2011 09 27 CLSA - David Roche
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This memorandum is based upon information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned herein.
This memorandum is provided solely for the information of pro fessional investors who are expect ed to make their own investment decisions without undue reliance on this memorandum and save for any liability o r obligations under the Financial Services Act 1986 and/or
the rules of the Securities and Futures Authority Limited. Independent Strateg y Limited accepts no liability whatsoever for any direct or consequential loss arising from any use of this memorandum and its contents. It may not be circulated to or used by private investors for
any purpose whatsoever. This memorandum may not be reproduced, distributed or published by any recipient for any purpose.
David Roche October 2011
INDEPENDENT
STRATEGY
‘ if ’
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The great plurality
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STRATEGYFigure 1Ifs – the great plurality
3
When outcomes have no normallydistributed probabilities of occurring
from the certainty of the known knowns to the
unquantifiable uncertainty of the knownunknowns and the of the unknown unknowns
The plurality of outcomes
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INDEPENDENT
STRATEGYFigure 4Distribution of deadly conflicts according to the number ofpeople killed
6
0
100
200
300
400
500
600
0.02 0.07 0.2 0.1 0.2 0.9 1.1 6 7 10 20 120 130
Fatalities (m)
No of
conflicts
Distribution is not normal bell curve
but a power law: double the no of
deaths and wars become four times
less common. The power law impliesthat when a war starts out, there is
no indication of how big it will come
(unlike human height distribution)
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INDEPENDENT
STRATEGYFigure 5Probability distribution for fluctuations in S&P-500 index
7
0
2
4
6
8
10
12
-20 -15 -10 -5 0 5 10 15 20
Normal Levy* Actual
Variation
P r o b a b i l i t y
* A Levy flight distribution is arandom distribution punctuated by
occasional big leaps ie 'fat tails' -fluctuations in stock market arecloser to the Levy flight distributionthan a normal distribution
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INDEPENDENT
STRATEGYFigure 6Knightian uncertainty
8
In his seminal work, Risk, Uncertainty, and Profit , economist Frank Knight(1921) established the important distinction between risk and uncertainty:
“ Uncertainty is.. radically distinct from risk. Risk means a quantity susceptible of measurement… a measurable uncertainty. that’s far
different from an immeasurable uncertainty ”
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INDEPENDENT
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Global sovereign debt crisis
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Derivatives 4%
Bond Debt 79%
BankLending
65%
PowerMoney
4%
Derivatives 173%
Bond Debt 141%
BankLending74%
PowerMoney
6%
Derivatives 125%
Bond Debt141%
BankLending
64%
PowerMoney11%
Figure 7The liquidity pyramid: the measure of global liquidity (% of GDP)
Note: * counterparty risk value
1990152%
2007394%
2011341%
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INDEPENDENT
STRATEGYFigure 8Global private credit and sovereign debt ($ trn)
11
0
20
40
60
80
100
120140
160
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Private credit Public debt
$41trn
$100 trn
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STRATEGY
12
Figure 9Credit explosion
A: OECD – private credit and public debt ($ trn) B: OECD credit (% of GDP)
C: OECD credit (as % of real GDP) D: OECD: annual change in credit (%)
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Private credit Sovereign debt
Recession Recession
EM crisis
0
50
100
150
200
250
300
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11Private credit Sovereign debt
120%
48%190%
92%
100
140
180
220
260
300
340
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Private credit Sovereign debt
132%
53%210%
101%
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INDEPENDENT
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Note: * includes US, Germany and Japan.
Real 10 yr BY CPI inflation Nominal 10 yr BY Average real 10 yr BY
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
Q 2 1 9 8 1
Q 2 1 9 8 2
Q 2 1 9 8 3
Q 2 1 9 8 4
Q 2 1 9 8 5
Q 2 1 9 8 6
Q 2 1 9 8 7
Q 2 1 9 8 8
Q 2 1 9 8 9
Q 2 1 9 9 0
Q 2 1 9 9 1
Q 2 1 9 9 2
Q 2 1 9 9 3
Q 2 1 9 9 4
Q 2 1 9 9 5
Q 2 1 9 9 6
Q 2 1 9 9 7
Q 2 1 9 9 8
Q 2 1 9 9 9
Q 2 2 0 0 0
Q 2 2 0 0 1
Q 2 2 0 0 2
Q 2 2 0 0 3
Q 2 2 0 0 4
Q 2 2 0 0 5
Q 2 2 0 0 6
3.7%
1.6%
Figure 10OECD* CPI inflation and ten-year bond yield (%)
13
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INDEPENDENT
STRATEGY
14
Figure 11US non-financial debt (% of GDP) and national savings rate(% of GDP)
100.0
120.0
140.0
160.0
180.0
200.0
220.0
240.0
1 9 5 2
1 9 5 4
1 9 5 6
1 9 5 8
1 9 6 0
1 9 6 2
1 9 6 4
1 9 6 6
1 9 6 8
1 9 7 0
1 9 7 2
1 9 7 4
1 9 7 6
1 9 7 8
1 9 8 0
1 9 8 2
1 9 8 4
1 9 8 6
1 9 8 8
1 9 9 0
1 9 9 2
1 9 9 4
1 9 9 6
1 9 9 8
2 0 0 0
2 0 0 2
2 0 0 4
2 0 0 6
12.0
14.0
16.0
18.0
20.0
22.0
24.0
Credit - LHS Nat sav rate - RHS
128%139%
225%20.7%
19.7%
13.4%
GDP = 3.0% p.a.
GDP = 3.6% p.a.
Post-war decades
INDEPENDENT
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INDEPENDENT
STRATEGYFigure 12Global sovereign debt crisis
15
• Interest costs higher than growth
• Debt ratio above 90% of GDP (60% in EMs)
• Negative primary budget balance
• Current account deficit
• High foreign ownership of debt
• Shallow domestic bond market and short maturity of debt
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INDEPENDENT
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INDEPENDENT
STRATEGYFigure 14Net government debt and structural budget deficits,2010 (% of GDP)
17
-40
-20
0
20
4060
80
100
120
140
-2 0 2 4 6 8 10 12
Aus
Bel
Swe
Swz
Ita
Jap
US
UK
Gre
Ire
Spa
FraPor
Eur
Neth
Den
Ger
! DANGER ZONE !
EMU Export bloc
EMU Austerity blocOther
Structural deficit/GDP
N e t d e b t / G D P
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• Sovereign debt no longer risk free. No risk free rate for valuation of financialassets.
• Fiscal policy neutralized as sovereign debt no longer safe haven. Less refluxof capital to sovereign bonds in crises to help finance fiscal deficit spending.Fiscal debt and spending already too high.
• Monetary policy integrated with fiscal policy to prevent market pricing ofsovereign debt risk. Transfer of volatility from price-rigged to market pricedassets.
• Sovereign debt backstop to financial system discredited making banks more
risky and capital more expensive.
Fig 16A: The New Risk Paradigm - DM’s:
INDEPENDENT
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STRATEGY
• Accumulation of DM sovereign bonds as international reserves makes forsolvency and liquidity risk as big as historical foreign debt risks.
• Threat to export growth model due to deleveraging in DM’s.
Fig 16B: The New Risk Paradigm - EM’s:
INDEPENDENT
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INDEPENDENT
STRATEGYFigure 17Three IFs and fat tails
21
NORMAL
UNCERTAIN
Ice age Long grind Halcyon days
P r o b a b i l i t y
%
INDEPENDENT
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STRATEGYFigure 17Three IFs and fat tails
22
P r o b a b i l i t y %
NORMAL
UNCERTAIN
Ice age Long grind Halcyon days
INDEPENDENT
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STRATEGYFigure 17Three IFs and fat tails
23
P r o b
a b i l i t y %
NORMAL
UNCERTAIN
Halcyon daysLong grindIce age
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STRATEGY
2
The Bedrocks:
• Death of Disinflation
• Emerging Market Model
INDEPENDENT
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STRATEGYFigure 18Bedrocks: the death of disinflation
25
HISTORY FUTURE
• Globalisation of labour supply • Slowing EM labour supply
• Tough central bank policy • Easy monetary policy
• More regulation;Government intervention
• Supply-side reform
• Maturing hi-tech markets• Hi-tech revolution
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INDEPENDENT
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STRATEGYFigure 20Bedrocks: the emerging market model
27
HISTORY FUTURE
Export-led growth Economic models based on domesticdemand
High savings, high
investment
Falling savings, rising consumption
and wages in national income
Plentiful young labour Increasingly old, scarce and moreexpensive labour
Low costs, capitalinflows
Less recycling and away from $ assets
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INDEPENDENT
STRATEGYFigure 23
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STRATEGYFigure 23Credit boom
30
A: Cumulative change in central bankassets and broad money 07-10 (%)
0
20
40
60
80
100
120
140
CB assets Broad money
DM EM
B: Change in credit/GDP from long-term trends (% pts)
0
5
10
15
20
25
Turk Bra China Indo Russ
Worry point as defined
by Basel Committee
C: Cumulative change in property prices 2006-10(%)
0
5
10
15
20
25
30
35
40
Indo Kor Mex China Russ
206!
INDEPENDENT
STRATEGYFigure 24
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STRATEGYFigure 24EM risk
31
A: EM-DM CDS differential B: BRIC real policy rate (%) and relative to realgrowth (% pts)
50
100
150
200
250
300
350
400
N o v - 0
8
J a n - 0
9
M a r - 0
9
M a y - 0
9
J u l - 0
9
S e p - 0
9
N o v - 0
9
J a n - 1
0
M a r - 1
0
M a y - 1
0
J u l - 1
0
S e p - 1
0
N o v - 1
0
J a n - 1
1
M a r - 1
1
M a y - 1
1
J u l - 1
1
* EM CDS is average of top seven EM
sovereign issuers; DM is average of top
four DM sovereign issuers
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
A u g - 0 7
D e c - 0 7
A
p r - 0 8
A u g - 0 8
D e c - 0 8
A
p r - 0 9
A u g - 0 9
D e c - 0 9
A
p r - 1 0
A u g - 1 0
D e c - 1 0
A
p r - 1 1
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
Real pol icy rate - LHS Less real growth - RHS
INDEPENDENT
STRATEGY
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STRATEGY
3
Investment wrap
INDEPENDENT
STRATEGYFi A
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STRATEGYFigure 25AThree IFs and fat tails
33
NORMAL
UNCERTAIN
Ice age Long grind Halcyon days
P r o b a b i l i t y
%
INDEPENDENT
STRATEGYFigure 25B
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STRATEGYFigure 25BThree IFs and fat tails
34
Ice age Long grind
P r o b a
b i l i t y %
Halcyon days
NORMAL
UNCERTAIN
INDEPENDENT
STRATEGYFigure 26
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STRATEGY
The uncertain outcomes
35
Death of disinflation
New paradigms for EMs
US: end of empire
Global sovereigndebt crisis
Ice age Long grind Halcyon days
Deflation:govt bonds and gold;
safe-havencurrencies
4-6% inflation:high-yield equities,
safe-havencurrencies
8-10% inflation:commodities, gold,growth stocks, EM
equities
Deflation: new EMmodel postponed – out of EM assets
Gradual move to newEM model: buy EM
consumer stocks and
Rmb; short EM debt
New EM modelwithin five years:buy EM equities
Deflation: hastenedcollapse of US power – out of US assets
except for govt bonds
End of US$ asreserve currency:
short US$ and fragileEMs
High US externaldeficit financed by
foreigners:buy US assets
Deflation: out ofbanks and cyclical
stocks
Contagion: out ofUS, UK and Japan
govt debt
Debt yields rise:stay out of govt debt
INDEPENDENT
STRATEGYFigure 27
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STRATEGYFigure 27Asset Allocation
36
There are gains under most outcomes
Short term: halcyon days
Medium term: grind
Long term: ice age
LONGS: Selected EMU sovereign debt (Ireland);index linked bonds; gold; euro, NZ$, S$, CHF
SHORTS: Sovereign debt; soft and hard commodities; US$
NEUTRAL: core blue chip high dividend yield equities.
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INDEPENDENT
STRATEGY
Contact details
Guido Manca or John Armstrong
Tel: +44 20 77304965Email: [email protected]
INDEPENDENT
STRATEGY
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Appendix
INDEPENDENT
STRATEGY
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3
The euro: sovereign debt,
banking and currency crises
INDEPENDENT
STRATEGYFigure A1
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The fiscal
4
Figure 1B: Net public debt to governmentrevenues (%), 2011
Figure 1D: Gross national s avings by sector (%of GDP), 2011
Figure 1C: Primary budget balance (2011) and thatrequired to stabilise debt at current level (% pts ofGDP)
Figure 1A: Public sector debt to GDP (%), 2011
87100
229
67 72
128
0
50
100
150
200
250
Eur US Jap
Gross debt Net debt
150
231
386
0
50
100
150
200
250
300
350400
450
Eur US Jap
-1.7
-8.6-9.0
-0.3
-1.8
-0.8
-10
-9
-8
-7
-6
-5-4
-3
-2
-1
0
Eur Jap US
Prim budg bal Req prim bal
5.4
11.5
6
9.0
10.823.3
-2.1 -4.0-3.1
19.2
25.3
12.3
-10
-5
0
5
10
15
20
25
30
35
US Eur Jap
Gov
Corp
House
Total
INDEPENDENT
STRATEGYFigure A2
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Figure A2Government debt held abroad (% of total debt outstanding), 2010
41
3229
7
0
5
10
15
20
25
30
35
US Eur Jap
INDEPENDENT
STRATEGYFigure A3
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Bank exposure
4
Figure 3B: Bank lending by sector (% of GDP), 2011
Figure 3D: Bank leverage (x) and equity to assetratio (%), 2011
Figure 3C: Bank exposure to PIIGS sovereign andbank debt (€bn ), 2011
Figure 3A: Total national gross debt by sector(% of GDP), 2011
91
72
74
76
142
138
97
148
188
100
87
229
0 100 200 300 400 500 600 700
US
Eur
Jap
Household Non-Fin Corp Financials Public sector
63
56
30
29
71
60
8
12
76
0 50 100 150 200
US
Eur
Jap
Households Corporate Government
75
115
18 22
116
72
43 33
0
20
40
60
80
100
120
140
160
180
200
Ger Fra US UK
Sov Bank
INDEPENDENT
STRATEGYFigure A4
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Figure A4Bank wholesale funding as share of total liabilities (%), 2010
43
0
5
10
15
20
2530
35
40
45
50
Jap US Eur
€10trn
€3.7trn
€11.6trn
INDEPENDENT
STRATEGYFigure A5
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gBank rollovers in 2012, % of total debt
44
5
7
9
11
13
15
17
1921
Ire Spa Por Neth Ita Ger Fra Aus Bel Gre UK
€21bn€88bn
€17bn €95bn
€142bn €227bn€182bn
€163bn
€34bn
€8bn
€3bn
Total Eurozone debt
rollover in 2012 = €795bn,
or 16% of total bank debt
`
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INDEPENDENT
STRATEGYFigure A7Growth and bailouts
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Growth and bailouts
4
Figure 7B: Required net trade contribution (%pts of GDP) to achieve growth rate
Figure 7D: EFSF (only) cost of bailing out thePIIGS through 2014 (€ bn)
Figure 7C: Funding for Eurozone governments (€bn)
Figure 7A: Required nominal GDP growth rate tostabilise govt debt ratio and 2011 rate (%)
3.0 3.3
3.8 4.04.4 4.5
1.3
-3.0
0.5
4.0
2.1
-1.1
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
Ita Gre Ire Bel Spa Por
Req nom GDP rate 2011 rate
0.40.5
0.6
0.8 0.9
1.5
0.3
-0.3
-1.1
0.1
-0.5
0.7
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Bel Ita Spa Por Gre Ire
Req Ave 02-07
440
142
432
922
1022
0
200
400
600
800
1000
1200
EFSF Existing bailouts Add Spain Add Spa+Ita Add Spa+Ita+Bel
110
390
216
0
50
100
150
200
250
300
350
400
450
Asset purchases* Liquidity provision** Bailouts
* ECB's SMP
** ECB collateral holdings
*** IMF/EFSF/EFSM bailouts
1.6% of Eurozone GDP
5.7% of Eurozone GDP
3.2% of Eurozone GDP
INDEPENDENT
STRATEGYFigure A8Gross public debt and contingent liabilities of key EMU
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Gross public debt and contingent liabilities of key EMUstates if EFSF tripled in size (% of GDP), 2011
47
0
50
100
150
200
250
300
Ita Bel Ger Fra Spa Neth Fin
Pro rata Joint & Several
483%
800%
INDEPENDENT
STRATEGYFigure A9
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EFSF capacity as share of requirements (%)
48
% share
Spa+Ita req funding to end 2012 54
Spa+Ita req funding to 2014 30
Bank recap cost on sovereign default 22
Total PIIGS debt 10
EFSF capacity relative to weekly ECB SMP funding 33 weeks
INDEPENDENT
STRATEGYFigure A10
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The euro debt crisis
49
The options
Fiscal integration and economic reform
Monetise and underwrite fiscally EMU state debt
Reconstitute the euro (Treaty changes to allow weak EMU states
to leave or be expelled)
Abolish the euro (birth of new Super-DM euro?)
International funding initiative coupled with IMF governed reformof PIIGs