Global Growth Remains Solid, Fed Edges Towards More Stimulus

- "We continue to look for sustained but uneven global growth, led in general by strong emerging market growth and with more modest recoveries in the US and Europe. But, after a slight bias to GDP forecast downgrades in the last two months, this month we make more GDP forecast upgrades than downgrades. We regard a "double-dip" as unlikely. Rather than negative growth, the greater likelihood is that recoveries in some key industrial countries will not be strong enough to quickly eliminate slack created by the recession."
- "As last month, we expect the Fed, ECB, BoJ, BoE and PBOC all to keep their key policy rates on hold to the middle of 2011 and indeed we expect the US Fed to keep rates on hold to end-2011 as well. The Fed is edging towards further stimulus. Barring material improvements in the outlook, we would anticipate action as early as the November meeting."
- "Chief Economist Essay (by Willem Buiter, see page 14). There is no such thing as completely safe sovereign debt. The cost-benefit analysis of sovereign default may favour default for the most highly indebted sovereigns, especially if they also have surpluses in their primary budgets. Default looks most likely for Greece, and Ireland may not be able to make whole both its sovereign debt holders and all unsecured creditors of its banks."
- "Citi rate strategists have become a little more bearish over the past two weeks. Citi strategists believe that corporate credit in core countries looks attractive in risk/reward terms, while Citi equity strategists argue that global equities can make healthy gains in 4Q10. For securitized products, Citi strategists remain positive, and recommend overweighting CMBS and Agency MBS while marketweighting consumer ABS. Citi FX strategists believe that SEK offers best fundamental value among G10 markets, while GBP looks stretched. For EM, our medium-term FX forecasts remain generally bullish versus forwards."

Relationship between spare crude oil supply capacity and prices

- "Crude oil prices continue to consolidate in a lateral range. We largely attribute their range-bound action to an uncertain economic outlook. Another factor militating against an upside breakout of their trading range is the existence of ample supply capacity globally. If the global economy weakens, crude oil prices would likely gain downside momentum. Conversely, if crude oil demand grows as projected by the IEA amid favorable economic conditions, upward pressure on crude oil prices would presumably begin to intensify. Spare crude oil supply capacity is currently equivalent to 6.4% of demand, a historically price-suppressive level. However, curtailment of petroleum resource development during the 2008–09 economic downturn bodes unfavorably for growth in production capacity through 2012. If demand grows in line with the IEA's forecast without any offsetting growth in production capacity, we estimate that spare supply capacity will fall to 4–5% of demand. Historically, when this ratio of spare supply capacity to demand has fallen below 5%, crude oil prices have risen steadily, fueled by concerns about supply constraints. Spare supply capacity bears close watching in terms of the outlook for crude oil prices."

Yen Intervention and Yuan Adjustment

- "Japan’s intervention in foreign exchange markets last week was a response to the slow pace of CNY appreciation and the yen’s rapid appreciation. Unlike the yuan, the yen is not an undervalued currency but it had appreciated faster than other Asian currencies this year."
- "China’s revealed preference for real appreciation via inflation rather than nominal exchange rate appreciation is paying off. Wages are rising rapidly and the current account surplus is falling as the real effective exchange rate rises. We forecast a current account surplus of only 2.7% of GDP next year."
- "The appropriate metric for assessing currency values is the real effective exchange rate. On that basis, most Asian currencies appear undervalued, but the CNY’s undervaluation is relatively modest in comparison with some of its neighbours. We consider two estimates of the deviation of the real exchange rate from equilibrium and the larger estimate is only 13.5%. That implies a 24% appreciation in CNY/USD over the next five years, which is consistent with our forecast. But that may overstate the necessary extent of CNY appreciation."

India: Small plays on the big capex idea

- Infra capex — next ramp-up point approaching "We believe the Indian investment cycle is likely to witness a significant structural inflection in the next few years, led by a significant improvement in the cashflows of private infrastructure operators. Despite some short-term delays, the story on both infra and corporate capex is expected to be strong in India. We think that 2012-13 will see a significant inflection in activity levels in the Indian infrastructure sector."
- Industrial capex turning around "On the corporate capex side, while the picture is becoming positive, companies with dependence on large and late-cycle industrial capex have not recovered fully.
Overall, strong demand, high capacity utilisation and a relatively stable macro environment present a positive environment for a revival in corporate capex."
- Looking for mid-cap beneficiaries "We have looked at mid-cap (US$200mn-US$1.5bn) companies which are fairly leveraged to and are likely to benefit significantly from a pick-up in capex activities. These are companies with strong competitive positions in relatively consolidated industries with large capacity expansions (without equity dilution)."
- Our top mid-cap picks "Voltas (18.4% earnings CAGR over FY10-12F, 40.6 % ROE, 15x FY12F P/E) is a well established, liquid stock with a world-class engineering project portfolio and a successful refrigeration business. Triveni Engineering’s (52% CAGR over FY10-12F, 20% ROE FY09, 14.6x FY12F P/E) tie-up with GE brings its market-leading turbine business into sharper focus and a spin-off could unlock value. Sterlite Technologies’ (14% CAGR over FY10-12F, 32% ROE, 10.7x FY12F P/E) strengths in optical fibre and power conductors fit right into telecom expansion and the significant growth in power capacity. Maharashtra Seamless (13% CAGR over FY10-12F, 16% ROE, 7.5x FY12F P/E) is the leading supplier of seamless pipes to the oil and power industries. We also present Nomura Nuggets (non-rated reviews) on GEI Industrial Systems, Elgi Equipments and Techno-Electricals."

The new geography of global innovation

- The new geography of global innovation "While the United States and Japan remain leaders in innovation, increased competition from growth markets, notably China, suggests a changing landscape. Research and development spending in Asia surpassed EU levels in 2005, and is likely to overtake US levels in the next five years, thanks primarily to striking growth in R&D investment in China. Measures of R&D intensity, or R&D investment as a share of GDP, allow for cross-country comparisons of commitment to R&D. R&D intensity has remained flat across G7 markets during the last decade at 2.1%. In China it has impressively doubled as a share of GDP since 1999, reaching 1.5%, which remains low by international standards. R&D investment is driven largely by the corporate sector, which finances more than two-thirds of total R&D spending in many countries. Companies in a range of industries, from pharmaceuticals to technology hardware, have exposure to new hubs of global innovation."
- Pipeline concerns and the role of human capital "The new geography of global innovation is critically dependent upon higher education in science and engineering (S&E) fields. Student interest in S&E is low in G7 countries, suggesting that these markets are likely to have difficulty replacing an aging cohort of native-born scientists and engineers. Reliance on foreign-born skilled labor is set to rise further as the world’s S&E skill base shifts toward Asia, notably China, where S&E fields represent 40% of all new university degrees awarded (more than two and a half times US levels)."
- New geography demands a policy response "Innovation-led productivity growth in the G7 will increasingly require public policies which attract and retain skilled foreign students and workers. In the short term, a more flexible and talent-friendly immigration regime can help developed economies and companies to benefit from the globalization of S&E skills. Longer-term investments in R&D and science education can further enable G7 countries to remain competitive by rebuilding student interest in S&E fields and by expanding the domestic supply of skilled S&E labor."

Musical chairs

- "The M&A theme is back. When we wrote Musical chairs in November 2006, we felt that the corporate world was ready for a round of consolidation. This played out during the 2007 frenzy brought on by the rapid rise of the emerging-market economies. The world has changed much since then, but we believe conditions are ripe for another wave of M&A in Asia Pacific ex-Japan."
- "Despite widespread concerns over a 'balance sheet recession' in the US, the corporate sector is behaving very differently from households. Companies are re-leveraging given the ability to fund themselves at close to historically low rates."
- "When new order flows slow down, acquiring competitors to increase market share becomes more attractive than capex, given the still real risk of initiating new investment only to find that the demand has evaporated by the time a plant opens one or two years hence."
- "In this report, we highlight five stocks that we think are likely to be under scrutiny as potential acquisition targets: MobileOne (BUY), Biosensors (BUY), Korea Exchange Bank (BUY), Primary Health Care (BUY) and Wing Hang Bank (Rating suspended). We include fresh updates on the four rated stocks."
- "We include global data on M&A and corporate fund-raising."

Flow Rider

- Huge waves — "Flows are away from developed market equities towards bonds and EM equities. Mega caps have been caught in this underperformance rip tide."
- Awesome — "We estimate European mega caps have at least €375bn of firepower. While the UK mega caps have £200bn. How will it be used? M&A or buy backs?"
- Hang 10 — "M&A will continue the flow imbalance away from mega caps and towards large ex mega and mid cap. Long mega cap is short M&A."
- Radical — "Mega caps struggle under the weight of too many shares issued during the bull market of the late 90s. Be radical. Shrink the share count."
- Wipeout — "Over time those companies that have consistently shrunk the share count have outperformed those that have kept issuing shares."
- Gnarly, dude — "Get in front of the flows. Buy those companies that will retire their own equity and don’t own those who are buying someone else's."

If the US Sneezes...

- "Although our forecast for US growth has been more downbeat than the consensus for a long time—and remains so—our view on the rest of the world continues to be more optimistic. This kind of forecast appears to be in conflict with the popular notion that ‘if the US sneezes, the whole world catches a cold’. Nevertheless, we argue that it is plausible. All else equal, a significant US slowdown would slow growth to a degree in the rest of the world, and in some places more than others. But  espite the conventional wisdom, export channels are too small to transmit a US slowdown to a comparable degree. And while transmission through financial channels is arguably more capable of spreading a US slowdown, there are few signs currently of the kinds of pressures on financial conditions or stresses that would signal such an impact."
- "As a result, we continue to expect further divergence in growth and policy between the US and many others relative to what the market is pricing. And we have been recommending trades around that theme in recent months, particularly with respect to the emerging economies and the smaller G10. In particular, this gives us a bias towards widening rate differentials between the US and many others, further broad USD weakness and a preference for EM exposures in equities, both at the index level and within the major markets."
- "As our analysis here suggests, the principal risk is that a global shock acts to ‘connect’ the various economies more than we expect—either through financial markets, the banking system or some other new event. That is not what we expect, but it is this possibility, and not the fact of a US slowdown itself, that we think needs to be monitored."

The Death of the Equity Culture ?

- "The recovery in equity indexes that started in March 2009 has stalled as many indices have gone sideways since late May 2010. The overall year-to-date performance is close to zero."
- "This hesitating pattern is a clear reflection of the ongoing uncertainties pertaining to the economic growth. The doubledip risk is clearly visible in the sharp retrenchment registered by our proprietary News Index."
- "One can clearly see that the correlation between this index and the S&P 500 has strengthened since 2008. A quick look at the VIX chart below shows that this relationship is clearly regime-dependant: in times of heightened uncertainty on growth, the stock market is much more correlated to VIX than economic data releases."
- "This regime-dependant pattern is due to last and may explain why traditional valuation tools may not be pertinent for short term investors."
- "Speaking of double dip risk may suggest that we remain in a cyclical perspective. The crisis may yet have had some long run implications (for equilibrium valuation notably)."

Latin America: Scrubbing Up for Major Intervention

- "Ample global liquidity coupled with improved regional fundamentals, particularly higher commodity prices, should lead to further appreciation of LatAm exchange rates against the US dollar. We do not expect any depreciation in the major currencies (BRL, CLP, MXN and COP) against the USD in the next three months. In fact, we have changed our USD/BRL forecast for year-end 2010 to 1.72 from 1.80"
- "Global interest rates should remain at their current low levels for an extended period of time. This environment tends to support commodity prices, thus favoring terms of trade in Latin American countries. Increases in commodity prices amid reductions in risk aversion, which are part of the same phenomenon, have led to increased capital inflows into many Latin American countries."
- "The direct link between commodity prices and terms of trade lies in the large share of commodities in Latam exports. The weight of commodity exports in Latam countries ranges from 18% (in Mexico) to 95% (in Venezuela) of total exports, highlighting the great significance of those prices on exports dynamics."
- "Against this backdrop, we believe pressures for additional Central Bank intervention, in the form of dollar purchases in both spot and forward markets as well as capital controls, are likely to gain momentum."

Euro on the mend

- Overview: Euro on the mend "The euro is recovering against the dollar. The former mirrors the EMU which is a dynamic and well balanced economy. The latter suffers from the US economic slowdown. Nonetheless the EU single currency has still some weak points."
- US: Second quarter flow of funds accounts "Household debt once again declined markedly in the second quarter, whilst non-financial companies’ debt remained stable. The value of assets held by households declined, reflecting a correction in financial markets. Profits of non-financial companies grew further and reached their highest level since 2007. Public sector debt continued to rise at a rapid rate, driven by the federal component."
- Japan: Second quarter flow of funds accounts "In Q2 2010, strong overseas demand and very accommodative policies resulted in a widening of the financial deficits of the rest of the world and the government. The appreciation of the yen has led to an increase in overseas investment. In the coming quarters, the government’s financial balance is expected to improve gradually, while the financial surplus of the private sector might decline modestly."

Is Obama like Clinton or Bush?

- Macro viewpoint: Is Obama like Clinton or Bush? "Continued gridlock in Washington would be very bad for the economy. We expect a reluctant compromise on taxes at the last second."
- Fed watch: QE2: Pondering when and how "The Fed has adopted a clear easing bias, but there is no rush: the economy is weak but not drifting toward recession and Bernanke will want to get broad support from his committee before acting. The Fed has a number of options to further stimulate the economy. Now that they have acknowledged that inflation is “somewhat below” acceptable levels, one way to ease further would be to the “extended period” language to the inflation outlook. The Fed could also tie its asset purchase program to bond yields – buy whatever amount is needed to bring the 10-year yield down to a specific range."
- Housing watch: Builders still downbeat "New home sales remained close to record lows, the NAHB housing survey remained depressed and single-family permits fell, setting the stage for further declines in housing construction. The housing market will be a clear drag to GDP growth this quarter and next."
- The week ahead: New month; New ISM "We are not expecting any major revelations in next week's data flow and expect continued evidence of a weak economic landscape. The main event will be the release of the ISM manufacturing index on Friday. We are expecting the index to decline to 54.0, its lowest level since November 2009. We'll also receive the personal income and spending report."

What can be done when conventional economic policies are ineffective? The current example of the United States

- "The problems encountered by the US economy are structural:• excess indebtedness and loss of household solvency;• required adjustment in corporate balance sheets, leading to a distortion of income sharing at the expense of employees;• resulting deteriorations in the situation of the labour market and the real estate market."
- "In view of this situation, the Obama administration and the Federal Reserve are tempted to:• abstain from reducing fiscal deficits;• make the monetary policy even more expansionary."
- "But these economic policies can no longer be efficiently used:• fiscal deficits will have to be reduced under the pressure from public opinion, rating agencies and perhaps financial markets later. Moreover, the United States has an overall shortfall in savings;• there is no point in increasing liquidity further, as it is already overabundant and private economic agents are deleveraging."
- "So what economic policies remain?• the dollar's exchange rate, which is abnormally strong because of the high level of risk aversion, cannot be controlled;• we could imagine the Federal Reserve or the Treasury taking over (writing off?) part of the debt of over-indebted households (with negative equity on their mortgage loans), financed by an increase in the taxation of companies’ non-invested profits, in order to reduce household defaults and accelerate the correction in their balance sheets. The distortion of income sharing in favour of companies in fact leads to higher profits than what is needed to finance investments. This would amount to an organised partial default on the US household debt."

Why do investors always buy when prices are at their highest?

- "We can see that investors (in a broad sense: institutional investors, banks, funds, non-residents) almost systematically buy assets in the United States and Europe when the prices of these assets are abnormally high, but not when they are abnormally low. This holds for currencies (especially the dollar), equities, bonds, etc."
- "It is well known that this is explained by herd behaviour, VaR and capital constraints, short-term horizons, competition between investors and monetary policies. However, this is extremely destabilising and, curiously, the crisis has not put an end to this behaviour."

Slowdown, but with a soft landing

- Short view: Weaker growth for longer "Commodities witnessed a pronounced sell-off in late August led by disappointing economic data. However, since then, prices of most products have risen despite little improvement in fundamentals. Volatility will probably remain high in H2, but heading into 2011 the prices of oil and base metals should gradually start to move higher as the business cycle matures and a soft landing on the back of the current mid-cycle slowdown is eventually confirmed."
- Energy: Soft patch ahead "Weakness is materialising in the oil market with both OECD and non-OECD demand softening. Due to lower GDP projections, we have taken down our forecasts for oil consumption in 2010 and introduce cautiously optimistic 2011 estimates. We now see stocks building for this year on average and postpone our call for a decline in world oil inventories to 2011. The OPEC October meeting will focus on quota compliance."
- Base metals: Still risk of a correction "Declines in global PMIs during the autumn should prove challenging for base metals. Notwithstanding, we continue to see the direction as being upwards and recommend buyers take advantage of almost inevitable price setbacks over the next couple of months to position for higher 2011 levels, especially for copper."
- Grains: Focus on tightness in corn "Wheat has showed continued strength but attention is shifting to corn, the market for which is growing increasingly tight. The projected output shortfalls for this year are unlikely to change the outlook for near-record harvests of most grains, but with demand simultaneously rising, stocks-to-use ratios are declining to less comfortable levels."
- Hedging: Consumers should await correction "We suggest consumers await setbacks in metals, crude oil and crack spreads for distillates before locking in 2011 prices for e.g. diesel."

Why the Federal Reserve’s recent and probably future policy is very dangerous

- "Since Lehman’s bankruptcy, the Federal Reserve has been implementing an ultra-expansionary monetary policy (nearly zero interest rates and liquidity growth), which will probably be stepped up because of the problems facing the US economy."
- "This policy in reality has virtually only drawbacks:
1) it has no positive effects on the US economy, since it does not lead to any upturn in credit or any rise in asset prices, in particular because of the ongoing deleveraging;
2) it leads to the appearance of excessive liquidity being held in banks’ balance sheets, and other economic agents that will subsequently be able to turn into purchases of assets and result in bubbles in asset prices;
3) it leads to growth in global short-term debt in dollars, hence:
• a distortion in exchange rates (appreciation in the yen and the Swiss franc, etc.);
• foreign exchange risk-taking (borrowers in dollars, lenders in other currencies);
• interest rate risk-taking (borrowers in the near term, lenders in the long term)."
- "In all likelihood, US monetary policy will remain very expansionary for a long time. To curtail the risks stemming from this situation, possible solutions include:
1) restricting international capital flows, but this would be difficult and might be inefficient;
2) regulating (curbing):
• foreign exchange risk-taking by banks (borrowing in foreign currencies, lending in local currency);
• interest rate (duration gap) risk-taking by banks (borrowing in the near term, lending in the long term)."

Who will do less badly? The United States or the euro zone?

- "The perception of the financial markets is oscillating: in very late 2009 and in early 2010, the consensus forecast an economic recovery in the United States, but not in the euro zone. Subsequently, investors turned despondent about the United States, before a slight upturn in confidence at the end of the summer 2010."- "What should one think in reality? Which zone, the United States or the euro zone, will post less deterioration in its economic performance after the crisis?"- "We have to compare:• productivity gains, and their probable trend (which depends on the investment drive, the utilisation of corporate savings, etc.);• industry’s capacity to benefit from the robust growth in emerging and oil-exporting countries;• the efficiency, the more or less reasonable nature of changes in income sharing;• changes in the breakdown of jobs between skilled jobs and lowskilled ones (with low wages);• the solvency of borrowers and the outlook for credit;• the need to improve public finances."- "We find that the euro zone is in a better situation than the United States for 4 criteria out of 6, and in an equivalent situation for the remaining 2."

The global economy has all the features of a deflationary economy. What can be done?

- "Some economists have mentioned the possibility of a rapid recovery in global growth, others emphasise the risk of inflation and excess liquidity, while others speak of a double dip."
- "And yet, it seems clear that the global economy shows all the features of a deflationary economy, i.e. excessive savings and hence sluggish demand; ineffectiveness of economic policies in kick-starting activity; unemployment and under-utilisation of capacity resulting in very low inflation; as a consequence abnormally high real interest rates, hence a fall in asset prices and deleveraging which exacerbate the fall in demand."

There is no solution in Japan without an increase in wages

- "The Japanese economy is caught in three traps:
• negative inflation, which increases real interest rates and keeps the country in deflation;
• fiscal deficits and the level of public debt, which has become huge;
• the appreciation of the yen, due to capital inflows and the trade balance surplus."
- "The usual remedies do not seem to be effective:
• increasing the deficit and the public debt further to boost the economy and offset the appreciation of the yen would be irresponsible;
• conversely, increasing VAT to reduce the fiscal deficit would eventually worsen deflation (as in 1997);
• foreign exchange interventions to weaken the yen may be ineffective, as in the past."
- "We believe that the only solution would be an increase in wages: it would lead to positive inflation and stimulate consumption and activity and would reduce the fiscal deficit, it would reduce the trade surplus and would weaken the yen; it would not have any negative effect on companies, which have excess savings and huge financial reserves due to the distortion of income sharing."

What happens if prices become stickier than wages?

- "Traditionally, it is believed that prices of goods and services are relatively flexible and nominal wages relatively sticky. The goods market therefore rapidly returns to equilibrium, while the labour market disequilibrium (unemployment) may persist. In this configuration, a fall in demand for goods (for instance a rise in the savings rate after a wealth loss) drives down prices and drives up the real wage, leading to a fall in output and employment but also a boost in household demand, drives down profits and therefore investment."
- "But in contemporary economies (we look at the situations in the United States and the euro zone) the labour market has become more competitive, whereas inflation is very inert, which must reflect the shortfall in competition in product and service markets. If wages have become more flexible than prices, the reaction of the economy is totally changed. A fall in demand drives down output and employment, but not prices; the nominal wage is curbed, leading to a fall in the real wage that amplifies the decline in household demand, but boosts profits. This is definitely the dynamics seen today, which is unfavourable if the propensity to spend profits is lower than the propensity to spend wages."