FX for surfing, FI for diving

- FI Strategizer: Stable policy rates and slowing growth momentum should prove beneficial for long-term yields, especially AAAs. The belly of the curve performed well in 3Q, but the 2/5-year spread still offers value for yield hunters. Spreads within the eurozone should stay volatile in 4Q.
- EU Portfolio Strategy: Over the next several quarters, we face a global fiscal policy tightening (reversed German reunification) which calls for a modest long duration, adding to the active deviation if 10Y Bunds rise by another 25bp. Country wise, we continue to favor BTPs within periphery. We also take a prudent stance on France.
- Money Market: Demand for liquidity at the ECB refinancing operations has stabilized in recent months, although at regional level we still observe high reliance on ECB funding. Full allotment should stay in place until 2Q11, contributing to smoothing the path of MM rates in EMU.
- Inflation: As we had pointed out last quarter, EMU BE proved a good opportunity in 3Q. Now we are back to more “average” and unattractive levels. In 4Q we expect inflation to remain subdued, recent ECB remarks on upside risks are the only factor that may provide further support.
- Supply Corner: 4Q will be the least liquid quarter of the year, with just EUR 82bn in redemptions and EUR 30bn in coupons. We expect gross supply in 4Q to be EUR 165-180bn, with risks skewed to the downside. Net supply should be EUR 80-95bn, up from EUR 25bn in 3Q.
- FX Strategizer: Global uncertainty is still on and investors will continue to frequently change their mind due to opposing and temporary short-term drivers. The FX market remains more interesting for big-wave surfers than for free-climbers.
- EUR: EUR-USD will reflect again global and local risk factors (US growth fears vs. EMU woes), staying mostly trendless throughout 2H11. More strength will occur in late 2011, when the ECB starts hiking rates.
- JPY: BoJ intervention managed to stem JPY appreciation, but USD-JPY reversal is unlikely to exceed 90-95 in the medium term. In turn, EUR-JPY should progressively pull back above 125 by the end of 2011.
- CHF: SNB sounded more dovish on growth and inflation, but this will not prevent EUR-CHF to slide again below 1.30 if risk aversion persists. The 2011 outlook still points to a consolidation back towards 1.35.
- GBP: Cable may suffer again and a rally above 1.60 can be penciled in only in late 2H11, when we now expect the BoE to start a rate hike cycle. EUR-GBP should again remain mostly stuck within the 0.80-0.85 band.
- Commodity Currencies: The recent rally of the three dollars should be reverted if risk aversion escalates. More AUD, NZD and CAD strength should occur in 2011 in case of a relaxation of the global picture.
- Nordics: More EUR-SEK and EUR-NOK weakness is in the pipeline, but more attacks & retreats can be expected along their appreciation path.
- FX Special: Risk aversion has clearly enhanced the role of safe-haven currencies, but our dedicated special demonstrates that the yen tends to outperform the CHF and the greenback in this role.

China water: Flowing strongly

- Pressing water shortages raise awareness of conservation• "Severe drought in southern Chinese provinces has threatened rice crops and reservoirs."• "Macau and Zhuhai rely on the Xijiang River in Guangdong, and they experience salt tides."
- 12th Five-Year Plan to lend further support to the sector• "Continued focus on water conservation: bodes well for tariff hikes and privatisation, in our view."• "Investment of RMB700bn during 2011-15F (up from RMB330bn during 2006-10) in wastewater treatment industry is forecast by the Ministry of Construction."• "Opportunities in recycling water: target to recycle 10% of wastewater emission in urban area by 2015F, representing a CAGR of 24% from 2009."
- Tariff hikes should come in steeper and more widely• "Avg water tariffs in 36 major cities grew by 8%, from RMB1.7/m3 in Jun 2009 to RMB1.84/m3 in Jun 2010"• "Chinese water tariffs only account for 0.8% of disposable household income."
- Wastewater treatment: maturing, but growth will be sustained• "As the market matures, capacity growth should slow to 8% pa from 2010F, compared with 11-16% in 2006-08, by assuming a wastewater treatment ratio of 90% by end-2015F."• "But we are not close to over-capacity, given third- and fourth-tier cities and counties are still showing wastewater treatment ratios of 30-50%, compared with 73% in urban areas in 2009 and 80%-95% in OECD countries."

- Tap water supply remains a privatisation story
• "Management ability in M&A execution and track record are key success factors."
- Waste-to-energy is the next attraction
• "Industry is still in its infancy, though proper legislation should open up opportunities."

• "WTE should outshine other waste treatment projects in terms of capacity growth, at 17% CAGR versus 10% in overall waste treatment, given it has higher environmental standards and energy efficiency but accounts for less than 20% of China’s residential waste currently being treated, compared with 80% from landfill sites."

- Defensive against rising commodity prices and inflation
- Risks: intensifying competition, rising interest costs
- Our stock-picking criteria and preferences

• "Search for company-specific strengths to identify outperformers in the sector — solid track records and rich catalysts for growth in 2010-11F, followed by quality management, undemanding valuations, and healthy balance sheets."
• "Preferences for quality players: Guangdong Inv’t (270 HK, BUY), China Everbright Int’l (257 HK, BUY)."
• "Risks/rewards opportunities: Beijing Enterprises Water (371 HK, BUY), China Water Affairs (855 HK, BUY), Sound Global (SGL SP, BUY)."
• "NEUTRAL on Hyflux (HYF SP) due to financial risks as overhangs."
• "Avoid Tianjin Capital Environmental (1065 HK, REDUCE)."

The forgotten financiers

- "The Basel Committee has agreed on stricter capital requirements for banks. It argues that the impact on the economy via bank lending should be limited. But banks account for only 22% of credit in the US and 44% in the eurozone. Since the behaviour of the remaining lenders is not well understood it is premature to conclude that the regulatory changes will result in greater stability in the financial system."

JPY intervention starts as we expected

- JPY intervention starts as we expected "The MOF intervened unilaterally in the forex market on 15 September by selling JPY, likely triggered by the government’s motivation to defend the 80 line. Although the intervention was unilateral, we think it was probably unsterilized (i.e., that the BOJ is unlikely to try to mop up the liquidity created). Judging by reports that MOF sold some ¥2.0trn of JPY on 15 September, we estimate that by the time its intervention is finished they would have sold ¥10–20trn. Although we estimate that USD/JPY could rebound to 85–87 in the near term, forex market trends are largely determined by USD weakness against all major currencies, which reflects the poor fundamentals of the US economy. We are therefore maintaining our forecast for USD/JPY at 82.5 by end-2010 and 80.0 by end-March 2011."
- Impact of JPY intervention on the rest of Asia "In our view, Japanese FX intervention (first since March 2004) marginally weakens the short USD/Asia story. Asian central banks may view Japan's intervention as an additional reason to resist local FX appreciation, despite global political pressure to move (namely on China). However, we do not believe the Asia ex-Japan authorities can argue on the same fundamental basis as Japan given the large divergences in broad economic performance, exports, equity markets and FX valuation. In this respect, we think that the impact of JPY intervention could be important, but not decisively for Asian FX. This may, for example, support reducing our short USD/CNY trade. However, we do not think that it markedly alters the core story (see FX Insights: China Visit Notes, 1 September 2010). Likewise, it reduces our conviction on our short EUR/KRW trade (See FX Insights: Recommend marginally adding a short EUR/KRW trade, 6 September 2010)."
- JPY - Why JPY appreciation had accelerated despite an increase in Japanese outward investment
"In August, USD/JPY dipped below 84, its lowest level in 15 years, as JPY continued to strengthen. However, the MOF's latest International Transactions in Securities report revealed that Japanese net outward portfolio investment increased to roughly ¥5trn in the same month. We see three likely reasons for the apparent contradiction between an increase in outward portfolio investment and observed acceleration of JPY appreciation: (1) transactions not involving forex transactions, (2) purchases of short-term Japanese bonds by a number of foreign government investment institutions, and (3) currency hedging by Japanese institutions and companies. What appeared at first sight to have been large-scale Japanese outward investment in August turned out not to be powerful enough to reverse the downtrend in USD/JPY in August."
- GBP: Further recovery in store "This week, we released the second in our series of Strategic Currency Views, which presents a comprehensive analysis of the key factors influencing the outlooks for currencies. Here we summarise our findings for sterling. For the outlook in its entirety, please see The UK pound: Further recovery in store, 14 September 2010."

- RBNZ signals slow path to a lower “neutral” rate: Receive NZD IRS 5fwd 5yr "The Reserve Bank of New Zealand (RBNZ) kept its policy rate unchanged at 3.0% today, which was widely expected, but the policy statement and subsequent comments by Governor Alan Bollard were more dovish than expected. The RBNZ is signaling both a slow path to a “neutral” policy rate, and that the level of that “neutral” rate has declined. We recommend maintaining long duration positions in the NZD IRS curve, but see the NZD IRS 5fwd 5yr as currently offering a more attractive opportunity than the front end of the curve. For investors concerned about liquidity risk in terms of the IRS curve beyond 5 years, we also see value in receiving the NZD IRS 2fwd 2yr."
- EMFX Portfolio Update: Enter ILS 1v2 steepener, a proxy 1y1y payer "Israel is one of the few emerging market countries whose unemployment rate has reached pre-crisis levels. Increasing inflation expectations and housing prices all suggest that the ILS front end is very vulnerable to the upcoming inflation releases. In addition, the 1v2 slope appears cheap by around 20bp on a number of metrics. To establish our view in a low-carry way we are putting USD10k to the 1v2 steepener. We also continue to recommend USD/ILS shorts, based on the higher probability of a faster pace of rates hikes."
- EMFX Portfolio Update: Fading RUB's temporary MXN disease "We recommend buying a RUB basket – selling 3m USD/RUB and EUR/RUB (entry 34.75, stop 35.25, target 33.65) – based on our explanations of recent underperformance and our identification of various changing dynamics. Inflation should provide a catalyst for the rouble as the trend caused by the negative food price shock appears to have reversed, partly due to the lagged effects of monetary and fiscal loosening during 2009. In the NDF space we see rate differentials on the rise after a period of contraction since Q4 2009, which would have turned off yield-hungry investors. Furthermore, REER overvaluation retracement, a declining external debt repayment schedule, relative equity market underperformance and upsides from any oil price increment are all supportive of the trade."
- FX Quant Insights: Pump up the volume "Volume data are often used in other asset classes (such as equities) to act as a further input into technical trading rules. In FX, they tend to be used less, largely because of the scarcity of volume data. The idea of using volume data is that they can be used to confirm technical moves. If there is a significant technical break higher and volume does not spike, we would conjecture that the move is relatively shallow. Conversely, a spike in volume would be supportive of the price action. Our focus is on combining on balance volume (OBV) with more traditional technical-based momentum style trading rules. In particular, we look at breakout style rules on OBV. Our volume-based basket has annualised returns of 3.9% and an information ratio of 0.66 since 2002."

Nikkei Average rebound to test July high of 9,800 or June high of 10,250

- Japanese equity market—expecting rebound to continue in near term; move off bottom should be clear after Oct–Nov: On 1 September, the Nikkei Average fell to 8,796 and the TOPIX nearly dipped below 800, but they did not drop any further and have since started to rebound slightly. We think the indices did not fall as far as they might have because investor pessimism had already peaked, as suggested by the TSE’s short-selling ratio exceeding 30% on 1 and 2 September. We think the indices have likely entered a near-term rebound given that they have broken out of the diagonal triangle pattern on the chart that has been in place since April. If the yen appreciation that has impeded any market rally enters a more pronounced lull, we could see Japanese equities stage something of a rebound toward the rally highs of 14 July (9,807 for the Nikkei Average, 874 for the TOPIX) or 21 June (10,251 and 904). On the other hand, the wave count suggests that we are in a consolidation phase ahead of the next rally, and thus the market could remain in a broadly defined holding pattern until Oct–Nov. Only after this do we think it will become clear that equities have moved off their bottom.
- US equities—likely to trade in tight range until Oct–Nov: US equities have been regaining ground since 27 August. The three main indices have broken through the resistance line connecting 26 April and 9 August highs, and are now within sight of those same 9 August rally highs (10,719 for the DJIA, 1,129 for the S&P 500, 2,309 for the NASDAQ composite). A normal correction pattern based on wave count would point to the rebound from 27 August running out of steam, but if the three main indices regain their 9 August rally highs, it would add weight to the possibility that the correction phase ended with July lows (9,614 for the DJIA, 1,010 for the S&P 500, 2,061 for NASDAQ). Having said that, we make no major change to our view that US equities are likely to trade in a tight range until Oct–Nov, when the next four-month cyclical bottom is expected. Only after this do we think it will become clear that equities have moved off their bottom.
- Bond market—Japanese long-term interest rates heading for major bottom, followed by rebound; US long-term interest rates also heading for rebound off bottom: So long as the yield on newly issued 10-year JGBs does not fall sharply lower than the 25-day moving average (currently 1.02%), we think it will be fair to conclude that the yield of 0.895% on 25 August marked a major bottom. We think it is more likely to transition into an upward phase if it clearly breaks through resistance at the 1.15–1.19% level that has acted as a support line since 2004. We also think the yield on US 10-year T-Notes reached a bottom of 2.416% on 25 August. We expect yields to target the October 2009 low of 3.104%.
- Forex market—USD/JPY near to nine-month cyclical bottom, yen appreciation versus dollar in final phase; EUR/USD may have embarked on renewed upleg: USD/JPY is eyeing a drop below 83, but the chart suggests that the latest phase of yen appreciation versus the dollar may have entered its final phase. The nine-month cyclical bottom from the November 2009 low is approaching and technical indicators also suggest that the USD/JPY bottom is near. The diagonal triangle on the chart traced by the downtrend since May is now clearly visible, and we think the yen could be about to depreciate. In our view, USD/JPY could rebound to around 90 if large volumes of long yen speculative positions are unwound. The correction in EUR/USD from early August appears to have run its course and the rate may have already embarked on a renewed upleg.

- Commodity market—WTI crude oil prices could drop out of triangular holding pattern; COMEX gold futures could push on further from all-time high: WTI crude oil futures (front-month) have  oved into a triangular holding pattern, but wave count suggests that they are likely to fall south out of this pattern. If they were to fall below the key technical juncture of around $70–71, this could lead to further declines. Having reached an all-time high, we think COMEX gold futures (front-month) could push on toward $1,369/troy oz.

U.S. / Japan Comparisons Again: More than One Route to Perdition

- "Aspects of the U.S. outlook have become more reminiscent of post-bubble Japan than during other (merely) cyclically weak periods. However, structural and behavioral differences from Japan remain very significant, just as before."
- "In the U.S., a reality of disinflation has won over simplistic “hyper-inflation” forecasts. The risks of insufficient demand and deflation aren’t entirely negligible. For housing assets, the U.S. banking and GSE sectors seem poised to hold and work off bad debt gradually rather than purge it quickly. Fiscal intervention has been repetitive and insufficient to permanently change growth expectations, all ostensible similarities to Japan."
- "Monetary policy in the U.S. has been strikingly different than post-bubble Japan, particularly in the early aftermath of the Lehman event. However, it seems possible that inertia and misunderstanding keeps monetary policy in the U.S. from a truly aggressive track, even if warranted."
- "Even optimal monetary policy can’t generate higher living standards over the long run. But it can avoid lasting deflation (a spiral higher in the purchasing power of currency). The long-run monetary policy track in the U.S. has been and is likely to be more inflationary than Japan’s, as chronic currency strength in Japan and mild U.S. dollar depreciation also suggest."
- "Private sector behavioral differences remain vast. The U.S. labor market and capex are far more cyclical than in Japan, and suggest an early and lasting bottom. Even amid structural growth slowdowns in both economies, we believe cyclical differences will be notable. In effect, the U.S. is more prone to “boom and bust” than slow and lasting stagnation."

Inflation is sleeping

- Overview: Inflation is sleeping
- Focus 1: United States: A new context for monetary policy "The deterioration in economic data has changed the monetary policy situation. Now, the debate is over another easing of monetary policy and the most appropriate way of achieving it. During his speech at the Jackson Hold symposium, Ben Bernanke claimed the Federal Open Market Committee (FOMC) was prepared to act if prospects were to deteriorate further, thus indicating an accommodative bias. Expanding the Federal Reserve’s balance sheet via the purchase of Treasuries seems to be the preferred solution to make monetary policy more accommodative. Even though the FOMC seems to be divided, the camp that is more in favour of further intervention, led by Ben Bernanke, seems to be in a position to impose its views. Ongoing job creations in the private sector in August limit incentives to act as of September. In the months ahead, however, the slowdown in growth (estimated at a trend of 1.5% in the second half of this year, i.e. well below FOMC projections) and the fact that private sector job creations are likely to be insufficient to reduce unemployment might convince the FOMC to adopt a new programme of purchasing Treasuries."
- Focus 2: Basel III: Capital requirements not without impact "On 12 September, the Basel Committee unveiled the new capital ratios under the so-called Basel III prudential reforms plus the timetable for their application. The new regulatory thresholds are equivalent to at least a tripling of capital requirements between Basel II and Basel III due to the redefinition of both the numerator and the denominator. However, the recapitalisation efforts accomplished since the financial crisis and a relatively stretched-out timetable for application will allow most major European banks to comply with the new requirements without substantial capital increases. Even so, implied market demands could lead to the deadlines being brought forward. A number of elements of the reforms (additional capital buffer for systemically-important banks, definition of the long-term liquidity ratio) are yet to be defined and the economic impact based on the known elements should therefore be considered only partial."

Yield Attractions/Job Application

UK — Yield Attractions
- The 3Cs — "Conundrums, crossovers and cults. The centre of debate in financial markets. Suggests value in equity, especially in yield compared to other assets."
- Yield strategies — "We look for companies which offer income and growth. Next, Unilever and BP feature. UK “Big Guns” look attractive in absolute terms."
Pan-European — Job Application
- Mega-traps — "European mega-caps have underperformed for 10 years. Long time. Applying for post of President of European Mega Inc. to drive value creation strategies."
- Mega-shrink — "No flow to European equities from capital allocators. Headwind for mega-caps. Need to generate own excitement (growth) or shrink equity to perform."

Inflation remains a concern in the UK

- "Last week’s data was mixed, but, overall, pointed to a modest US economic recovery. Therefore, no major new announcements are expected at tomorrow’s FOMC statement (p.2, p.3 & p.4)."

- "This week’s focus is on the FOMC statement tomorrow and durable goods orders on Friday, and on the euro zone PMIs on Thursday and the German Ifo index on Friday (p.2, p.3 & p.4)."

- "The Chart of the Week shows the CPI inflation rate and public attitudes to current inflation in the UK. Inflation is of little concerns for the major Western central banks at present, especially not for the countries that are confronted with a modest recovery. However, there is an exception, and that is the Bank of England (BoE). CPI inflation in the UK has been more than 1% higher than its 2% target for 6 consecutive months in August. According to the BoE, too high inflation is due to temporary factors, such as the past depreciation of sterling, higher oil prices and the restoration of the VAT rate. However, a VAT hike and higher food prices might imply that CPI inflation will remain above the 2% target until the end of next year at least. In addition, the chart shows that, in line with actual inflation developments, consumers’ perceptions of the current rate of inflation (according to the BoE/GfK NOP survey) have been rising since late 2009, and also 1-year inflation expectations have increased to the highest level since 2008 (when oil prices rose sharply). Interestingly, inflation perceptions increased when inflation picked-up, but have declined far more modestly when inflation rates fell. As such, the BoE does not only face weak economic growth, but also adverse developments on the inflation front. Therefore, the BoE will have to act very cautious if it does not want to put its credibility as an inflation fighter further at stake."

No near-term rate hike from the CNB

- Market movers ahead: A couple of strong Polish releases are due next week "Next week’s calendar is very light. The most interesting items on the agenda are likely to be a number of Polish economic releases due on Tuesday and Friday, which should all show positive signs for the Polish economy. Polish core inflation should confirm the fact that inflationary pressure is still not an issue in Poland. We expect core inflation to remain unchanged at 1.2% y/y in August. On Friday we expect data on Polish retail sales to come out on the positive side, increasing to 4.5% y/y in August compared with 3.9% y/y in July. Also due on Thursday is the rate decision in the Czech Republic and minutes from the latest monetary policy meeting in Poland."
- Fixed income outlook: CNB rate decision "On Thursday next week the Czech central bank (CNB) has its rate setting meeting. We do not expect this to be a major event as we expect the CNB to keep its key policy rate unchanged at an historical low of 0.75%. Overall, we expect the CNB to maintain a rather neutral tone, as we do not see any changes to Czech monetary policy for some time."
- FX outlook: EUR/USD should set the tone "As the calendar does not hold many potential market movers we do not expect much activity on the EMEA FX markets in the coming week. The key driver could be a further move up in EUR/USD, which will be positive for the euro-sensitive CEE currencies."
- Scorecard-based trade of the week: buy ILS/ZAR "For the fifth week in a row, the highest-scoring currency in our EMEA FX Scorecard is the Israeli shekel, while the lowest-scoring is the South African rand. Therefore, we continue to recommend buying ILS/ZAR, based on our EMEA FX Scorecard."

OECD countries are about to change over to even more expansionary monetary policies: What will be the consequences and how effective will they be?

- "The United States, the euro zone and Japan are faced with less positive economic situations than what the governments expected:
• renewed slump in growth in the United States due to labour market and property market problems, ongoing deleveraging and balance sheet adjustments;
• prospects for slower growth in the euro zone due to the weakening of global trade, the rise in savings, the profitability problems in several countries, the reduction in fiscal deficits and deindustrialisation;
• risks on growth in Japan, since it is still linked to exports and since the yen continues to appreciate."
- "Fiscal policies cannot be made more expansionary, so governments and central banks will use monetary policies once again: additional stimulus from banking liquidity, reinforcement of quantitative easing and credit easing, etc."
- "We believe these monetary policies, which will be even more expansionary, are:
• ineffective because liquidity is already extremely abundant and credit demand is declining; and because the real problem is not of a monetary nature: it is the distortion of income sharing at the expense of wage earners and, in Europe the United States, the balance sheet adjustment;
• dangerous, by making it even more likely that speculative bubbles will reappear in the future."

Basel III rules on minimum capital ratios announced

- "The release of the Basel III rules on new minimum capital requirements was the dominating news in the credit market this week. The rules were slightly less tough than was stated in press reports last week and consequently financial spreads performed well. Of particular interest to the subordinated debt market is the transition rules concerning bank capital. Essentially, extension risk has been reduced for hybrids – especially those with step-up coupon features – and on the back of this we saw a massive rally in the Tier 1 market. The rally was partly halted after the market became aware of certain possibilities for some issuers to make calls of outstanding bonds by 2013 in case these bonds no longer qualify as regulatory capital. This was particularly the case for highcoupon bonds trading above par. For a further description of the new rules, see below."
- "On the back of the confusion on whether to call or not to call hybrids and at what date, it seems that Abbey (owned by Banco Santander) is not calling an outstanding UT2. We think that ongoing uncertainty over how to design subordinated debt instruments such that they comply with Basel III requirements will make issuance limited in the short term. Against this background, it is perhaps not surprising that some banks opt not to call outstanding sub debt, as the ability to substitute it is uncertain. Therefore, in our view it is possible that more banks will follow in the footsteps of Santander (which is one of the major market players, after all), especially on UT2 instruments where there is no amortisation of capital after the first call date."

USD: relief bounce on FOMC?

- USD: relief bounce on FOMC? "Intervention by the BoJ and a surprisingly brutal reaction to SNB forecast revisions caused trends to shift in G10 currency markets over the past week and threaten to compound volatility over the coming days as the FOMC meets to discuss monetary policy and in the UK the Sep MPC meeting minutes are published. The USD may be in a win/win position going into the FOMC. If the Fed are downbeat, the USD may benefit from a risk sell off, while if they are more positive, it may benefit from a back up in US yields as QE2 fears are put on the back burner. With the EUR suddenly back in favour and central bank intervention forcing investors to trim long JPY and CHF strategies, predicting flows under a ‘risk off’ scenario is not straightforward. Even though correlations with risk have rebounded, we are alert to retracements in EUR crosses as talk of debt restructuring flares up in the periphery and risk reversals signal a possible counter trend move."
- "The BoJ intervened to weaken the yen through alleged unsterilised sales of JPY (tbc next week). The yen jumped in response from a low of 82.88 to the end-of-week highs in the region of 85.80 to the dollar. Despite strengthening against JPY, USD weakened against GBP and EUR as speculation persisted regarding QE2 amidst a slew of weak macro UK numbers. It was a strong week for GBP as it strengthened vs all G10 currencies from oversold levels. The EUR too rallied against G10 currencies except GBP, with concerns over Ireland causing a wobble on Friday. The SNB kept the policy rate unchanged but downward revisions for 2011/12 CPI sparked aggressive unwinding of long CHF positions causing EUR/CHF to spike 300pips before eventually settling below 1.32."
- "It was another week of soft indicators for the UK economy with a weak RICS survey and a surprise decline in August retail sales. CPI inflation surprised on the upside as it stayed unchanged at 3.1%. Amidst elevated inflation levels, MPC minutes next week are much anticipated but may not bring much clarity on the outlook for monetary policy. On the other hand, data in the US somewhat alleviated double-dip fears with rising retail sales and inventories, surveys showing stable confidence (though Michigan survey down) and declining initial claims to 450k. Core annual CPI fell below 1% in August to 0.9%, causing disinflationary worries to resurface. Euro zone industrial production was flat on the month and the ZEW survey showed declining economic sentiment."
- "A turbulent week for government bonds dominated by mixed 2020 and 2030 gilt auctions ended with yields closing at the lower end of the range. The front end and belly of the curve outperformed the long end, resulting in a steeper 2y/10y curve (through 240bp for gilts) and 10y/30y (103bp). The 2y/10y swap curve held steady in a range around 182bp pivot. 5y swaps climbed 7bp to 2.24%, retracing from an earlier 2.31% high. A busier than usual week of late for corporates brought sterling issuance from Bank Nederlandse Gemeenten (£200 mln 2015), EDF (£1.0bln 2050) and Co-op Bank (£400mln 2017)."

Japan: After Two Weeks of Political Shows

- MoF eventually intervened — "The MoF intervened in the FX markets after PM Kan's victory in the DPJ presidential election sent the yen higher. However, the FX intervention seems unlikely to change the recent trend in the FX markets for a long time. If Fed takes additional easing measures in months to come, downward pressures on Yen/USD will likely overwhelm the FX intervention."
- Impasse in economic policies unlikely to unravel — "Debates about imminent economic issues did not deepen during the DPJ election campaign and the basic thrust of economic policies likely will remain largely the same under new Kan Administration. Most importantly, the political decision-making will likely be dysfunctional as the ruling coalition falls short of the absolute majority in the Upper House of Parliament."
- We expect the economy to manage to maintain an uptrend — "We now expect real GDP growth of +3.2% in 2010 and +1.6% in 2011. The general trend of the Japanese economy is for slower growth as several factors which have driven activities since last year are waning: exports are decelerating, an
economic boost by the inventory cycle has run its course and reactionary moves after policy-driven strength are becoming evident. But a renewed recession is unlikely, in our view."

Hungary and Greece: What is the best strategy, that of the bad pupil (Hungary) or that of the star pupil (Greece)?

- "Greece is rapidly reducing its fiscal deficit, both via a cut in government expenditure and a tax hike, reforming its pension system and accepting a decline in activity and employment. As a result, it is receiving substantial international financing."
- "Conversely, the new Hungarian government prefers to maintain an unchanged fiscal deficit and tax financial institutions, but has decided to reduce household taxes to boost consumption and tax on earnings to boost competitiveness. However, it does not meet the conditions for receiving help from the IMF."
- "In the case of Greece (the star pupil), the major risk is the size of the shortfall in activity, which may be such that it will jeopardise the recovery in public finances in the future."
- "In the case of Hungary (the bad pupil), the major risk is financial market distrust, which would weaken the currency (the forint), while most of the debt is denominated in foreign currencies."
- "What is the most serious risk, and what is the market perception? Currently, the financial markets clearly prefer Hungary’s strategy to that of Greece. However, both countries have to stabilise their domestic savings at a higher level, which requires a reduction in the fiscal deficit."
- "Nevertheless, Hungary risks an exogenous shock in the event of a rise in risk aversion and a weakening of the forint. It is therefore under the threat of an uncontrollable event."

The main problem of the global economy is the shortfall in consumption

- "Almost all regions of the world are currently suffering from the shortfall in household consumption:
• in the United States and Europe because of the imbalance of the balance sheets of households (excess indebtedness relative to wealth) and the distortion of income sharing at the expense of wage earners;
• in Japan, due to the constant distortion of income sharing in favour of companies;
• in China, because of the insufficient share of wages in GDP;
• also in Asian emerging countries other than China, India and oilproducing countries, but not in Latin America or Central Europe."
- "The shortfall in consumption is weakening global growth, since there is a savings glut. Furthermore, it is making the global economy more cyclical and more erratic. The reason is that the weight of the most volatile demand components (investment in construction, corporate investment) is too high."
- "Fiscal deficits cannot be a permanent remedy, but a rise in the share of wages in GDP can be a remedy in many countries."

Does the deterioration in the situation of public finances make banks more risky, or does the deterioration in the situation of banks make public debts more risky?

- "It is possible to have two interpretations of the relationship between sovereign risk and banking risk:

(1) If a country’s public finances deteriorate, the government will not be able to bail out the banks  especially major banks) since there will not be any budgetary resources to do so; the banking risk is therefore increased by the lack of a possibility of a bail out. This implies a causality heading from sovereign risk to banking risk.

(2) If a country’s banks struggle, investors believe that the government will have to bail them out; this increases the expected fiscal deficit. There is then a causality heading from banking risk towards sovereign risk."

- "To discriminate between these two hypotheses, we look at the causal links between sovereign CDS and bank CDS. We find that bank CDS are correlated, with a lag, to sovereign CDS in most cases: most often, sovereign risk causes the banking risk."

Standards and transition period determined

- Regulatory minimums — "The minimum capital standards announced by the BCBS on September 12 were 4.5% for Core Tier I capital, 6% for Tier I capital, and 8% for overall capital adequacy."

- Capital buffers — "Banks will be required to secure a 2.5% capital preservation buffer (via common stock) by 2019. In addition, they will be required to amass a buffer of up to 2.5% during periods when the economy is overheating (lossabsorbing capital is acceptable)."

- Transition period — "The new capital adequacy regulations will be introduced in stages. In stage one, minimum capital adequacy ratios will be phased in (the Core Tier I ratio will be 3.5% in 2013 and 4.5% in 2015). The capital preservation buffer will be introduced in the second stage (0.625% in 2016,

2.5% in 2019)."

- Existing preferred securities — "Banks will lose the right to count capital that does not meet new stricter standards as Tier I capital in 10ppt increments from 2013 (with the full amount removed from Tier Ih capital by 2023)."

- Leverage ratio — "A monitoring period will run from 2011 to 2013, followed by a trial period until 2017. Full-scale introduction will come in 2018. The minimum leverage ratio (Tier I capital in the numerator) will be 3%."

- Liquidity coverage ratio — "The Liquidity Coverage Ratio (LCR) will be introduced in 2015 and the Net Stable Funding Ratio (NSFR) will be introduced in 2018. The minimum for both will be 100%."

Separate ways

- "We identify the magnitude of the shock to global GDP that would derail the capex and labor market recovery in the eurozone. A 1pp slowdown in global growth vs. our baseline scenario would induce a shallow capex recession in 1H 2011, with employment managing to hold up in slightly positive territory next year. Global GDP would need to be around 3pp weaker than expected to trigger a significant capex recession and a double-dip in the labor market, a scenario that we deem as quite unlikely."
- "As worries about decoupling within the eurozone are increasing, a crucial issue is whether the investment upswing will be widespread within the area. From a cyclical point of view, one of the drivers of investment is capacity utilization. In this regard, Germany seems ready to benefit from a genuine pick-up in investment spending, while for Italy, Spain and Greece the picture is less supportive. Hence, now that global demand is moderating, only the most competitive countries will be the ones where the investment recovery will continue to support economic growth."
- "A sustainable revival in French domestic demand is probably the “swing factor” to determine whether the current growth divergence across the area will be long-lasting. Our analysis suggests that the legacy from the financial crisis should not meaningfully alter the historical pattern that sees shallower recessions in France being followed by more sluggish recoveries than in Germany."
- "The easing in eurozone core inflation has come to a halt during the summer, but we are still convinced that another leg of core disinflation remains the most likely outcome. We also show that the recent spike in food commodity prices poses some upside risks to our food CPI projections in three-to-six month’s time."
- "We argue that a large divergence in the GDP performance across the area and pockets of weakness in the banking sector of some peripheral countries increase the chances that the ECB will have to raise the refi rate before fully exiting unlimited liquidity provisions, tightening collateral rules and discontinuing the govies purchase program."
- "Although UK inflation remains surprisingly sticky so far, the BoE’s projections in the August Inflation Report brought a downward revision in the growth outlook and envisage a steep downward trajectory for CPI. Against this backdrop, the BoE is very likely to remain on hold for longer than previously expected: we now see the first rate hike in 4Q 2011."
- FI: "Given our outlook for steady policy rates, 2Y yields in EMU, the US and the UK should trade around the current levels until end-1Q 2011. Subdued growth and low inflation should keep demand for long-term maturities healthy, especially for top rated issuers. The belly of the curve has performed quite well in 3Q, but the 2/5-year spread still offers value for yield hunters. Core-periphery spreads to stay volatile in 4Q."
- FX: "Resuming EMU worries may keep EUR-USD in an overall tight trading range throughout the autumn, but persisting global uncertainty will keep volatility high and prevent the formation of clear trends on major FX rates. Currency markets will remain a playground for big-wave surfers rather than for free-climbers in the next few quarters as well."

Income solutions via equity & credit

- The investment world has a problem: it needs income "European pension funds require a return on assets of roughly 6-8%, safety doesn’t pay much in a backdrop where growth is slower and rates are lower. In the UK pension funds went from 82% in equities in 1990s to 47% today. UK bonds picked up the slack and their weight has quadrupled. But the real yield in the UK and Europe is less than 2%. The solution: corporates are a good home for income - let the battle between Equity and Credit commence."
- An equity strategist’s view: the equity de-rating has gone too far "The real yield gap between government bonds and equities is at a 25-year high (favouring equities). The 12-month forward dividend yield of 4% is above its 30 year average of 3%. Dividends are the performance enhancer in a slow growth environment with range bound markets. We see upside in markets and are not worried about dividend cuts (chart 18)."
- A credit strategist’s view: the equity de-rating could continue "The de-rating of equities will continue given demographic issues and volatility. Credit provides an excellent “middle ground” for income seekers. In particular, BB/B offers income, stability, and upside potential as strategic M&A rise."
- Solutions: in equities, credit and across asset classes "Equities: dividends as a return enhancer for growth & big dividend payers (pg 18). Credit: Risk/Reward opportunities within BB/B bonds (pg 21) Cross Asset Baskets: where we prefer equity to bond and vice-versa (pg 27). Below is our list of a cross-asset preference for equities."

Richard Koo: fiscal stimulus remains essential

- Globalized economies, localized politics

- Extreme economic pessimism has diminished

- Even monetary authorities lack confidence in US economy

- Is recession really attributable to Obama reforms?

- US monetary authorities admit they cannot rule out balance sheet recession

- Two concerns of people who understand that US is in balance sheet recession

- US politics characterized by growing polarization and obstruction tactics

- Obama has proposed second round of fiscal stimulus

- Little chance of new measures becoming law immediately

- Banks in some parts of US are easing lending posture

- Significance of IMF’s support for fiscal stimulus

- Change in stance by IMF and UNCTAD may prevent double-dip recession

- DPJ leadership election debates laid foundation for fiscal stimulus in Japan

- Lessons of the failed social experiment called Incubator Bank of Japan

- Incubator Bank of Japan’s creation also tied to bashing of BOJ and Japanese banks

- Will cap on deposit insurance really be a plus for Japan’s economy?

- Limits to what banks can achieve in a balance sheet recession

Intervention and regulation

- Market Movers ahead 

• "In the US, the FOMC meeting is expected to largely maintain the status quo. The economy has not worsened enough for additional quantitative easing (QE)."

• "In Europe, PMIs and the German Ifo are poised to disappoint, suggesting growth is now easing."

• "In Asia, attention will be on possible further intervention from Japan. Japan could face criticism when global leaders gather for the UN meeting in New York."

• "We expect Norges Bank to keep interest rates unchanged at this week‟s meeting, but suspect the statement will be a bit more hawkish."
- Global update 

• "Japan intervened for the first time since 2004 and has so far been successful in stemming the appreciation of the yen." 

• "The Basel III proposal has eased fears that it forced banks to rush to raise capital and weigh on the global recovery." 

• "Encouraging data in the US and China ease fears of a double dip." 

• "However, data from Europe have been disappointing suggesting that growth is now slowing."
- Focus 

• "In the first Focus article, we look at leading indicators ability to predict G10 exchange rate movements. Our conclusion is that to some degree they can." 

• "In the second Focus article, we look closer at the sustainability of public finances in the US. Our conclusion is that fiscal tightening is needed but at this stage it is not urgent."

Ireland: great complexity

- "Ireland’s issues remain large and complex. Its economic, fiscal and financial sector problems are interconnected and considerable. Irish GDP is more than 10% below its peak in real terms and closer to 20% in nominal terms; this year, the Irish core government deficit is likely to be 12% of GDP, general government debt has risen by 60% of GDP since 2007; in addition, the balance sheet of its troubled banking sector is almost five times the size of annual GDP."
- "Although the recent widening in Irish government bond spreads appears to be related to issues in the financial sector, it is worth remembering that Ireland’s financial, fiscal and economic problems are interrelated."
- "The process of transferring troubled assets from banks’ balance sheets to the NAMA bad bank has revealed that the quality of those assets is far worse than expected – haircuts have been around 50% compared to expectations of much smaller discounts when the scheme was announced. And the government’s actual and contingent liabilities from the banking sector are considerable."
- "A large government deficit, combined with capital injections into the banks, means Irish government debt is likely to peak above 100% of GDP. If the government guaranteed NAMA bonds were also counted as government debt – they’re backed by assets, so it’s doubtful as to whether they should – then that number would be closer to 130% of GDP."
- "So markets are right to be concerned about Ireland. But there are several positive points that shouldn’t be disregarded. The process of deficit consolidation is well on track: the deficit has already started to fall. And the government’s strong political determination to reduce the deficit should once again be apparent in the budget later this year."
- "Ireland is also in an extremely strong financing position. This year’s funding needs have almost all been met. We estimate next year’s financing needs to be a manageable €30bn (18% of GDP). That’s especially the case as we think the Irish government holds over €20bn in cash, providing a considerable buffer if market conditions become problematic."
- "And perhaps more importantly, recovery is underway. Ireland is particularly sensitive to trade outside the euro area, so the euro’s recent decline, boosted by falling prices in Ireland, has led to a sharp improvement in competitiveness. That’s having an effect – industrial production is already back above its pre-recession peak."
- "Ireland’s problems are considerable, and will likely remain so for some time. But, so far, the government and the economy seem to be doing reasonably well at coping with and addressing them."

Fading Operational Leverage

- Sluggish Global Economic Recovery — "The global economic recovery continues to disappoint. Lead indicators are softer and economists are lowering expectations."

- Sharp Global Profits Recovery — "But the profits recovery has been sharp. Analysts have upgraded forecasts as many underestimated the rebound in revenues and the effects of operational leverage."

- High Margins — "We expect profit margins to be approaching peak levels over the next 2 years. Continued cost control suggests they are sustainable even as the economic backdrop is sluggish."

- Accretion Kicks In — "Operational leverage will fade as we progress through the cycle. But EPS accretion should kick in. We expect many companies to retire expensive equity with cheap credit."

- Stock Analysts Closer Than The Market — "We forecast global non-financial EPS growth of 12% in 2011 and 9% in 2012. While analysts’ estimates seem too high, they are closer to our forecasts than the market appears to be pricing in. We believe analysts need to cut expectations a little, the market needs to raise them."

Ireland – the sovereign implications of the banking crisis

- "A very costly bank restructuring process (amounting to 24-31% of GDP) and concerns about the impact of weak macroeconomic conditions on banks’ battered loan portfolios are unsettling the Irish bond markets. While the Irish treasury does not have immediate liquidity needs, the colossal fiscal effort which will be required to stabilise the public debt over the medium term leaves little fiscal space to deal with any further unexpected financial sector losses – this is a source of market instability."

- "In our view, the resolution of Anglo Irish Bank, by splitting it into a funding bank and an asset recovery bank, is essentially equivalent to a wind up of the bank in ‘slow motion’. Over the medium term, the remaining assets of Anglo Irish Bank will have to be sold, disposed of or liquidated to repay the bank’s liabilities. Further injections of public funds into Anglo Irish Bank cannot be discounted (so far, the government has pumped a total of €25bn into the bank)."
- "At this juncture, given the comfortable near-term liquidity position of the Irish treasury, we argue that the government does not need to draw on financial assistance from the EU-IMF – at least not yet. Yet should further unexpected financial sector losses materialise or macroeconomic conditions deteriorate beyond our baseline forecasts in the coming months, the government may need to seek outside help. On the IMF side, the “enhanced” Flexible Credit Line facility recently approved by their Executive Board could provide a suitable funding vehicle should this be required by the Irish government, in our view."

JPY intervention starts as we expected

- "MOF intervened unilaterally in the forex market today by selling JPY, likely triggered by the governments motivation to defend the 80 line. The decision was also likely motivated by the excessive nature of JPY appreciation in light of US stock market and interest rate trends, and by domestic political conditions following the DPJ leadership election. Although the intervention was unilateral, we think it was probably unsterilized (i.e., that the BOJ is unlikely to try to mop up the liquidity created). Judging by reports that MOF sold some ¥1.5tn of JPY today, we estimate that by the time their intervention is finished it could have sold ¥10–20tn."
- "Based on the impact of previous intervention and the current level of US interest rates, we estimate that USD/JPY could rebound to 85–87 in the near term. However, forex market trends are largely determined by USD weakness against all major currencies, which reflects the poor fundamentals of the US economy. Judging from past interventions, such JPY selling can only prop up the USD for one to two months, thereafter developments will once again depend on US fundamentals. We are therefore maintaining our forecast for USD/JPY at 82.5 by year-end 2010 and 80.0 by end-March 2011."

Impact of JPY intervention on the rest of Asia

- "Confirmation that the Japanese authorities have intervened in USD/JPY (the first intervention since March 2004) marginally weakens the short USD/Asia story, in our view. Asian central banks may view Japan’s intervention as an additional reason to resist local FX appreciation, despite increased global political pressure to move (namely on China and to some extent Korea ahead of the G20 summit of 11-12 November). However, we do not believe the Asia ex-Japan authorities can argue on the same fundamental basis as Japan given the large recent divergences in broad economic performance, exports, equity markets and FX valuation. In this respect, we think that the impact of JPY intervention could be important, but not decisively for Asian FX. This may, for example, support reducing our short USD/CNY trade (as it reduces our conviction in that trade from 75% to say 65%). However, we do not think that it markedly alters the core story (see FX Insights: China Visit Notes, 1 September 2010).1 Likewise, it reduces our conviction on our short EUR/KRW trade to perhaps <60% from 65% previously (See FX Insights: Recommend adding a short EUR/KRW trade, 6 September 2010)."

Why could the internationalization of RMB and its non convertibility make Hong Kong a RMB offshore center?

- "Chinese currency is wanted to be internationalized in long term horizon. However, it will remain unconvertible for a long time. The key solution in this context is to develop a RMB offshore center as intermediate step. The need of such a center could be also pragmatic in short and medium term. Hong Kong would be the natural candidate. Deeper RMB businesses will be developed quickly in Hong Kong in response to Chinese RMB internationalization promotion program."

Can the global economy grow only with very expansionary monetary and fiscal policies?

- "We fear that the nature of economic cycles has changed significantly. In the past, they were linked to the appearance of inflation and restrictive monetary policies at the end of the growth period. At present, it seems that growth exists only when all economic policies are very expansionary, and that the return to "normal" policies triggers a recession. Could the world experience growth only as a result of abnormally expansionary economic policies, with a high level of indebtedness and a subsequent increase in private savings?"

Keeping a Modest Overweight

- Long double-dip risk — "In August, markets responded negatively to the slide in the US data. Yet our economists continue to believe that double dip concerns are overstated. Near-term European peripheral liquidity fears also seem overdone."
- Keeping a modest overweight — "Investors show strong appetite for risk. However, risks remain from the sheer size of the pipeline, elevated sovereign spreads, and potential downward 3Q earnings revisions. With these in mind, stay only modestly overweight."
- Bonds over CDS — "Bonds are the cheapest they have been to CDS since January. While CDS spreads are priced to perfection, cash still has a lot of catching up to do. We favor index and single-name CDS hedges."
- BBBs yet again — "Resurfacing of M&A activity argues in favor of buying cheap lower-rated non-financials with healthy balance sheets, which could become attractive acquisition targets."
- TruPS — "Comerica and City National called their hybrids, justifying our preference for yieldy TruPS - especially those trading at a discount."
- Premium bonds — "Not only do they trade cheap to low-dollar bonds, but also could be taken out in favor of issuing low-coupon debt."

Why is the variability of growth in China too high?

- "Chinese growth is highly variable, with a quick succession of periods of sharp growth and periods of pronounced economic slowdown."
- "We believe this is explained by the excessively low weight of consumption, which is not very cyclical, compared with the (highly variable) cyclical demand components: investment (especially in construction), exports, etc."
- "The following would therefore be needed in China:• a less brutal management of monetary policy (of lending conditions);• accelerating the government programme aimed at supporting wage earners and boosting consumption."
- "The worrying point is that - for the time being - Chinese growth becomes insufficient when credit no longer finances speculative investments."

FX: Risk on, risk off, risk on, risk off.../Rates and yields: strong rand pushes down South African yields

- FX: Risk on, risk off, risk on, risk off... "Emerging Markets FX markets have been relatively directionless the over the past week, with about half of the EM currencies that we cover appreciating against EUR and USD and the other half depreciating. The overall theme has no doubt been whether the G3 economies are heading for a double-dip or whether the global recovery will continue. Lacking a decisive answer to this key question, the EM FX markets have mostly drifted sideways."

- Rates and yields: strong rand pushes down South African yields "It has also been remarkably calm in the EM fixed income markets. The most interesting “story” has certainly been the decline in South African yields, which have been driven down by the continued strengthening of the rand. That said, we do not see much potential for South African yields to fall further."

Risk management in agriculture: Towards market solutions in the EU

- "Volatility in agriculture is expected to increase – production volatility, mostly driven by climate change as well as price volatility, due to higher production volatility, a tight supply/demand balance, volatile energy prices, and other factors."
- "The responsibility to manage risks is increasingly in farmers’ hands. The EU’s Common Agricultural Policy is undergoing major reform towards greater market orientation. Tighter budgets as well as environmental and trade consider-ations have led to the reduction of market interventions. The post-2013 CAP is currently being discussed along those lines."
- "Agricultural producers will need to rely more heavily on market-based tools. We investigated the main risk management tools available for EU farmers pre-dominantly in the light of their effectiveness to stabilise their income – also taking into account, wherever possible, their impact on the environment and their effect on food security. EU farmers will benefit from a growing variety of private risk management tools in the future. Most likely, they will increasingly use financial derivatives and insurance products."
- "The derivatives market is still limited in Europe but developing, and the potential is significant. Public support may encourage the use of derivatives to cope with price volatility by promoting training on these products, ensuring availability of information and ensuring judicious regulation: this will be essential so that commodity derivatives keep serving their purpose of price discovery and hedging."
- "The insurance market is also expected to develop, to cope with production risk and mitigate financial risk. The current insurance level in the EU is generally insufficient to smooth major income reductions in bad years."
- "For the sake of environmental sustainability, thus long-term food security, it is important to reward farmers for delivering public goods: biodiversity, water quality and availability, air quality, soil functionality, climate stability, etc. Key to shifting to a more sustainable agriculture (until other actions are taken to price these externalities), payments for the provision of public goods can also contribute to stabilising farmers’ income."
- "All in all, public policy could be most useful in increasing the risk management ability of farmers. Any extension of the public safety net will reduce the incentives for farmers and other agents along the food supply chain to manage their risks effectively through derivatives, private insurance or on-farm strategies like production diversification. Policies need to empower farmers to take their own risk management decisions and to have access to a diversity of instruments and strategies. More direct interventions are likely better kept as a means of last resort and restricted to measures which do not act at the expense of the rest of the world or of environmental sustainability."

Central banks – slow motion exit

- Central banks. "The global economy is losing momentum, while worldwide growth risks are on the rise. This benefits not only safe-haven investments like gold and government bonds but also money market rates, which will stay extremely low for an extended period. It will likely be late 2011 or early 2012 before major central banks start hiking rates, while the exit from the ultra-expansive liquidity policy is being pushed back."
- US. "Here, it is primarily the growth risks, i.e. the fear of a double-dip recession, that prompted the Fed to adopt a more cautious stance when it announced that it would reinvest all the proceeds from maturing and prepaid agency debt and MBS in longer-term Treasuries."
- Fed. "The US central bank has, therefore, not only abandoned its slight tightening bias but also opened the door again to additional quantitative easing measures. Things should not, however, go that far: Additional purchases of Treasury securities would lower the yield level only marginally. Moreover, the transmission channels of lower interest rates to the real economy are already clogged (pages 6-9)."
- EMU. "Here, it is still the ongoing sovereign debt crisis, the again surfacing concerns about the solidity of banks, and the strong real economic divergence that are making the central bank more cautious."
- ECB. "As a result, the European Central Bank will not be able to forge ahead, as planned, with its exit strategy, which would even not have to be completed before the first rate hike, not expected before the end of next year (pages 10-12)."

The Importance of M

- "Money matters, but it is better to look at money flows instead of money stocks, and sometimes it is necessary to look at the counterpart of money, credit, to see what is going on."
- "We argue in this note that if the equation of exchange—which is at the heart of the Quantity Theory of Money (QTM)—is recast in terms of money flows rather than money stocks, then the velocity of money proves to be more stable, and changes in money have more direct implications for nominal activity. We find empirical support in the euro area for this relationship. Latest money flow readings still point to an expansionary impulse, though its strength may be receding in coming months."
- "When non-bank sources of credit are creating non-bank money in significant amounts, as is the case in the US or the UK, measures of money relying on bank balance sheet data no longer capture actual monetary developments. In this case, it is necessary to analyse the counterpart of money, credit, as we have done with our credit impulse measure over the last two years. The latest data suggest that the credit impulse in the US and the UK has remained positive, giving continuing support to the recovery."
- "An important task for policy makers is to smooth the credit (and hence money) cycle, among other things by countering both excessive optimism and excessive pessimism in credit markets. Policy makers failed to do the former during the credit boom, but they were quick off the mark doing the latter when the bubble burst. After excessive optimism and pessimism a return to realism is now needed. As this happens, growth may well fall short of the levels reached during the credit boom as fewer but economically more viable projects will be funded. Monetary policy that ignores the diminished potential of the economy, risks fuelling another money and credit driven cycle."

Relative share price MACD maps

- "In this report, we consider the use of relative share price Moving Average Convergence-Divergence (MACD) maps as a sector rating and stock selection tool. Relative share price MACD maps can be used to determine which sectors or stocks are the most attractive candidates for long or short positions from a technical analysis perspective. For example, in the exhibit below, an MACD map based on share prices relative to the TOPIX (for TOPIX-17 Series sectors as of 3 September 2010) indicates that the electric power & gas, pharmaceutical, foods, real estate, automobiles & transportation equipment, and commercial & wholesale trade sectors are potential candidates for long positions. However, electric power & gas is at the top of the map and looks close to a turning point. Conversely, the energy resources, electric appliances & precision instruments, raw materials & chemicals, and retail trade sectors appear to be potential candidates for short positions. The map indicates that financials (ex banks) is another possible candidate for shorting, but we think this sector is also approaching a turning point and should actually be considered for bottom picking from now on. At the end of this report, we provide MACD maps based on share prices relative to the TOPIX for the top five companies in terms of market cap in each of the TOPIX-17 Series sectors."

• "Relative share price MACD can be used for sector ratings and stock selection: MACD is a technical analysis trend indicator that focuses on the widening or narrowing of the gap between a short-term moving average and a medium-term moving average. In general, although technical indicators are useful for helping to identify the optimum timing of transactions in individual indices or stocks, they are not easy to use for the purpose of a side-by-side comparison of individual sectors or stocks. MACD is no exception in this respect, but the use of MACD based on relative share prices enables us to avoid the problem of trading signals being affected by the direction of the market as a whole or being skewed toward a particular position."

• "Basic concept of relative share price MACD maps and how to use them: In this report, we present
relative share price MACD maps as a sector rating and stock selection tool. By plotting the relative  hare price MACD on the x-axis and the MACD histogram on the y-axis, we can see the relative status of each individual sector or stock at a glance. The MACD maps show movements in the various data series over time, and our basic strategy is that sectors or stocks that are either in the 1st quadrant or about to move into it are potential candidates for long positions, while sectors or stocks that are either in the 3rd quadrant or about to move into it are potential candidates for short positions. In addition, the direction of each individual data series can help identify which stocks to buy on dips and which stocks to sell to lock in profits, within a particular quadrant, by indicating the strength or weakness of the buy or sell ratings."

Comprehensive income and equity valuation, Part 2: Importance of corporate balance sheet management ability

- Hosting an IFRS seminar — "We will be hosting a seminar on October 13, 16:00–18:00, at the 9th floor conference room in the Shin-Marunouchi Building. Our guest speakers will be Mr. Ikuo Nishikawa, chairman of the Accounting Standards Board of Japan (ASBJ), and Mr. Takehiro Arai, Vice Chairman of the ASBJ. The theme will be Convergence with the IFRS and reform of Japan’s accounting system."
- What is profit? — "We believe comprehensive income, rather than NP, is coming to exert a substantial impact on share prices. This is in our view particularly pronounced when NP is positive and comprehensive income is negative. Companies with sizeable overseas assets, equity holdings, and corporate pensions see big swings in comprehensive income."
- The case of Mitsubishi Corp. — "Mitsubishi Corp. reported FY3/09 NP around the ¥370bn mark. However, comprehensive income was in the red to the tune of ¥384.9bn. The shares fell that year by 57.3%, while TOPIX was down only 36.2%. To our mind, this is a good example of the impact of comprehensive income on share prices."
- The case of April–June 2010 — "Mitsubishi Corp. reported NP of ¥140.4bn but a comprehensive loss of ¥59.4bn (other comprehensive losses amounted to ¥199.9bn). The shares fell 23.9% in the quarter. Sumitomo Corp. reported NP of ¥64.6bn but a comprehensive loss of ¥22.3bn. The shares fell 16.5%."
- The cases of Toyota Motor and Panasonic — "Leading companies that were in the red for comprehensive income but in the black for NP are Toyota Motor and Panasonic (Toyota does not disclose comprehensive income, so this is our estimate). In April–June, Toyota shares fell 17.8% and Panasonic 21.5%."
- Companies with few equity holdings — "Among other global Japanese companies, we consider balance sheet risk to be relatively slight at Hoya, Canon, Fanuc, and Murata. We think they offer more investment appeal in the current strong yen, low share price environment than companies with volatile comprehensive income."

The UK pound: Further recovery in store

- GBP: "We expect GBP to strengthen on a TWI basis into year-end. Our year-end target for EUR/GBP is 0.80 (our USDGBP forecast are under review)."
- Country-specific factors: "Key bullish factors include cheap valuation, favourable M&A and central bank flows, recovery in the financial sector, and a clear fiscal consolidation plan (and stable CDS spreads). The deteriorating housing market is likely to be the main negative influence over coming months."
- Global USD direction: "A dovish Fed along with below-potential growth in the US (but no double-dip recession) should facilitate USD weakening into Q4."
- Global risk factors: "After a period of elevated risk aversion, we expect the risk environment to shift to neutral for the next 3-6 months."

• "We expect the UK economy to grow at a slow pace in 2010 and 2011, at 1.7% and 1.9% respectively, following the announced budgetary spending cuts (this forecast is close to consensus)"
• "CPI inflation has been persistently high over the last few months – far higher than the Bank of England (BoE)’s 2% target rate. However, it has started to moderate. We expect inflation to remain high for the rest of this year and not to hit its target rate until 2012. The rise in the VAT rate in January 2011 should provide further upward pressure to consumer prices."
• "Nomura’s economics team forecasts the BoE to hike rates by 25bp in February 2011 to 0.75% and again in May 2011."

Japan: Costs of currency market intervention from a fiscal perspective

- Costs of currency market intervention from a fiscal perspective
• "The government intervened in the currency market, buying USD and selling yen."
• "As well as discussing the outlook for intervention, it seems worthwhile revisiting the costs of sustained intervention and the resulting further expansion of the government’s Special Account of Foreign Reserves mainly from a fiscal perspective."
• "First, the need for the Account to set aside provisions for unrealized losses from foreign security investment should mount unless the yen weakens, affecting the availability of so-called hidden reserves to reduce the amount of deficit bond issuance by the government."
• "Second, government debt would continue to expand with the Financing Bills outstanding growing in a non-stop manner."
• "Third, the autonomy of monetary policy would be substantially limited as any small rise in the short-term interest rate would lead to a major increase in debt servicing of Financing Bills."

- Another drop in manufacturers’ capacity utilization
• "Capacity utilization rate among manufacturers dropped for the second consecutive month to the lowest level since last December"

- Demand for Funds Remains Weak
• "Bank lending continued to drop, falling 2.0%yoy in August, reflecting the weak demand for funds among the private corporate sector"

U.S. Japan Comparisons Again: More than One Route to Perdition

- "Aspects of the U.S. outlook have become more reminiscent of post-bubble Japan than during other (merely) cyclically weak periods. However, structural and behavioral differences from Japan remain very significant, just as before." 

- "In the U.S., a reality of disinflation has won over simplistic “hyper-inflation” forecasts. The risks of insufficient demand and deflation aren’t entirely negligible. For housing assets, the U.S. banking and GSE sectors seem poised to hold and work off bad debt gradually rather than purge it quickly. Fiscal intervention has been repetitive and insufficient to permanently change growth expectations, all ostensible similarities to Japan."
- "Monetary policy in the U.S. has been strikingly different than post-bubble Japan, particularly in the early aftermath of the Lehman event. However, it seems possible that inertia and misunderstanding keeps monetary policy in the U.S. from a truly aggressive track, even if warranted."
- "Even optimal monetary policy can’t generate higher living standards over the long run. But it can avoid lasting deflation (a spiral higher in the purchasing power of currency). The long-run monetary policy track in the U.S. has been and is likely to be more inflationary than Japan’s, as chronic currency strength in Japan and mild U.S. dollar depreciation also suggest."
- "Private sector behavioral differences remain vast. The U.S. labor market and capex are far more cyclical than in Japan, and suggest an early and lasting bottom. Even amid structural growth slowdowns in both economies, we believe cyclical differences will be notable. In effect, the U.S. is more prone to “boom and bust” than slow and lasting stagnation."

Fading RUB's temporary MXN disease

- "When we talk about a disease in Russia, we usually mean “Dutch disease”, which is commodity-price-driven real effective rate appreciation. We use the term “MXN disease” to describe a recent underperformance unjustified by fundamentals, secular trends and recent recovery in risk appetite."

- "Hard currency external debt redemptions from the corporate sector in the past four months contributed to the RUB underperformance, but have been moderating in September and October."

- "In terms of fundamentals, the very benign inflation backdrop and rapid REER appreciation in Q1 resulted in the Russian Central Bank (CBR) treading cautiously and building up reserves relatively aggressively. When the collapse in implied yields was added to this RUB underperformed. But this is a phenomenon of the past, not the future and something we anticipated in April when we exited the RUB longs that we had been holding since December 2009."

- "Going forward, we think the inflation picture is likely to change this dynamic, driven by food inflation and Russia's recovery. We see the likelihood of a hike before year-end rising significantly and we would not be surprised to see a 25bp hike in mid-autumn. Additionally, we think the domestic hard currency redemption picture should be more benign until year-end and the rouble slightly weaker. We identify a 3% opportunity for the currency gains."

- "Foreign investors’ recent lack of interest in RUB, combined with its recent underperformance in relation to oil, strengthens our conviction."

- "We recommend fading this MXN-disease by buying a RUB basket – selling 3m USD/RUB and EUR/RUB (entry 34.75, stop 35.25, target 33.65, time horizon 1-month, US$5mn on the model portfolio). We intend to add to the position close to the top of the range at 35 depending on the price action."

Bad days for the basis

- Resi: Bad days for the basis
- CRE: Introducing the DB quality score "The DB quality score can be a useful benchmark in assessing the potential volatility of collateral and bond cash flows."
- Consumer ABS: Positive momentum in autos shows support for lending in middle-risk credit tiers "Auto lenders more comfortable with sector have started to reach further down the credit spectrum."
- Economics: Exports a key positive contributor to economic performance "Strong capex and robust exports will together keep real GDP growth modestly above trend."
- Rates: Who’s afraid of buying Treasuries? "We remain constructive on yields. Primarily this reflects anemic growth with outright deflation risk, but not a double dip view."
- Agency MBS: A new taste of seasoning "Seasoned 30-year 5.0%s look rich while low pay-up 5.5%s and 6.0%s appear attractive."
- Non-Agency MBS: Competing risks in jumbo MBS  "Interest rates have reached the point where jumbo MBS investors should expect a jump in old fashioned refinancing while credit performance continues to deteriorate."
- CRE: Loan in the spotlight: One Alliance Center "One of the larger specially serviced loans faces significant tenant rollover and refinance risk."
- Consumer ABS: Assessing the spread pick-up for FFELP student loan ABS vs. credit card ABS "Current levels argue for further FFELP tightening."

Defusing the tax bomb

- Macro viewpoint: Defusing the tax bomb "The dysfunction in Washington could cause a “growth pause” in the fourth quarter. However, we expect the Obama Administration to focus on economic growth in the run-up to the Presidential election."
- Fed watch: Taking their time "With the economy decelerating but not crashing into a double dip or outright deflation, we believe Fed officials are unlikely to rush into renewed QE over the next few FOMC meetings. By January, we expect weak economic conditions will allow Chairman Bernanke to forge a consensus supporting the potential for additional asset purchases."
- Housing watch: Spilling over "The construction industry has shrunk as a share of the economy, but the effects of the housing bust are still being felt. Nearly a third of total job cuts were in housing-related industries and a bulk of the drop in consumer spending was in housing-related goods. Bank repossessions have started to pick up steam and should continue to depress the housing market, and by extension, the economy."
- The week ahead: FOMC meeting and housing data deluge "The main event this week will be the FOMC meeting on Tuesday. We’ll be paying particularly close attention to the FOMC statement for any signs of QE2. Our forecast assumes they resume easing in the first quarter of 2011. Besides Tuesday’s FOMC meeting, the week’s data releases will center on the housing sector. Overall, the data should reflect the depressed state of the housing sector."

Which investment is preferable in the euro zone: Peripheral sovereign debt of reasonable credit quality (e.g. Italy) or investment grade credit (corporate and bank bonds)?

- "Euro-zone investors are faced with the following dilemma: they can obtain a yield that is at least as high on euro-zone peripheral sovereign debts of reasonably good credit quality that are reasonably liquid (Italy, possibly Spain) as on investment grade companies or banks. Has sovereign risk really become greater than corporate risk, or is there a discrepancy between the valuations of the two types of debt?"
- "We believe that:• the sovereign risk on Italy is insignificant;• the sovereign risk on Spain is harder to evaluate;• corporate and bank default risk is 13 bp (A) to 30 bp (BBB) per year, and at present corporate profitability is rising again rapidly."
- "The best portfolio is probably one diversified in Italy, corporates and senior bank debt."

Economic slowdown confirmed: now what?

- "The global mid-cycle slowdown that we introduced in our previous Forecast Update has materialised further, but without pushing the pro-cyclical currencies lower. The slowdown is already priced in markets and if the outlook doesn’t deteriorate further, we don’t think the ‘smaller’ G10 currencies will lose ground against the ‘larger’ ones."
- "Risk sentiment remains an important – but rather unpredictable – driver to our forecasts and we regard financial markets as closely interlinked across asset classes. We recommend to consider a higher-than-normal degree of FX hedging."
- "We see both downside and upside risks to EUR/USD and foresee a bumpy ride around the current spot level with a moderate upward bias on the longer horizon as the most likely. We think the BoJ will prevent JPY from drifting much stronger in the short run and keep our bias for weaker yen in the long run. We remain positive on the Scandinavian currencies but acknowledge that levels may seem stretched and that risk-reward has been better."

Citizens in "non-exporting" euro-zone countries should be told the truth

- "In the euro zone, a number of countries (Finland, Netherlands, Ireland, Austria, Belgium, Germany) have a substantial capacity to export to high-growth countries, thanks to their innovation drive, improvement in the product range and cost control in the case of Germany. But other countries (France, Italy, Spain, Portugal, Greece) have a low exposure to countries enjoying rapid growth (emerging countries, oil exporters). We call them "non-exporting" countries."
- "The leaders of these countries should have the courage to tell public opinion that:• growth in these countries will be subdued: shortfall in the innovation drive and therefore in productivity gains; inability to use indebtedness to boost growth in the wake of the crisis, lack of stimulation of the economy by foreign trade;• the standard of living will decline due to deindustrialisation, offshoring and the need to improve competitiveness and profitability;• the reduction in fiscal deficits will be difficult and painful due to the sluggishness of growth, and it will be necessary to adjust the generosity of welfare systems because of the modest long-term growth and more stringent European budgetary rules;• this improvement will take a long time: the time needed to create new jobs in potentially growing sectors;• inequalities will inevitably widen between employees in companies that are adapted to globalisation and the others."

No bond market bubble

- Recent market movements "Bond yields are trading roughly in line with the forecast we released a month ago. However, this hides a decline in the second half of August which has reversed in September. Changes in the market’s perception of double dip risks have been the key driver of yield movements. As such, the yield increase in recent weeks has been driven by slightly better indicators out of the US and Asia. Also, fluctuating demand from the European L&P industry has exacerbated yield movements. L&P companies were heavy buyers of bonds when yields declined but L&P bond purchases appear to have slowed a little as yields have moved higher. Illustrating this is the fact that yields in the 30Y segment saw the steepest fall when yields declined in August but have rebounded the most in recent weeks."
- Macroeconomic outlook "Economic indicators out of the US have surprised on the downside in recent months, although the past few weeks have seen a few positive surprises. Leading indicators are generally pointing towards a sharper slowdown, and in the past month we have downgraded our US growth forecast by almost one percentage point. We expect the US economy to grow 1½-2% in H2 10 and then to recover slowly to a 3% growth rate. Manufacturing ISM is expected to decline to the 50-51 region by the end of 2010. Payroll gains, which are generally very important for bond markets, are expected to average around 100,000 a month in the coming quarters, rising towards 200,000 by the end of 2011. All things considered, we do not expect a double dip in the US economy but the weakening of ISM data over the next 3-6 months should keep double dip fears alive. In the eurozone the news flow has been more positive in recent months, but we see increasing signs of growth losing momentum. German industrial orders and eurozone industrial production have remained flat for a couple of months, and the OECD leading indicator for the eurozone is still pointing downwards. We believe that GDP growth peaked in Q2 at about 4% q/q AR and we expect it to slow gradually to 2% q/q AR in 2011. Activity indicators such as the German IFO and eurozone PMI are set to decline in the coming quarters. We continue to expect very divided growth within the eurozone, with Germany outperforming while growth momentum remains subdued in southern Europe. Inflation is not giving much cause for concern. Core inflation in the US is running at a very low rate of 1%. In Euroland the inflation rate appears to have stabilised at roughly 1.5% in the eurozone and we expect it to remain there over the next 12 months."

Back to the Future

- What happens if we mean revert? — "We have run long-term commodity price assumptions through our models to determine what earnings and cash flow would look like under a mid cycle commodity price environment. On our analysis, the large diversifieds would be trading at an average PE of 12.6x, which is slightly ahead of the long-run PE multiple for the sector of 12.3x."
- Near-term commodity momentum critical — "The copper price has been trading in a $6,000 to $8,000 per tonne trading range since the beginning of 2010 (currently $7,486/t) and we expect it to remain in this range for the rest of the year. A breakdown of this range is likely to occur at some point and with inventory drawdown, lack of new LME inventory, and increase in cancelled warrants, the risk in the short term could be to the upside."
- What is being priced in — "The diversified miners are trading on an average PE of 8.1x spot 2011e earnings, versus 7x on our base case. Moreover, the mining sector is currently trading at a 20% discount to the market on spot commodity prices and on a historical basis it has traded at a 5% discount. In order for the sector to return to market multiples, then the copper price (along with the basket of commodities would have to fall by c15% or copper would have to fall to around $6,800/t ."
- Stress testing balance sheets and cash flow — "The key negative impact of the downturn in 2008 was the impact on cash flows and high debt positions of the mining companies. Under our long-term pricing scenario, free cash flow for the sector would fall by c70%, however the large diversifieds would be in the strongest positions, while the pure commodity companies would be impacted the most. Kazakhmys, for example, would experience difficulty given its $1.4bn capex commitment in 2011 and swing into negative cash flow under long-term prices. Once again the diversified miners look the strongest, with each able to maintain sufficient Free Cash Flow for expected capex under such a scenario."
- What to do — "We recommend investors sticking to the large diversified miners, with key picks of Xstrata and BHP Billiton. We are currently neutral on the sector, after being buyers in May and we would look to move to an underweight position on higher equity prices."

Why is the dollar not depreciating?

- "The trend in the dollar against emerging countries' currencies as well as the euro may seem surprising."
- "First, the outlook for the US economy has actually worsened significantly since the start of 2010: anaemic household demand, ongoing deleveraging, useless corporate profitability, deterioration in the labour market situation and in household solvency, still high external deficit and unbalanced public finances."
- "Second, some central banks (the People’s Bank of China in particular) have admitted that they are increasing the weight of the euro and the yen in their foreign exchange reserves to the detriment of the dollar. So why is the dollar so resilient? The possible explanations are:• the dollar's role as a safe-haven currency when risk aversion increases, since the summer of 2008;• concerns also about the economic situation of the euro zone and emerging countries;• the perception that the valuation of emerging assets is too high;• the very sharp earnings growth among US listed companies."
- "We confirm the roles of risk aversion, concerns about the situation of the euro zone and the return of non-resident buyers of US equities."

Credit Markets in 4D: Double-dip & debt-deflation?

- "To clarify one thing right at the start: neither a (global) double-dip recession nor a debtdeflation process is our base-case scenario. The most likely path is one of sluggish growth, a scenario that would be – at least in theory – preferable for credits. Nevertheless, there are plenty of signs that the tremendous recovery is coming to an end. Hence, with a slowdown of economic activity ahead, investors will ask themselves “where will the slowdown stop – above or below the zero line”? It is this discussion in a fragile environment that we are concerned about, as investors do not wait to discount an adverse scenario until it really unfolds. Moreover, developments over the last couple of years have shown that investors do not necessarily have to be the “follower” of economic developments, they can be the “leader”. An adverse economic development can be triggered by an erosion of confidence in financial markets. The problem is that – in particular in the European periphery – governments lack the financial flexibility to weather another storm. Investors should not forget that the major ingredients for a Great Depression-like scenario were “too much debt” and “deflation” – two factors that are also hanging like a Damocles Sword above us in the current scenario."
- Macro Outlook: "Reducing macroeconomic disequilibria in the eurozone implies the need for significant internal devaluation: Lessons from the Baltic countries, which are undergoing a similar problem, suggest huge challenges for the economies."
- Micro Fundamentals: "With government yields at record lows and piles of cash on corporate balance sheets, the question is whether a new M&A boom is imminent. We take a look at leverage of European corporate bond issuers to gain more insight."
- Debt-Equity-Linkage: "M&A activity and the loan market are two sides of the same coin. As M&A activity remains subdued so does loan origination."
- Credit Quality Trend: "The default rate forecast is driving spreads, but what is driving the forecast? Is it really highly sophisticated economic forecast models?"
- Market Technicals: "Loan origination volumes grew rapidly before the crisis and collapsed afterwards, partly due to the turmoil in the CLO market."
- Valuation & Timing: "Our fundamental concerns are more on a mid-term horizon. But on a short-term perspective, investors' focus on eurozone periphery sovereign debt, the 3Q earnings season and the outlook for 2011 could present catalysts for a more pronounced spread widening in the coming weeks."

- Other Credit Markets: Derivatives: "The rapid growth in credit derivatives over the last few years enlarged the spectrum of hedging possibilities also in EEMEA credits, albeit the market is still small and in most cases illiquid. Securitization: Update on European and US housing market. EEMEA Credits: Two-speed recovery also bears some deflationary risks."

- Allocation: "We leave our defensive credit portfolio allocation unchanged."

- Model Portfolio: "Our financials portfolio outperformed the benchmark by 9bp, while the non-financials portfolio outperformed by 6bp."

Our review of recent academic research

- "Twice a year we compile a list of what we consider to be the most interesting journals on Quantitative Investment. We select articles based on whether the subject matter is interesting, and also whether they are representative of the trends that we are witnessing in the industry. While it is not designed as a comprehensive overview, we hope you will find them of interest."