Spring 2014

Global Macro Strategy

David Zervos Chief Market Strategist dzervos@jefferies.com

+1 212 323 7586

Jefferies LLC

The Winners and Losers from the

Great Reflation

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

0

2

4

6

8

10

12

14

16

18

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14

FED ECB BOE BOJ BOC RBA PBOC SNB SRB RBI

The single most important driver for ALL global asset prices is the aggressive and unprecedented moves in global central bank balance sheets.

2

Source: NCBs through both Bloomberg and Haver Source: Bloomberg

Total Assets of Major Central Banks ($ Trillion) US Monetary Base ($T)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

'75 '80 '85 '90 '95 '00 '05 '10

QE3

QE2

QE1

Operation Twist

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Since 2008 there has been quite a lot of divergence in central bank aggressiveness.

3

Total Asset Levels of Major Central Banks Central Bank Total Assets as a % of GDP

For Both, Source: National Central Banks: balance sheets and GDP figures

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

550%

1/08 1/09 1/10 1/11 1/12 1/13 1/14

Ind

exed

Val

ue

s in

Nat

ion

al C

urr

ency

, 20

08

=1

00

%

BOE BOJ FED ECB SNB BOC

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

'08 '09 '10 '11 '12 '13

BOE BOJ FED ECB SNB PBOC

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The story for the last 15 months has been the BoJ’s commitment to catch up, and the ECB’s reluctance to stay the course. This has played itself out aggressively in EURJPY and the relative outperformance of the Nikkei vs EStoxx. This trend will likely continue throughout 2014.

4

Source: Bloomberg

EURJPY Currency Change of Nikkei and Estoxx (Aug. 2012=100%)

90%

100%

110%

120%

130%

140%

150%

160%

170%

180%

190%

8/12 11/12 2/13 5/13 8/13 11/13 2/14

Nikkei Euro Stoxx90

100

110

120

130

140

150

8/12 10/12 12/12 2/13 4/13 6/13 8/13 10/13 12/13 2/14

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

As we look across developed markets inflation remains subdued, but Japanese inflation is finally starting to look more “normal”. Who would have thought Japanese inflation would running ABOVE US, Italian, French and German inflation in 2014!!!! If QE is actually applied with the correct it works just fine!!

5

Source: OECD, NCBs, Bloomberg

World Inflation (YoY %)

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

'01 '03 '05 '07 '09 '11 '13

US Germany Japan UK France Italy Canada

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

GDP growth has been accelerating nicely in the US, Japan, and the UK. Is it any coincidence that these are the countries with the deepest commitment to central bank balance sheet expansion!

6

Source: OECD, NCBs, Bloomberg

Real GDPs (Jan 2008 = 100)

90

92

94

96

98

100

102

104

106

108

1/08 7/08 1/09 7/09 1/10 7/10 1/11 7/11 1/12 7/12 1/13 7/13

US France Germany Japan Italy UK

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Short term real interest rates provide the best indication of the stance of monetary policy. Ex-post real short rates have moved sharply lower since the crisis, but they are on the rise except in Japan. Ex-ante real short rates have a similar pattern. Overall real rates remain in “the highly accommodative zone” across most developed markets. The sad exception to all this is the periphery of Europe!

7

Real Rates of Developed Countries

Real Rates, Source: Bloomberg (2yr yields – 2 Year Annualized Headline CPI) Implied Real, Source: Bloomberg (5yr yields – Breakeven Inflation)

5 Year Implied Real Yields

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

'00 '02 '04 '06 '08 '10 '12 '14US Germany Japan UK France Italy

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1/07 7/07 1/08 7/08 1/09 7/09 1/10 7/10 1/11 7/11 1/12 7/12 1/13 7/13 1/14

US Germany Japan UK France Italy

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

As long as real rates fall enough - policy becomes accommodative, inflation rises and unemployment falls…in other words QE WORKS!!!! But if real rates are not pushed low enough, unemployment and disinflation problems remain. That was the problem in Japan for 20 years and it’s the current problem in the periphery of Europe. Complicating the employment picture however are changes in the participation rate. Central bankers can never really be sure if there is truly slack in the economy or if there are structural and demographic issues in play.

8

Source: Bloomberg

Unemployment Rates (%) Participation Rate (%)

0

2

4

6

8

10

12

14

'91 '94 '97 '00 '03 '06 '09 '12

US Germany Japan Italy France UK

45

50

55

60

65

70

'70 '75 '80 '85 '90 '95 '00 '05 '10

US Germany Japan Italy France UK

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

But based on what we know about the US from the FOMC’s summary of economic projections (SEP). FOMC sees A LOT of slack in the US economy – even at equilibrium at the end of 2016. How else could you explain these forecasts?

9

Source: Federal Reserve Bank

Target federal funds rate at year-end 2014 2015 2016 Longer run

Sept

Mean 0.40 1.25 2.26 3.93

Median 0.25 1 2 4

Dec

Mean 0.34 1.06 2.18 3.88

Median 0.25 0.75 1.75 4

December 2013

FOMC SEP (Midpoint of Central tendencies) 2014 2015 2016 Longer

run

Change in real GDP 3 3.2 2.9 2.3

Unemployment rate 6.45 5.95 5.5 5.5

PCE inflation 1.5 1.75 1.9 2

September 2013

FOMC SEP (Midpoint of Central tendencies) 2014 2015 2016 Longer

run

Change in real GDP 3 3.25 2.9 2.35

Unemployment rate 6.6 6.05 5.65 5.5

PCE inflation 1.55 1.8 1.85 2

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

'90 '93 '96 '99 '02 '05 '08 '11

GDP, ex-Govt Govt (additive) Govt (subtractive)

But as much as the Fed sees slacks, the private sector has performed remarkably well post crisis.

10

Source: Bloomberg, Jefferies

Real GDP of Govt and non-Govt Sectors (YoY, %) US Real GDP, by Component (YoY %)

Cumulative Annualized GDP Figures Private Sector Nominal GDP from 1990-2007 = 5.4% Private Sector Nominal GDP from 2010-2014 = 5.1% Private Sector Real GDP from 1990-2007 = 3.0% Private Sector Real GDP from 2010-2014 = 3.2%

US Avg. Real GDP from 1990-2007 = 3.0% from 2010-2014 = 2.2%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

'90 '93 '96 '99 '02 '05 '08 '11

Govt Ex-Govt

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The FOMC looks like it will be taking some significant longer term inflation risks in order to unwind slack associated with a falling participation rate. And the BoJ finally looks like is will apply QE in such a way as to keep risk free real rates low and negative. But the Europeans are just flailing in the wind. The ECB got it right in the beginning of the crisis, but since the summer of 2012 they have let the trade weighted Euro appreciate sharply. The ECB is making the same “relative” mistake the Japanese made during their lost decades. That is why they have high real rates, a weak economy, a strong currency, strong bond markets and weak equity markets! It’s a tragic mistake!

11

Source: Bloomberg, ECB

Trade-Weighted 20-Country Euro NEER

90

95

100

105

110

115

'09 '10 '11 '12 '13

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Looking ahead, there are surely long term developed market inflation risks associated with all of this monetary expansion. And while breakeven inflation rates suggest these risks are minimal, Gold still prices in some serious long term inflation dislocations. So far though the breakevens seem to winning the battle! But there is no question, over the long run, the developed market central banks are taking significant risks with long term inflation stability.

12

Source: Bloomberg

Inflation Adjusted Gold Prices (indexed to 1983) Fed 5y5y Breakeven (%)

-2

0

2

4

6

8

10

12

14

16

0

100

200

300

400

500

600

700

800

900

'70 '75 '80 '85 '90 '95 '00 '05 '10

Inflation Ajusted Gold Prices $ (LHS) US YOY Inflation % (RHS)

1.5

2.0

2.5

3.0

3.5

4.0

6/99 12/00 6/02 12/03 6/05 12/06 6/08 12/09 6/11 12/12

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Near term, as developed market central banks push the printing press pedal to the metal, force risk taking and generate increased real growth potential, EMG will become the weak link - remember the last time US rates started to rise, a US recovery took and Japan went on a devaluation tear by using a combination of expansionary fiscal and monetary policies.

13

For Both, Source: National Central Banks: balance sheets and GDP figures

Japan’s Fiscal Expansion Post the 1995 Yen Lows Dollar/Yen & Japan’s Monetary-Base

3,500

4,000

4,500

5,000

5,500

6,000

80

100

120

140

160

'90 '92 '94 '96 '98

USDJPY (LHS) Japan Montary Base 12MMA (RHS, NSA ¥10 Bln)

30

31

32

33

34

35

36

37

80

90

100

110

120

130

140

150

'92 '93 '94 '95 '96 '97 '98

USDJPY (LHS)1988-1994 'Avg Annual Gov't Spending/GDP' (RHS)1995-2001 Avg 'Annual Gov't Spending/GDP' (RHS)

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

It did not end well for EMG. And take a look at the relative value of SPX to MXEF - EMG looks VERY expensive!!

14

Source: Bloomberg, MXEF is a free float weighted emerging market equity index.

SPX/MXEF Ratio (1988=1)

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

'88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Here are the winning and losing assets in the great reflation.

15

There Are Two Types of Assets

Non-Printable • Equity Capital • Real Estate • Commodities • Distressed Fixed-Income Assets

Printable • Cash • Low-Yielding Fixed Income Instruments

In a world where the developed market central banks drive risk-free real rates lower, and the portfolio balance channel forces risk taking, two things can happen. The risk-taking generates innovation, technological advance, productivity gains, real returns on capital, real growth and job creation; or, the risk taking does generates no innovation, no technological advance, no productivity gains, no real returns on capital, no real growth and no job creation. Folks who believe in the former – the lovers - should own equity capital, real estate, and distressed assets. Folks who believe in the latter – the haters - should own commodities such as precious metals. No one should own printable assets - anyone who does so will be in the “loser” camp.

Winners Losers

• Nikkei • S&P • DAX • Real Estate • Distressed Fixed-Income Assets

• Cash • Low Coupon Bonds • Emerging Market Assets

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Our favorite way to play the great reflation has evolved through time. In general we have always recommended at “long/long” strategy. For every 100m of risk assets (ie SPX), we would hedge with 100k/01 in 2s, duu’s, blues or chartreuse. For 2014 we are fully risk-on. No more levered fixed income hedges in the front-end. It’s time for just Spoos and Q’s!!!

16

2010, SPX & 2s

Source: Bloomberg, Jefferies: -Using weightings of $100K/01 for every $100m in equities. Glossary: SPX is the S&P 500…. DUU’s refers to Schatz futures contracts …. Blues are blue (3 yrs out) Eurodollar futures contracts …. Chartreuse is blue and green (2 and 3 yrs out) Eurodollar future contracts

2011, SPX & DUU’s

-5%

0%

5%

10%

15%

20%

25%

1/10 3/10 5/10 7/10 9/10 11/10 1/11-10%

-5%

0%

5%

10%

15%

1/11 3/11 5/11 7/11 9/11 11/11 1/12

0%

5%

10%

15%

20%

25%

30%

1/12 3/12 5/12 7/12 9/12 11/12 1/130%

5%

10%

15%

20%

25%

30%

1/13 3/13 5/13 7/13 9/13 11/13 1/14

2012, SPX & Blues 2013, SPX & Chartreuse

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The Fed backstop is fully in place, QE has worked its magic and US equities do not look expensive.

17

Source: Bloomberg, Fed, Jefferies.

Total US Equity Market Cap/GDP Real Value of US Equities (in 2013 dollars)

0

250

500

750

1,000

1,250

1,500

1,750

2,000

2,250

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

'27 '37 '47 '57 '67 '77 '87 '97 '07

DOW (LHS) SPX (RHS)

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

'27 '32 '37 '42 '47 '52 '57 '62 '67 '72 '77 '82 '87 '92 '97 '02 '07 '12

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Meet the new bubble….same as the old bubble.

18

Source: Bloomberg.

Adjusted Nasdaq Composite Index (Jan 1990 = 100%)

0

200

400

600

800

1,000

1,200

'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13

GDP Adjusted CPI Adjusted

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The most important lesson from the CORRECT implementation of QE is that the US is NOT Japan.

19

Source: Bloomberg, Jefferies.

US Equities and Japan Equities Performance

0

20

40

60

80

100

120

140

0 20 40 60 80 100 120 140 160 180 200 220 240 260 280

Months from Peak

S&P Peak to Present Nikkie Peak to Present Nasdaq Peak to Present

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The greatest monetary policy mistake since the 1930s took place in Japan, from 1990 to 2013.

20

Source: Bloomberg, Jefferies.

US Price Levels (1980=100) Japan Price Levels (1980=100)

US GDP Japan GDP

0

50

100

150

200

250

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12CPI (1980=100) 2.5% Annual Inflation

100

150

200

250

300

350

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14CPI (1980=100) 3% Annual Inflation

0

4,000

8,000

12,000

16,000

20,000

24,000

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12GDP (1980=$2,730B) 6% Nominal GDP YoY

0

100

200

300

400

500

600

700

800

900

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12

GDP (1980 = 250T ¥) 3.5% Nominal GDP YoY

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Sadly, Japan relied on fiscal policy expansion instead of monetary policy expansion to spur a recovery….that clearly did not work out very well.

21

Source: Bloomberg,.

Government Gross Debt/GDP Levels (%)

0

50

100

150

200

250

'81 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11 '14

Japan USA France UK Spain Canada Germany Mexico Austrailia China

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The bottom line is that we have seen some amazing benefits from QE when it is appropriately applied. However, like any pain medication, the benefits are very much upfront and the costs are much long term. What are some of these long term costs:

22

1. Financial instability/bubbles

2. Losses on the balance sheet

3. Inability to extract reserves and control short rates on the exit

4. Unhinging of long term inflation expectations

5. Income and wealth distribution skews

All of these are serious issues for the long run, but the most worrisome one is the income distribution skews. We are likely to see much more political instability in the US over the long run as QE continues to widen these skews. Let’s look at a few charts on the negative distributional consequences of US QE.

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

A worrisome trend developing.

23

Source: Bloomberg, US Census.

US Gini Coefficient

0.33

0.35

0.37

0.39

0.41

0.43

0.45

0.47

'47 '50 '53 '56 '59 '62 '65 '68 '71 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10

Tightening Fed Monetary Policy (noted from 1954 and after) US Gini Coefficient

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Income has stayed the same for the upper class, but has fallen for the middle and lower-tier earners.

24

Source: US Census.

US Cumulative Real Income Increases since 1967, by Income Cohort

0%

20%

40%

60%

80%

100%

'68 '72 '76 '80 '84 '88 '92 '96 '00 '04 '08 '12

Tightening Fed Monetary Policy (noted from 1954 and after) Cohort of Bottom 40% Earners: Mean Income Cohort of Top 40% Earners: Mean Income

Cohort of middle 20% of Earners: Mean Income Cohort of Top 5% Earners: Mean Income

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The wealth distribution has also widened sharply.

25

Source: US Census, Fed., Jefferies.

US Household Nominal Wealth Growth Since 1989 by Cohort

0%

50%

100%

150%

200%

250%

300%

'89 '93 '97 '01 '05 '09

25-49.9 50-74.9 75-89.9 90-100 All Households & NPOs

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Big house, low rate - small house, high rate.

26

Source: Five Bridges Advisors, Sept ‘13.

Average Original Loan Size ($K) by Net Coupon(%) (Fannie & Freddie 30-yr, Conforming and Non-Conforming)

0

50

100

150

200

250

300

350

2.50 3.00 3.50 4.00 4.50 5.00 5.25 5.50 5.75 6.00 6.25 6.50 6.75 7.00 7.50

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

Recently the jumbo-mortgage rate has dipped below the conventional mortgage rate.

27

Source: MBA and Bankrate.com.

US 30-yr Mortgage Rates

-2.00

-1.80

-1.60

-1.40

-1.20

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

'98 '00 '02 '04 '06 '08 '10 '12

Spread (Conventional-Jumbo, RHS, %) 30-Year Jumbo Rate (%, LHS) BankRate.com 30-Year Fixed (%, LHS)

Global Macro Strategy Jefferies LLC

David Zervos – Chief Market Strategist – dzervos@jefferies.com - +1 212 323 7586

The structure of the US mortgage market is the culprit behind these distributional asymmetries. A fixed rate mortgage combined with a house price collapse is a toxic structure. The biggest problem for the US has been the inability of those in the lower income quintiles to refinance. The Fed should have thought more clearly about these distributional issues back in 2009!!

28

Source: Fed, SCB, RBA, BoE

Effective Outstanding Mortgage Rates (%)

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

'06 '07 '08 '09 '10 '11 '12 '13 '14

US UK Sweden Australia

0

2

4

6

8

10

12

14

'77 '82 '87 '92 '97 '02 '07 '12

US

Global Macro Strategy Jefferies LLC

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David Zervos Chief Market Strategist dzervos@jefferies.com

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Ryan Siegal Analyst, FI Strategy

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