The Decoupling Debate And Its Consequences

- "If decoupling just means a bigger growth differential between emerging and advanced economies, then decoupling is becoming more and more apparent: we expect Emerging Markets to generate 2.3 ppts of the world’s 3.7% GDP growth rate this year, and a bigger share next year."
- "More EM growth is coming from domestic spending, and this should reinforce concerns about inflationary risks. Although some EM inflationary pressures can be absorbed by rising imports, we think that some dangers may lurk here, partly because of the consequences of the 2010 global food price shock."
- "A number of EM central banks should be hiking rates over the next several months, but resistance to rate hikes among a number of EM central banks appears to be growing. One crucial reason for this is likely the fear of higher levels of unwelcome capital inflows."
- "So the dilemma is this: either you keep rates too low and raise the risk of asset bubbles; or you hike rates and suck in yield-seeking capital inflows. Either way, emerging currencies seem bound to strengthen over time, in spite of more aggressive fx intervention by many EM central banks in the short run. One consequence of this is likely to be more experimentation with controls on capital inflows."

Pension Solvency and the Long-End

- "Government bond yields fell sharply in August, contributing to a further easing of financial conditions. US 10-yr Treasuries reached our forecast of 2.5%, before bouncing higher. Valuations are now roughly ‘fair’, according to our Bond Sudoku model."
- "The prospect of further quantitative easing by the Fed, amid ongoing uncertainties over the trajectory for growth, argue against a quick reversal of the rally. But, based on our global macro projections, we think the cyclical trough for bond yields has already been seen. We forecast a steeper US 2s-10s curve than the forwards are discounting. We would position for a flattening of the 10s-30s Gilt curve against Germany. This ‘box’ spread has co-moved with the level of rates lately."
- "The rally over the past month was amplified by asset-liability management flows, particularly in continental Europe. We have commented on these dynamics in our weekly Bonds Snapshot publications. Here we present our updated Pension Solvency Indices, which help track changes in solvency positions through time and across regions."
- "Peripheral EMU markets have been volatile again, but the market has been much more discriminating than it was in May-June. Ireland is under pressure because of the contingent liabilities from banks. Portugal and Greece are suffering from growth concerns. But Italy and Spain are now participating in the rally. We have recommended long positions in 10-yr Italy vs. France, and in 30-yr Greek bonds, which already discount a substantial credit risk premium."

The implications of extended QE

- Overview: "A raised probability of further QE by the Fed extends the potential upside for US Treasuries slightly. We recommend unwinding short UST versus Bund trades but retain our outright short Bund recommendation."
- US Rates: "With an increased likelihood of further Fed balance sheet expansion we examine the likely structure of such a move and its potential impact."
- Euro Rates Strategy: "On a relative basis we are more worried about Portugal than Ireland. We suspect the market will find it much easier to believe in the risk/reward of being short Portugal than long. Italy remains our long of choice."
- Sterling Rates Strategy: "Speculation of further QE in the UK looks overdone. We suggest fading the recent strong performance of short-term sterling contracts and the belly of the gilt curve."
- Global Inflation Strategy: "TIPS break-evens are vulnerable if market expectations for QE are disappointed. 10yr euro real yields look historically attractive versus TIPS. Euro linker issuance for 2010 is around 80% complete."
- APAC Rates Strategy: "We continue to recommend flattening trades in Asia: 7s30s swap curve flatteners in JPY and 3s10s via futures in AUD."
- Flow Analysis: "Buyers of Europe remain more confident than buyers of the US, where net demand has been weak recently. In Europe, Italy, followed by Germany has seen the strongest net buying over the past month."
- Month-End Index Projections: "We expect a significant increase in the EGBI at the end of September. At a country level we see the largest weighted duration increases in France, followed by Italy and Germany."

TOPIX Core 30 outlook and key points

- "The TOPIX Core 30 briefly fell to 441 on 1 September before subsequently rebounding. Concerns about a further downturn spread when the index broke through the November 2009 low of 457, but ultimately it did not fall that much, indicating that investor pessimism may have peaked. With the wave count pointing to a consolidation phase ahead of the next rally, we think the index will lack direction until around Oct–Nov, when the next nearterm (four-month) cyclical bottom is due. However, we think there is greater potential for a rally now that forex intervention by the government and BOJ has brought yen appreciation to a halt. Whereas defensive stocks have outperformed since April, the charts have started to point to a turnaround for economy-sensitive and export-related stocks. As such, we think investors would do well to gear themselves for a change in market trends."
• "Defensive stocks in the ascendancy since April, but this may change: Defensive stocks have been in the ascendancy since April, but we are gradually starting to see signs of change. For example, Kansai Electric Power [9503] posted a new high for the year in September, bucking the downturn in the  market as a whole, but technical indicators such as the RSI (25-days) started to flash red, and performance relative to the TOPIX also showed signs of peaking out."
• "Charts already giving off positive signals for some economy-sensitive and export-related stocks: By contrast, some economy-sensitive and export-related stocks have started to show signs of bottoming. Indeed, some charts have already begun to give off positive signals. For example, Shin-Etsu Chemical [4063], Komatsu [6301], Nissan Motor [7201], Honda Motor [7267], Canon [7751], and Mitsui & Co [8031] have broken through the upper limit of the resistance band (cloud) on the daily Ichimoku Kinko Hyo equilibrium chart, and their MACD based on share prices relative to the TOPIX has moved into positive territory or moved upwards within negative territory. Companies such as Nippon Steel [5401], JFE Holdings [5411], Sony [6758], and Mitsubishi Corp [8058] appear likely to join this group in due course."
• "Other stocks for which charts are giving off positive signals: Meanwhile, the charts have started to give off positive signals for stocks other than those sensitive to the economy and exports, including Japan Tobacco [2914], Astellas Pharma [4503], Tokio Marine Holdings [8766], Mitsubishi Estate [8802], Nippon Telegraph and Telephone [9432], and NTT Docomo [9437]."
• "No need for excessive pessimism despite ongoing downside risks for some stocks: By contrast, we see ongoing downside risks for some stocks, including megabanks such as Mitsubishi UFJ Financial Group [8306], Seven & i Holdings [3382], Toshiba [6502], Toyota Motor [7203], and East Japan Railway [9020]. However, we see no need for excessive pessimism, as most are stocks that look to be trading in their bottom range over the longer term and/or stocks with limited downside risk, based on technical indicators."

Spanish Banks: Deleveraging and the misallocation of capital

- "We are cutting our rating on SAN to Neutral from Outperform and reducing our target price to €11.75 from €12.25. While SAN has emerged as one of the main winners in the current financial crisis, we are concerned that it is now so big that structural growth is likely to decline and it may face marginally declining returns. We note Brazilian profitability might be slowerthan-expected."
- "We continue to have a cautious view on the Spanish economy and the domestic banks. An overleveraged private sector and structurally high unemployment are likely to affect banking results. We think the banking system is facing a significant deleverage process and the adjustment in the real estate sector is not yet complete which will likely translate into higher credit losses. We think the structural profitability of the banking system has been permanently impaired and we do not expect the domestic banks to meet their cost of capital in the next two years at least. Money illusion relating to negative real interest rates is partly responsible for the lack of recognition of certain credit losses and for unusually high (and unsustainable, in our view) net interest income relating to the carry trade."
- "The Cajas sector has started restructuring but this might be a long process. We think the market is underestimating the execution risk and costs associated with the integration process. We believe some institutions might lose money and require extra equity over time."
- "SAN is one of the leading banking franchises in Europe, in our opinion, but we believe that any excess capital generated is likely to be directed to increase size through non-organic growth; this strategy may not necessarily create value for shareholders in the long term. We believe it would be more difficult for the shares to continue to outperform."
- "Stock Calls: We maintain our Underperform rating on all the pure domestic Spanish banks we cover and our Outperform rating on BBVA."

Why The Gold Price Rally Will Continue

- "Gold prices hit a new all time nominal high this week. We believe this rally has further to run. Indeed at the end of June we highlighted why gold prices would need to surpass USD1,455/oz to be considered extreme in real terms and hit USD2,000/oz to represent a bubble."
- "For the time being we believe the drivers of this rally are fundamental rather than speculative. However, we admit physically backed gold ETFs are playing an important role in the gold market."
- "However, we view interest rate and exchange rate trends as gold price bullish. Indeed history would suggest a collapse in the US dollar can not be dismissed out of hand. Moreover central banks have become a new source of gold demand while gold mining companies remain committed to closing their hedging programmes."

Moving closer to QEII

- Market Movers ahead
• "We expect the US ISM to decline to 54.5 after the surprise increase in August."
• "In Euroland, PIIGS will probably remain on the radar screen. On the data front, focus will be on inflation."
• "In Asia, the release of China’s two manufacturing PMIs and Japan’s Tankan will be in focus. We expect a confirmation that the Chinese economy is currently bottoming out and a gain in the Tankan index for Japan’s large manufacturers."
• "A lot of data out of Sweden including retail sales, PMIs and the NIER surveys."
• "In Norway particularly credit growth and retail sales should attract attention."
- Global Update
• "The FOMC statement struck a more dovish tone than expected. We now see a new round of quantitative easing as the most likely outcome."
• "In the Euro area, focus has centred on Ireland and worries about the costs associated with restructuring in the banking sector."
• "The global slowdown is now being felt in the manufacturing sector in core Euro area countries. German PMI and Ifo expectations posted declines."
• "Tensions between the US and China have intensified. The US is unhappy about the slow appreciation of the yuan."
• "In Japan, the prospects of new quantitative easing in the US has led to a stronger JPY. This puts pressure on both the BoJ and the Ministry of Finance."
- Focus
• "In this week’s focus article we take a closer look at Danish house prices. Prices are currently in line with the level predicted by our fundamental model. This is however all due to the historically low level of interest rates." 

A year of drifting… but better times beckon

- "For frontier market equities, 2010 has been a disappointing year. After rallying early in the year, the MSCI Frontier Markets (ex-GCC) index has steadily underperformed the emerging markets index and is flat for the year versus a gain of 6% for GEMs. This puts the frontier markets on track to underperform the larger emerging markets index for a fourth consecutive year."
- "Some success stories, but many markets have struggled. Sri Lanka, Bangladesh, Estonia, Argentina and Kenya have all benefitted from a combination of supportive political developments and a recovery from oversold conditions last year. Many Eastern European markets have lagged, as have Kazakhstan, Jordan and Lebanon."
- "The macro outlook continues to improve. Economic output in the frontier economies is recovering more quickly than expected, with average growth now expected to exceed 4% next year. Inflation has picked up modestly but remains close to historic lows, while current account deficits are back to sustainable levels in most countries."
- "Valuations: still reasonable if not cheap. Frontier market earnings have not rebounded as quickly as they have in emerging markets and thus the region’s discount to EM has closed somewhat. However at 12.3x trailing earnings and 1.7x book value, the index remains at a significant discount to both its own history and EM peers."
- "Low volumes, high correlations. Trading volumes have been muted, and frontier markets are not providing much diversification with the 40-week correlation to global markets now at an all-time high of 80%. We do not expect either trend to last however."
- "With the growth story largely intact, frontier markets look positioned to outperform. Our top markets are Nigeria, Argentina and some of the “value” Baltic/Balkan markets, especially Estonia and Bulgaria. We also like Kazakhstan and Kenya. Preferred frontier market stocks under coverage include: Galicia (Argentina), Halyk Bank (Kazakhstan), Hikma (Jordan), Kazmunaigas (Kazakhstan), Nova Kreditna Banka (Slovenia) and Solidere (Lebanon). Indirect plays on frontier markets that we like include Afren, Aggreko, CETV, Millicom and MTN Group."

India: The four good reasons that explain the hike in the key benchmark interest rates

- "The Reserve Bank of India has just carried out its fifth consecutive interest rate hike since March 2010, continuing the withdrawal of a significant part of the stimulus implemented during the financial crisis. This very gradual monetary policy tightening seems logical in an environment where inflation is relatively high and where prices of financial assets are rising sharply. Furthermore, the interest rate hike does not endanger the domestic financing of the fiscal deficit (which is declining markedly) at reasonable borrowing costs. A likely appreciation of the rupee will probably not adversely affect India’s price-competitiveness for exports, which has improved against India’s trading partners during 2010. If the current macroeconomic environment (i.e. high nominal GDP growth, high inflation, negative real interest rates, lowering budget deficit and rupee stability) persists, more gradual monetary tightening in the months to come will be very likely."

US Mid-Terms: Still The Economy, Not The Tea Party

- "The Tea Party movement, the latest manifestation of a deeprooted tendency in the US, is now set to dominate coverage of the run-up to the 2 November Mid-Term elections."
- "But we doubt that its recent successes in the Republican primaries will have any significant impact on the outcome of the Mid-Terms where the economy will remain pivotal."
- "Overall, it remains our view that the Republicans are likely to secure a majority in the House of Representatives but will struggle to do likewise in the Senate."
- "Irrespective, we anticipate gridlock in Congress through to 2012, even though a Republican majority in one or both houses would be an incentive to reach compromises with the Democrats."
- "Most importantly to sentiment in the short to medium term, we look for agreement to be reached on extending all the Bush tax cuts for 12 months once the Mid-Terms are out of the way."
- "Beyond that, we expect little agreement on fiscal policy other than, possibly, more help at the margins for business."
- "We also expect bipartisan agreement on keeping the pressure on the Administration to take more punitive action against China’s alleged “currency manipulation”."
- "We do not expect possible Republican efforts to repeal healthcare reform to be successful."
- "Legislation to limit carbon emissions now looks unlikely; so the Administration may resort to regulatory measures."
- "Sarah Palin, the Tea Party’s de facto leader, appears to be positioning herself to run in the 2012 Republican presidential primaries. We do not dismiss her chances."

Currency interventions to stabilise exchange rates seem to be relatively ineffective

- "Based on the recent experience of many countries (e.g. Japan, Switzerland,
Brazil, South Korea), policies of currency intervention (use of foreign
exchange reserves) to stabilise exchange rates (in the cases studied, to
prevent an exchange rate appreciation) in a flexible exchange rate regime
seem to be relatively ineffective."
- "This is probably due to the fact that the expectation of an exchange rate
appreciation has, in the contemporary period, attracted to the country in
question a larger mass of capital than what the central bank is prepared to
accumulate in its reserves, in a situation of flexible exchange rates and
perfect capital mobility."
- "China is a case apart, firstly because there are capital controls and secondly
because the exchange rate is not flexible but fixed, administered by the
central bank, which may limit expectations of an appreciation."

In the 2010s, five years of anaemic nominal growth, followed by five years of stronger nominal growth in the United States and in the euro zone

- "The first five (roughly) years of the 2010s should be characterised, from our viewpoint, in the United States and in the euro zone:• by further household and corporate deleveraging, due to the adjustment of debt ratios to the lower level of wealth resulting from the crisis;• by the distortion of income sharing to the detriment of employees owing to companies’ determination not to depend on external financing to carry out their investments;• by persistently quite low commodity prices, because of the contraction in global demand for commodities stemming from the crisis."
- "One will therefore likely have in the first half of the decade, both muted real growth and low inflation and, by consequence, very weak nominal growth. When deleveraging is deemed sufficient, and income sharing levels off, real growth will accelerate. At the same time, strains will appear in commodity markets owing to robust growth in demand for commodities in emerging countries, and this will generate additional inflation. Nominal growth should therefore be more robust from 2015 onwards."
- "Investors with a long-term horizon thus have to factor in this highly probable trend break in both real growth and inflation in the middle of the 2010s. If nominal interest rates move in line with nominal growth, this trend break will normally be neutral for equities, but obviously unfavourable for bonds. In reality, due to nominal short-sightedness, it will also be negative for equities. If real growth increases at the same time as inflation, real estate (both residential and commercial) is a good protection against this trend break."

Rates firmly on hold everywhere

- Market movers ahead: Rate decision and PMI in focus "We have four rate decisions in the coming week - in Romania, Hungary, Poland and Russia – and the outcome is likely to be the same everywhere; unchanged rates and little variation in rhetoric from any of the central banks. PMI for September due for release next week across the EMEA region will provide an indication of how well EMEA economies are doing. Overall, we expect EMEA PMIs to follow the global trend and to decline somewhat in September, but in general remain above the critical 50 level, indicating continued expansion in EMEA economies. Still, PMIs in several countries will fall fairly close to 50."
- Fixed income outlook: Downside potential for Polish bond yields "Polish Minutes published this week showed some MPC members advocated a 50bp rate hike at the August meeting. Still, interest rates remained on hold in August (absent majority support to hike) and will continue unchanged at next week’s MPC meeting as well. Nevertheless, many market participants expect the Polish central bank to deliver its first rate hike soon although we do not believe it will do so until Q1 next year at the very earliest given the continued benign inflation outlook. Based on our “dovish” outlook for Polish monetary policy for both the next 3-4 months and 2-3 years, we see further downside potential for Polish bond yields."
- Scorecard-based trade of the week: buy ILS/ZAR "For the sixth consecutive week, the highest-scoring currency in our EMEA FX Scorecard is the Israeli shekel, and the lowest-scoring the South African rand. We therefore continue to recommend buying ILS/ZAR based on our EMEA FX Scorecard."

JPY intervention starts

- "Last week was historic for USD/JPY. On 14 September, the DPJ leadership election saw the previous DPJ Secretary General Ichiro Ozawa lose his challenge of Prime Minster Kan. Ozawa was regarded as a stronger advocate of yen-selling intervention than Kan and market participants lowered their expectations of intervention once Kan won. With US rates falling, USD/JPY fell below 83 in the New York session that day, declining to 82.88 in the Tokyo session on 15 September, finally prompting the first Japanese government intervention since March 2004. The move immediately sent USD/JPY to 85. Since 16 September, there has seemingly been no further intervention. USD/JPY at one point declined to 85.23 on 16 September as Japanese exporters sold USD, but otherwise it maintained an 85 high as market participants remain alert to intervention and US markets stayed relatively calm."
- "Should USD/JPY move to a low 85 we would expect a second round of intervention. If the MOF fails to indicate 85 as a defensive line, USD selling against JPY might accelerate, particularly as government officials have already specified 82 as a line worth defending. We believe USD/JPY has the scope to weaken to 86-87, but as exporters are likely to sell USD forward at these levels, we expect limited upside for USD/JPY. Judging by fragile US fundamentals, we lowered our USD/JPY forecasts on 6 September and now expect USD/JPY to trade at 82.5 at end-2010 and at 80 at end-March 2011, even after considering the effects of intervention. We recommend shorting USD/JPY if it rallies to 86-87."

In many European countries, the problem before the crisis was simple: The fact that growth outpaced potential growth did not lead to an increase in potential growth

- "We describe the problem that many European countries (France, Spain, Italy, Portugal, Ireland) are encountering these days, as follows:
• prior to the crisis, growth outpaced potential growth (due to the fact that demand was stimulated by indebtedness, the fall in unemployment, immigration);• but this did not lead to a rise in potential growth; the pre-crisis growth model was therefore unsustainable. This unsustainability can be presented as follows: as productivity gains remained too low, real pay rises were too low for demand to continue to increase quickly without the help of indebtedness (or later fiscal deficits);• potential growth did not increase because the growth model drawn on above all developed unsophisticated, not very productive sectors (construction, domestic services, etc.), which accounts for the fact that there was no acceleration in productivity and no increase in R&D spending. Policies to stimulate domestic demand normally lead to a development of services and construction (of non-traded goods) to the detriment of industry."

It would be very useful to know the value of the fiscal multiplier, but it is difficult to estimate

- "While all European Union countries are set to rapidly reduce their fiscal deficits, it would be very useful to know the value of the euro zone’s fiscal multiplier, in order to estimate the shortfall in growth resulting from the reduction in deficits. But at first sight it is difficult to estimate this multiplier. Empirical estimates vary a great deal (from 0.3 to around 1.6), which is fundamentally explained by the fact that the value of the fiscal multiplier essentially depends on many factors (behaviours):
• the degree of stickiness of nominal prices and wages; if prices and wages are perfectly flexible, the multiplier is zero;
• the degree of short-sightedness among economic agents: if they have long time horizons and if they are rational, the multiplier is zero ("Ricardian neutrality"); if they face a liquidity constraint, they spend all their income in each period and the multiplier is high;
• of course, the marginal propensities to save and import; if they are high, the fiscal multiplier is low;
• the reaction of interest rates and the exchange rate to the fiscal expansion; if there is a rise in interest rates and an appreciation of the exchange rate, the multiplier is obviously low."
- "When looking at these factors as a whole in the case of the euro zone, we conclude that the euro zone’s fiscal multiplier is very difficult to estimate:
• two criteria (significant price and wage stickiness, lack of reaction of interest rates and the exchange rate) lead to a high fiscal multiplier;
• two criteria (presence of Ricardian neutrality effects, high marginal propensity to import) lead to a low fiscal multiplier."

Towards significant growth variability in emerging and export-dependent countries?

- "Growth in domestic demand in OECD countries will in all likelihood be weak and steady, due to deleveraging, the increase in capital requirements, the rise in profitability, etc."
- "But, conversely, we can expect significant growth variability in emerging countries and in countries whose economies are export-oriented, due to:
• the high volatility in the Chinese economy, and therefore in economies linked to China;• the sharp fluctuations in the exchange rates of emerging and OECD countries, due to the instability of international capital flows and risk aversion;• the high variability of lending in emerging countries, linked to capital flows and changes in monetary policies."
- "In the future, we will probably see economies with slow and regular growth in OECD countries where domestic demand dominates (United States, United Kingdom, France, Spain, Italy), and economies with very erratic growth in emerging and OECD countries linked to global trade (Germany, Japan, etc.)."

Turkey: and another “yes” for GDP!

- "The prospects for Turkey are looking brighter and brighter. On Sunday, the overriding "yes" in the country’s constitutional referendum boosted Prime Minister Erdogan’s position after this vote and lessened the risk of political instability. Yesterday, GDP figures for the second quarter confirmed the favorable wind behind Turkey’s economy. While macroeconomic performance was expected to be excellent following the first quarter’s results (+11.7% YoY), growth outperformed even the most optimistic forecasts (+10.3% compared with a consensus of +9% YoY). Historically low interest rates, stimulus measures and stability in the banking sector have all been driving forces for such expansion, making Turkey one of the most dynamic emerging countries together with China. We are thus revising our growth forecast for 2010 upward to 7.5%, from our earlier 6.2%."

Since the Lehman bankruptcy, the stock market has not discriminated between companies and sectors, and has been steered by risk aversion

- "Since the Lehman bankruptcy, all stock market prices (companies and sectors; we will look at the situation of the CAC and the Eurostoxx) have moved in lockstep. Discrimination between companies and between sectors has been significantly reduced; the stock market as a whole has fluctuated in line with risk aversion, which has become the dominant explanatory factor of the share prices of all companies, whatever their specific situations (trends in results, turnover, etc.). This has obviously generated very significant valuation anomalies (dispersion of PERs), and a need to forecast risk aversion in order to forecast stock market prices."