening of the Forint, it will not prevent phase II of the crisis.

Net foreign currency debt corrected for foreign currency deposits from Hungary's IMF and EU support package, is 43.6% of the total debt.

Now do you see the problem? Their budget spending is up 8% YaY, while the rest of Europe is trumpeting austerity. But if the currency moves down, their budget spending will be up much more than they think.

If the Forint keeps dropping, then even a boost in imports won't matter: their non-Forint debt burden will simply be too great to handle. They will have to default.

The internal economy in Hungary is still on its knees. The chart of the Hungarian labour force (overleaf) shows how bad it is ...


34

e Monthly Pub';,"'n No.66 Augu" 20to

Consumption has been zero for three years! Retail Sales have not had a positive reading since 2007 and have tumed back down, again ...


35

e Monlhl, Publ".'lon No.66 Augu," 2010

And the latest bust in Hungary? Petrol demand... demand held up pretty well for the entire crisis. And then it didnt..

Therefore in summary, the issues are simply that consumption and tax revenues cannot recover in time to save the country from defaulting. Since +40% of the debt is in non-Forint instruments, the currency becomes a major catalyst for problems (unlike Greece or Spain), which makes Hungary a focus point for financial markets.

At this point, Hungary potentially looks like one of the biggest catalysts for global meltdown. Just keep it on your screen ... and as much of the foreign funding is in CHF I suggest that you closely monitor CHF/HUF.

Overleaf is the chart ... it doesn't look good ...

(!;:) The Global Macro Investor 2010

36

e Monthly Publlo.lion No.66 Augu," 20to

Trade Recommendations

Sell to close US 2-Yr notes Buy to close Blackrock Buy to close PPR

+49% YTD +34% YTD -18% YTD

Don't get alarmed, I am not getting bearish on US yields but I think that there is no point keeping these as a trade as I've made great money and yields may fall a bit further, although not by much. The trade in the US bond market is going to be the yield curve flattener as QE forces down the long end. I'll take my profits in these for now ...

The other close-outs are legacy positions from last year that I want to get off the book and which net, net have produced a profit.

«:l The Global Macro Investor 2010

37


The Business Cycle

We've spent a long time in this monthly talking about ISM and I fully expect it to come lower over time, in line with ECRI etc. It remains elevated still but will fall through 50 this year ...

ISM

25
L. l> '" 0 ... lI> ~ 0 ... l> ... ~ ... » L R ... l> "- iii '- » L. ~ '- l> "- ~ ::. I>
I " ~ a ~ " a ~ -e '" .. " ~ " " '" .. " e ~ " c ."
., ~ ~ .. ~ e: " s .:.. ? .. ~ ~ 'i' ~ ~ ~ 'i' ;;. ~ .::. .. ~ .. ~ !
.. ~ '" '" ~ .... :;j : "" '" ~
CD co til en N "" '" co w '" '" .. ... w The 3M on 3M measure shows that ISM will fall below 50 in the next four months ...

30 70

15

-151'1t Lagged 2 MonU15

25 -151'11; 3m Q 3m%

20

10

-15

-20

-25

-30

-35 ~----------------------------------------------------------------~

65

, 60

55

so

45

40

35

30


38


The ECRI is also very suggestive of a sharp fall in ISM ...

eCRI Calis Tho Tllm In ISM S To ti Monthaln Advanee

80
75
10 ~
Rl
65
60
55
50

<15
40
35
30 --------------------~----·------------------------------~~------~.3~

The rest of the world is also slowing down. Chinese PM I, which is not a great indicator due to manipulation, shows that the Chinese economy is slowing. Don't expect this to reflect reality if the economy tilts into recession, but it shows that the economy is not immune to either policy tightening or the global business cycle. M2 has led the weakness in China ...

Chlnuo 1M2! YoYo/.

10
l;- ~ .. l> ~ ~ ... l>
c -e c -e-
:J ;; ., :J ~ ~
f.: g '" S ~ ~ ... 65
60
55
50
4S
40
35
~ ~
:J
.:. ~The Global Macro Investor 2010

30

20

10

o

·2()

39

e Monthly Publ;oat~n No.66 Augu," 2010

China's real problem is that the massive money supply and loan growth has let the inflation genie out of the bottle. So far the chart of Chinese CPI and M1 YoY seems to be playing out and could push inflation to very high levels ...

70

EO

~--------~----~--------------------------------------~.5

--------

30

20

10

15

10

-CI.lnns M1: YoB

-ChlnOio CPI; YoY'!.

But what is important is that Asian exports are still completely correlated to the US cycle. This chart versus ISM shows that we could be in for some further slowing in Asia as ISM comes down into a recession in the coming months (Thanks EJI).


40


Over in India, currently about the best economy in the world, they are starting to see a peak in the business cycle as rate hikes bite.

IP has rolled over and is expected to come lower over time ...

Indian IP: YoY'!.

~ r-----------------------------------------------------------------------,

10

--Indlon IP: YaY% I

2.5

15 1---------

10 ---

-5 ~------------------------------------------------------------------~

The problem is that the Sensex is highly correlated to Indian IP and we should expect weakness in the equity market. ..

.2:5

30 150
-Indian IP: YoY'!. 125
25
-Sons·ox "YoY%
100
20
75
15 50
10 15 ·SA------------------------------------------------------------------------L.TS

·50

Back in Europe, UK Consumer Confidence, which led UK GDP out of the recession, is now pointing the way back down ...

e The Global Macro Investor 2010

41

e Monthly PUbU",tlon No.66 Augu" 2010

Another leading indicator that is rather useful is the Belgium General Index of Business Confidence. It has rolled over and if that is the case we can expect EU GOP to stall. We need to keep our eye on this ...

{I;) The Global Macro Investor 2010

42


Charts to make you go 'Hmmm ... '

Chart 1

Wheat

Wheat prices have broken out on the huge Russian drought. This whole pattern now looks like a base has been formed. I do not expect wheat to run much further, but will expect it to pull back in due course and form another flag or wedge. That will be the one to buy. That's how major bases are formed ...

e The Global Macro Investor 2010

43


Global wheat stocks-to-use ratios are not at levels that would cause us a major concern that a secular bull market is underway yet ... although that may change in time ...

GI o~1 Wh03t Stoek Ta Usa Ratio

0~5r------------------------------------------------------------------------'

O.Z

1-'-

---- I---~---------------------------------------------~--

I~

- '-,

O.l5

-

- - -

-

.--'

0.3

-

1- ----

0.25

(I;) The Global Macro Investor 2010

44

e Moolhly Po.'"o"oo No.66 A090st 2010

Chart 2

South African Rand

«;) The Global Macro Investor 2010

45

e Monthl, "'.11,"'on No.66 Augu" 2010

Chart 3

Iranian Stock Market

Iran was one of my tips for the decade ahead. Since I wrote that comment in January the Tehran exchange is the second best performer in the world, rising 55% so far this year. It remains by far and away the cheapest market I have ever seen. I am very much a bull.

15050

11868

8686

5504

-8S0-t----r-----,----;----,------r--

Feb 1 201D Jan 6 2£ID7

Jar. 7200 Feb 27 2005 Feb 22 2009


46

_ Monthly Publ""fun No.66 August 2010

Chart 4

The Dollar

The DXY failed at its key resistance, as would be expected in this type of pattern. Expect it soon to find a base, and when that trend line goes, expect a huge and rapid move ...

(Q The Global Macro Investor 2010

47


Chart 5

The Euro

This chart of relative M2 has been spot on. It predicts a bit more fluffing about before the HUGE move starts. That move, in my humble opinion, will be the full sovereign debt crisis ...

·2
0.9
-4
0.8
-6 0.7
z g> c, ! f .... z ~ '- ;c f ... z g> .... E ~ ... z :c c, J ;c ... z g> ... ~ f lr z ~
~ e ~ ~ c ~ ~ s <: ~ ~ c ~ ~ ~ e ~
~ ~ ~ § " ~ 'l' ~ ~ ~ !. ti ; ~ ~
10 fg :!: * ~ :i: '" "' .. '" ~ ~ ~ Ii: ob i; ~ .!.
., '" ., ... .. ., ... It;) The Global Macro Investor 2010

48


Chart 6

The Chinese Stock Market

It's diverging a bit from the Saudi model, but not enough to make a difference. History rhymes but is never an exact fit...

23.(100
7500
21,000
19,000 6500
17,000
SS«lO
IS,COO
<$500
13,000
11,()OO lSCO

9,000
2500
7.()oO 1500
5,(JOO
HOD SOC
~ -" ::! .... -" ~ :::!: ::! :: .... .... -" ~ ~ ... ~ _. ....
.... ~ ;
~ ~ :i. ;_ j,. (, c ;r :i. z, ). ~ 0 ;r ).. t: j, 0. 0 ;_ j. 0 t ~ :i> ;_ j,. ~ 0
... c: ~ ~ i ... § ~ .. ... c ~ t .. ".. ... s ~ n ... c ~ ~
n ... ~ ::J rr ~ T n 'r ~ :l n g ~ ~ ~ ::: 7 !
b C Q Q .. .=. 0 l;;; Q C> C:. 0 b C, 0 C; .... ~
.... en en ." '" en '" "" ... .... .... .. CD CD '" co '" ... '" '" '" '" '" to 0 0 '" .. e The Global Macro Investor 2010

49

e Monthly ?"Ol',.bon No.66 A"g"," 2010

Chart 7

European Banks and US Confidence

The Dow Jones European Banks Index (SX7P) seems to be following US Confidence. I guess that sort of makes sense. US Confidence is starting to erode once more however".


50

Chart 8

The Yen

We are getting very close to the point where Yen strength will run out of steam and weakness will take over, as Japan starts moving closer to a default when the world moves back to recession.


51

e Monthly Publ;"lIon No.66 Augu" 20 10

Chart 9

Japanese Yield Curve History

So many people write utter nonsense. The amount of times I have heard people say that it is impossible for the US to go into recession with the yield curve this steep, is ridiculous.

They have no idea what they are talking about.

The Japanese yield curve shows what happens in a balance sheet recession or a depression. The yield curve NEVER inverts because short rates stay at zero. The yield curve bullishly flattens in recessions and bearishly steepens in better times.

Expect the US yield curve to undertake the mother of all flattenings ...


52

e Monthly P,","a"on No.66 A'g'" 2010

Positions

FX
Trade Recommendations Entry Price % Since Inception %YTD
USDvs. AUD Jan 13th 2009 1.5017 -26.35% -1.10%
USDvs.ZAR Jan 13th 2009 10.00566 -27.07% 0.1S%
Sell JPY VS. USD Mar 31st 2009 0.0101015 -14.06% -6.60%
Sell GBP VS. USD Oct 2nd 2009 1.5943 2.07% 2.95%
Sell CEEREU Index Dec Sth 2010 104.5 9.97% S.93%
Sell EUR vs. USD Jan 22nd 2010 1.415 7.76% 7.76%
RMB t-yr NDF's Jun 30th 2010 6.79 -0.24% -0.24%
Closed Out Trades 2010 Closing Date % Since Inception %YTD
USD VS. CNY (1-yrforward) Jan 1 jh 2009 Jan 12'h 2010 -2.89% 0.00%
Eur 1 Month 40 Delta Calls May 1 jh 2010 Jun 10th 2010 -110ticks -110ticks Fixed Income
RebJms Since
Trade Recommendations Entry Price Inception RebJmsYTD
Short UK 1 O-yr yields Sept 30th 2005 4.2S% +96bps+20.35% +64bps+ 2. 49%
Short US 30-yr bond yields Oct 31st 2008 4.37% +38bps+ 7.62% +6Sbps+ 2.55%
Short US 10-yr bond yields Jan 31 st 2005 4.14% + 123bps+ 22.79% +94bps+ 2.41 %
Short US 5-yr bond yields Mar 17tt1 200S 4.62% +303bps+20.04% +106bps+2.69%
Short US 2-yr bond yields Feb 4th 2009 0.98% +43bps+1.39% +54bps+0.57%
Short DE 5-yr bunds yields Sept so" 200S 3.48% +183bps+S.38% +100bps+2.03%
Short DE 10-yr bunds yields Oct 2nd 200S 4% +12Sbps+7.22% + 72bps+2.29%
Short DE 30-yr bunds yields Oct 31 st 200S 4.439% +107bps+7.77% + 71 bps+2.59%
Short US YC: 2's and 10's Sept 29th 2009 23Sbps +0.5 +40.5
Short EU YC: 2's and 10's Sept 29th 2009 197bps +S +15
Chinese 5-yr CDS Oct 2nd 2009 72.04bps +.S +3
UK 5-yr CDS June 1 st 2010 80.1bps -22 -22
Japanese 5-yr CDS June 1st 2010 90bps +5 +5
DE Vs. ES 2-yr Bond Spreads Feb 2Sth 2010 55bps +59 +59 Closed Out Trades 2010 Short UK 30-yr yields

Closing Date

Oct 31s1 2008 May 31st 2010

% Since Inception +12.09%

%YTD +4.08%

(!:I The Global Macro Investor 2010

53

e Monthly Publloa"on NO.66 Augu," 2010

Commodities
% Since
Trade Recommendations Entry Price Inception %YTD
Short HG Copper Oct 2nd 2009 267.15 -23.96% +2.26%
% Since
Closed Out Trades 2010 Closing Date Inception %YTD
Gold inHUF Feb 1rh 2009 Jan 2~d 2010 -6.09% 0.43%
Gold in ZAR Feb 1rh 2009 Jan 2~d 2010 -11.28% 2.11%
Gold in KRW Feb 1rh 2009 Jan 2~d 2010 -5.90% -2.11% Equities
% Since
Trade Recommendations Entry Price Inception %YTD
Short EEM Jan 13111 2009 23.83 -73.73% 3.07%
Short Hang Seng Jan 13th 2009 13668.05 -53.86% 3.64%
Short Shanghai Jan 13th 2009 1863.37 -41.54% 18.69%
Short Chinese H-Shares Jan 13th 2009 7080.53 -68.14% 6.63%
Short Sensex Jan 13th 2009 9071.36 -96.97% -1.76%
Short Franklin BEN Jan 13th 2009 59.54 -68.93% 6.87%
Short T Rowe Price TRON Jan 13ttl 2009 30.76 -56.79% 11.34%
Short Blackrock BLK Jan 13th 2009 123.53 -27.49% 33.99%
Short Coach COH Jan 13th 2009 17.26 -114.19% -1.82%
Short PPR Jan 13th 2009 45.64 -124.91 % -17.96%
ShortWMT Feb 4ttl2009 46.42 -10.28% 5.61%
VIX Feb 17ttl2009 48.66 -51.71% 17.27%
Short SPX Oct 2nd 2009 1029.85 -6.97% 2.77%
Short IBEX Apr 30ttl 2010 10492.9 -0.07% -0.07%
Short Banco Sabadell Apr 30th 2010 3.806 -14.66% -14.66%
Short Banco Popular Apr 30itl 2010 5.345 4.58% 4.58%
Short Bankinter Apr 30itl2010 5.54 -3.90% -3.90% Closed Out Trades 2010 SPX April 2010: 1000 Puts VIX Sept 65 Calls

Jan 2~d 2010 May 18th 2010

Closing Date April 161h 2010 Jun 1 fh 2010

% Since Inception -15 ticks 45

%YTD -15 ticks 45


54

e Monthly P,blj,atJon No.66 A'll"" 2010

Background

Raoul Pal has been publishing The Global Macro Investor since January 2004 providing original, high quality, quantifiable and easily readable research for the global macro investment community. It draws on his considerable experience in running a hedge fund and advising many more.

Raoul Pal retired from managing client money at the age of 36 in 2004 and now lives on the vetencien coast of Spain.

Previously he co-managed the GLG Global Macro Fund in London for GLG Partners, one of the largest hedge fund groups in the world.

Raoul moved to GLG from Goldman Sachs where he co-managed the hedge fund sales business in Equities and Equity Derivatives in Europe. In this role, Raoul established strong relationships with many of the world's pre-eminent hedge funds, learning from their styles and experiences.

Other stop-off points on the way were Nat West Markets and HSBC, although he began his career by training traders in technical analysis.

Should you wish to receive information about membership please email us at info@globalmacroinvestor.com. The number of members is STRICTLY limited, with only a few free spaces coming up each year, as the membership is full. If there are no free spaces available, a waiting list will apply.

Raoul Pal, The Global Macro Investor, Javea, Spain 2nd August 2010


55

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