all sections combined 101151513

8/20/2019 All Sections Combined 101151513

1/120

FIXED INCOME RESEARCH | MONDAY, MARCH 17, 2008

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 118

A Time for Calm

RELATIVE VALUE 8

The market overshoot/risk paranoia in the

dollar, commodities, yield curves, and

high-quality spread sectors is greatly

overdone, but not done. By contrast,

monetary, fiscal, and legislative

intervention is neither overdone nor done.

This market-policy contradiction suggests

further tactical portfolio defensiveness

(lowering recommended HY allocation

from 5% underweight to -15%) andincrementally more exposure to U.S.

agency MBS, which we increased from

3% underweight to 5% overweight

following the Term Securities Lending

Facility proposal. We also reviewed past

business cycles to estimate that long-term

yields, spreads, and equities are only

halfway to their cyclical turning points.

EQUITY STRATEGY 17

In the current environment, good news

comes at a premium. We are thus a little

surprised that the market has not responded

more positively to some of the recentdata in Japan, at least on a relative basis. In

no sense can we describe the economic

outlook there as “good,” but with

expectations already low and the speed

with which sentiment regarding the U.S.

economy has deteriorated in recent weeks,

we think a better relative performance is

justifiable. We remain Overweight.

ECONOMICS 20

The Fed is taking steps to improve market

liquidity. We expect it to keep slashing

rates, too. In Europe, we are now alert tothe risks of a sudden and sharp drop ingrowth. In Japan, the risk of recession isgrowing, but there is still a chance thatit can be avoided.

POLITICAL ANALYSIS 37

Global infrastructure investment is beingspurred by recently abundant self-

financing available in developing regions

and two decades of meager spending in

the U.S.

COMMODITIES 39

Investors often view commodities as

purchasing power protection, and recent

price movements against inflation

expectations support that view. Yet real

price and return calculations show an often

tenuous relationship between commodities

and inflation.

CURRENCIES 42

The deterioration in financial markets

remains a big upside risk to the yen,

especially since the Japanese have not yet

retreated from global capital markets.

That said, the effect of yen strength and

Nikkei weakness on Japan’s economy will

be significant.

INTEREST RATES STRATEGY 45

The Fed’s next steps, besides easing, are

likely to focus on broker-dealers, could

possibly include other AAA assets, but will

likely continue to be primarily financing

rather than purchase transactions.

SECURITIZED STRATEGY 77

Last week was another turbulent,

headline-driven week in the mortgage

market. The Fed’s TSLF programalleviated some concerns about financing;

but news of hedge fund defaults and bank

liquidity issues weighed on the market.

Given continued uncertainty, we think it is

hard to have strong conviction on the

mortgage basis. In CMBS, spreads

widened in volatile trading action; given

the volatility, we explore new trades in

index swaps and CMBX.

CREDIT STRATEGY 106

We believe that the Fed will eventually

win the liquidity battle, but with

fundamentals continuing to deteriorate,we expect to move from a liquidity crisis

to more fundamental solvency concerns,

as many entities remain overleveraged.

We thus expect the deleveraging to

continue. We also discuss the potential

influence of CLOs on secondary trading

in the leveraged loan market.


2/120

Contents

GLOBAL RELATIVE VALUE

A Time for Calm.............................. 8

EQUITY STRATEGY

Can Japan De-Couple? ................ 17

ECONOMICS

Global Economics

Liquidity Lesson ............................ 20

U.S. Economics

Street-Fighting Man ...................... 22

The Week Ahead .......................... 25

European Economics

Re-coupling with Decoupling ........ 28

Japan Economics

Resilience ..................................... 31

Asia Ex-Japan Economics

Australia: Mind the Gap ................ 34

POLITICAL ANALYSIS

Building on an InfrastructureFinance Strategy........................... 37

COMMODITIES

An Inflation Hedge,but for How Long? .........................39

CURRENCIES

Ongoing Risk AversionShould Sustain Yen Rally..............42

INTEREST RATES STRATEGY

U.S. Interest Rates Strategy

How Deep Arethe Fed’s Pockets? ........................45

Treasury Inflation-ProtectedSecurities: Are BreakevensUnderstating Inflation?...................55

Agencies:Widespread Underperformance.....58

European Interest Rates Strategy

It’s Always Fair Weather ................62

Euro Relative Value:U.K. Swap Spreads: Wild Thing ....66

Sterling Strategy:

Surprising Resilience… .................69

Euro Area Inflation Strategy:You’ve Got to Believe....................71

Asian Interest Rates Strategy

Rally CausesSeveral Distortions ........................75

SECURITIZED STRATEGY

MBS

Can Someone Hit the Brakes?......77

Mortgage Leveraged Portfolio .......79

ABS

Weekly Review: Fed Actions/S&PComments Spark an ABX Rally.....85

Liquidity Concerns and Asset Liquidations LeadResi-Credit Sell-off ........................86

HEL: Subprime Performance ina Negative HPA Environment........87

ABX: Update on the FebruaryRemittance Performance...............88

Residential Credit:Updated Loss Expectationsacross Residential Credit ..............89

ABX: Relative Value Viewsand Credit Leveraged Portfolio......90

Consumer ABS: Auto, Credit Cards,Student Loans ...............................91

CMBS

Market Monitor ..............................92

Trade Idea in Index Swaps............96

CMBX Update ...............................98

European Structured Products

Technicals TurnEven More Negative....................104

News In Brief ...............................105

CREDIT STRATEGY

U.S. Credit

Markets neither Shocked nor Awed…but Hope Endures...........106

The “CLO Factor” in a(Dis-) stressed Loan Market........108

REGULARS

Market Data .................................115

Calendar ......................................116


3/120

Lehman Brothers | Global Relative Value

March 17, 2008 3

Global Fixed-Income Asset Allocation

Summary Recommendation, as of March 14, 2008

Global Aggregate Portfolio

Sector

% Over (+)/

Under (-)

% Over (+)/

Under (-)

Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Weight Index Rec. Diff. Index Rec. Diff. Weight

Treasury 8.66 7.54 11.71 5 .95 11.71 15.60 6 .78 6.70 9.76 10.87 48.62 46.66 -4 2.92 3.07 0.14 0.00 0.00 0.00 -

Agency 2.27 1.89 2.62 3.30 2.65 6.11 1.15 1.17 0.90 9.86 12.20 24 0.48 0.55 0.07 0.48 0.57 0.08 17

Credit 2.65 5.02 5.71 5.78 6.51 6.82 2.59 0.25 3.22 3.16 20.67 21.03 2 1.14 1.02 -0.12 1.13 1.04 -0.09 -8

US Mortgage 3.42 7.50 8.57 2.49 3.64 13.42 12.21 -9 0.41 0.42 0.02 0.46 0.47 0.00 1

ABS / CMBS 0.17 0.51 0.40 0.76 0.88 0.51 0.29 0.15 0.23 1.89 2.00 6 0.10 0.07 -0.03 0.10 0.08 -0.03 -26

Collateralised (Pfandbrief) 1.13 3.35 1.93 1.57 1.59 0.96 0.57 0.00 0.31 0.02 5.53 5.90 7 0.23 0.14 -0.10 0.24 0.14 -0.10 -41

Total 18.29 18.31 29.87 25.92 25.83 33.64 11.39 6.95 14.62 15.18 100.00 100.00 5.29 5.27 -0.01 2.42 2.29 -0.13

% Over (+)/Under(-) Weight 0 -13 30 -39 4

Percent of Market Value by Duration Range

2-4 4-7 9+7-9 Option-Adj. Duration

Contribution to

Spread DurationTotal0-2

Global Aggregate Index by Currency of Issuer

% Over (+) /

Percent No. of Mod. Adj. Contrib. to Percent No. of Mod. Adj. Contrib. to Under (-)

Mkt. Val. Issues Duration Duration Mkt. Val. Issues Duration Duration Weight

U.S. Dollar 37.2 5,408 4.45 1.66 38.7 56 4.40 1.71 4

Euro 31.9 2,731 5.52 1.76 35.1 34 5.65 1.98 10

Japanese Yen 17.7 1,556 5.89 1.04 13.3 7 5.94 0.79 -24

British Pound 5.3 913 7.94 0.42 5.6 14 8.10 0.45 5

Canadian Dollar 2.6 457 7.00 0.18 2.3 3 6.82 0.16 -14

Australian Dollar 0.5 139 3.82 0.02 0.8 1 2.89 0.02 44

New Zealand Dollar 0.1 19 3.90 0.00 0.1 1 4.18 0.01 50

Swedish Krona 0.7 50 3.58 0.03 0.6 3 3.41 0.02 -18

Danish Krone 0.4 37 4.54 0.02 0.5 5 3.39 0.02 14

Norwegian Krone 0.2 10 3.96 0.01 0.1 1 1.63 0.00 -28

Singapore Dollar 0.2 20 5.21 0.01 0.1 3 4.74 0.01 -16

Korean Won 1.3 157 3.39 0.04 1.1 3 3.20 0.03 -17

South African Rand 0.2 45 5.26 0.01 0.2 1 2.11 0.00 -15

Hong Kong Dollar 0.0 1 1.36 0.00 0.00 -100

Chile Peso 0.0 4 3.41 0.00 0.0 1 5.45 0.00 -33

Mexican Peso 0.3 17 5.13 0.02 0.3 1 8.82 0.02 -13

Slovakia Koruna 0.0 7 3.98 0.00 0.0 1 8.42 0.00 -23

Hungarian Forint 0.2 21 3.57 0.01 0.2 1 4.15 0.01 31

Czech Koruna 0.2 16 5.77 0.01 0.1 1 4.69 0.01 -18

Polish Zloty 0.4 14 3.82 0.02 0.3 1 1.85 0.01 -19

Taiwan Dollar 0.4 68 6.97 0.03 0.4 1 6.37 0.02 -13

Malaysia Ringgit 0.2 25 4.84 0.01 0.2 1 4.52 0.01 -21

Total 100.0 11,715 5.29 5.29 100.0 140 5.27 5.27

Global Aggregate Index Global Aggregate Portfolio

Asian-Pacific Aggregate Index by Currency of IssuerOption-Adjusted

Duration: 101%

% Over (+) /

Percent No. of Mod. Adj. Contrib. to Percent No. of Mod. Adj. Contrib. toMkt. Val. Issues Duration Duration Mkt. Val. Issues Duration Duration

Japanese Yen 85.1 1,476 5.82 4.95 69.0 22 5.83 4.02 -19

Australian Dollar 2.8 125 4.07 0.11 3.5 3 1.15 0.04 26

New Zealand Dollar 0.5 14 4.06 0.02 0.3 1 3.79 0.01 -38

Singapore Dollar 0.9 20 4.65 0.04 1.1 2 1.71 0.02 18

Korean Won 7.4 129 3.31 0.24 8.1 2 4.34 0.35 10

Hong Kong Dollar 0.0 2 1.70 0.00 0.0 1 2.10 0.00 24

Taiwan Dollar 2.3 70 7.36 0.17 8.7 1 7.21 0.63 280

Malaysia Ringgit 1.0 26 4.79 0.05 9.3 1 5.17 0.48 812

Total 100.0 1,862.0 5.59 5.59 100.0 33.0 5.55 5.55

Asia-Pacific Aggregate Index Asian-Pacific Aggregate Portfolio

Under (-)

Weight

Market Value and duration contribution statistics reflect values as of the prior business day.Overweight/underweight percentages highlighted in shaded area represent current date recommendations.

22 bp

100%

95%

Tracking Error Volatility Option-Adjusted Duration Spread Duration


4/120


March 17, 2008 4

U.S. Fixed-Income Asset Allocation


U.S. Aggregate Core Portfolio

% Over (+) % Over (+)

Sector / Under /Under(-)

Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. (-) Wght Index Rec. Diff. Index Rec. Diff. Wght

Tsy 5.92 2.40 4.77 5.40 5.78 5.00 2.38 3.11 3.56 3.25 22.41 19.16 -15 1.15 1.29 0.14 0.00 0.00 0.00 -

Agy 3.70 5.86 2.53 1.78 2.10 1.03 0.73 0.00 0.57 1.44 9.62 10.10 5 0.34 0.39 0.04 0.35 0.38 0.03 9

Mtg. 12.56 17 .62 19.86 21 .30 6.57 2.05 0.00 0.00 0.00 0.00 38.99 40.97 5 1.08 0.84 -0.24 1.22 1.28 0.06 5

CMBS 0.45 0.00 1.18 0.00 2.95 3.91 0.63 0.00 0.00 0.00 5.21 3.91 -25 0.25 0.25 0.00 0.25 0.20 -0.05 -19

ABS 0.27 0.39 0.32 0.32 0.17 0.17 0.07 0.00 0.01 0.00 0.83 0.87 5 0.03 0.02 0.00 0.03 0.03 0.00 5

Credit 2.30 0.96 5.93 9.51 6.60 8.61 3.08 0.64 5.04 5.55 22.94 25.26 10 1.44 1.48 0.04 1.44 1.48 0.04 3

Total 25.20 27.23 34.59 38.31 24.16 20.76 6.88 3.75 9.17 #### 100.00 100.00 4.31 4.27 -0.04 3.29 3.37 0.08 3

% Over (+)/

Under(-) Weight 8 11 -14 -45 12


0-2 2-4 4-7 9+7-9 Option-Adj. Dur.

Contribution to Spread Duration

Spread Dur.Total

Recommended Portfolio by Duration Range Portfolio Allocation by Asset Class

8 11

-14

-45

12

-60

-40

-20

0

20

0-2 2-4 4-7 7-9 >9

% Relative

to Index

-15

5 5

-25

5

10

-30

-15

0

15

Tsy Agy Mtg. CMBS ABS Credit

% Relative

to Index

Passthrghs

Contribution to OAD by Asset Class Contribution to Spread Duration by Asset Class

12 13

-22

-1

-18

2

-1

-30

-15

0

15

Tsy Agy Mtg. CMBS ABS Credit Total

% Relative

to Index

Option-Adjusted Duration

99%

Passthrghs

9

5

-19

53 3

-25

-20

-15

-10

-5

0

5

10

15

Agy Mtg. CMBS ABS Credit Total

% Relative

to Index

Spread Duration

103%


Option - Adjusted Duration Spread Duration

99% 103%


5/120


March 17, 2008 5



U.S. Aggregate Core Portfolio

Approx. Percent of Market Value % Over

Maturity/ Dura. (+)/Under

Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Wght

Treasury 0.33 0.00 5.85 0 .00 2.64 0.00 2.65 0.00 1.67 0.00 3.79 0.00 3.05 0.00 2.76 0.00 22.74 0.00 -15

Agency 1.15 0.69 2.61 7.85 1.69 0.00 1.30 0.00 0.63 3.26 1.37 0.00 0.75 0.00 0.48 0.00 9.98 11.80 5

Mtg. Pass-through 0.30 1.94 2.89 15.13 4.43 4.75 13.03 4.30 13.36 18.78 4.41 0.00 0.00 0.00 0.00 0.00 38.42 44.90 5

CMBS 0.01 0.00 0.46 0.00 0.55 0.00 0.67 0.00 0.58 0.00 2.44 12.72 0.91 0.81 0.00 0.00 5.62 13.53 -25

ABS 0.03 0.05 0.29 0.27 0.25 0.66 0.11 0.23 0.07 0.40 0.11 0.04 0.05 0.00 0.01 0.00 0.92 1.65 5

Credit 0.15 0.00 2.20 0.92 2.60 2.72 3.23 5.30 2.32 5.02 4.34 6.26 2.79 0.58 4.69 7.32 22.32 28.12 10

Total 1.97 2.68 14.30 24.17 12.16 8.13 20.99 9.83 18.63 27.46 16.46 19.02 7.55 1.39 7.94 7.32 100.00 100.00

% Over (+)/Under(-) Weight 36 69 -33 -53 47 16 -82 -8

0-20 yr/ 7-10 y20-30 yr/ 10 + Total4 yr/ 3-4 yr T-Bills/ 0-1 yr 5-6 yr/ 4-5 yr 2 yr/ 1-2 yr 3 yr/ 2-3 yr 6-10yr/ 5-7 yr

Corporate Sector Recommendations (spread duration contribution)

'% Over (+)

/Under(-)

Index Rec Diff. Index Rec Diff. Index Rec Diff. Index Rec Diff. Weight

Spread Duration

0-3 0.03 0.06 0.03 0.02 0.01 -0.01 0.02 0.02 0.00 0.06 0.08 0.02 31

3-5 0.07 0.08 0.01 0.08 0.17 0.09 0.08 0.19 0.10 0.23 0.43 0.20 86

5-7 0.09 0.02 -0.06 0.10 0.13 0.03 0.09 0.20 0.12 0.27 0.36 0.08 31

7-10 0.08 0.02 -0.06 0.07 0.02 -0.05 0.07 0.00 -0.07 0.23 0.04 -0.18 -8110+ 0.22 0.13 -0.09 0.24 0.03 -0.21 0.23 0.70 0.47 0.69 0.86 0.17 25

Total 0.49 0.30 -0.18 0.50 0.36 -0.15 0.50 1.11 0.62 1.48 1.78 0.29 20

% Over (+)/Under(-) Weight -37 -29 125 20

Sector

Financial 0.21 0.07 -0.14 0.18 0.05 -0.13 0.05 0.09 0.03 0.45 0.21 -0.24 -54

Utility 0.00 0.00 0.00 0.04 0.00 -0.04 0.09 0.21 0.12 0.14 0.21 0.08 56

Industrials 0.06 0.04 -0.01 0.23 0.30 0.07 0.33 0.67 0.35 0.62 1.02 0.40 66

Non-Corp. 0.12 0.20 0.07 0.03 0.00 -0.03 0.03 0.14 0.11 0.18 0.34 0.16 84

Total 0.39 0.30 -0.09 0.48 0.36 -0.13 0.50 1.12 0.61 1.38 1.78 0.40 29

% Over (+)/Under(-) Weight -22 -26 122 29

Aaa-Aa A Baa Total


Option - Adjusted Duration Spread Duration

99% 103%


6/120


March 17, 2008 6


MBS Sector Recommendations (spread duration contribution)

Program & Price

% Mkt.

Val.

% Sprd

Dur.

% Mkt.

Val.

% Sprd

Dur.

% Mkt.

Val.

% Sprd

Dur.

% Mkt.

Val.

% Sprd

Dur.

GNMA

30-year < 98 0.64 0.03 0.00 0.00 -0.64 -0.03 -100 -100

98 to


7/120


March 17, 2008 7



U.S. Dollar Core Plus

Sector

ver

/ Under(-)

Over

Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Index Rec. Weight Index Rec. Diff. Index Rec. Diff. Weight

Tsy 5.17 1.96 4.17 3.78 5.04 4.85 2.08 3.08 3.10 3.55 19.56 14.21 -22 1.01 1.17 0.17 0.00 0.00 0.00 -

Agy 3.23 5.88 2.21 1.64 1.83 0.00 0.64 0.00 0.49 1.29 8.39 8.81 5 0.30 0.29 -0.01 0.30 0.32 0.02 5

Mtg. Passthroughs 11.01 19.08 17.48 13.00 5.76 1.23 0.07 0.00 0.01 0.00 34.34 33.31 5 0.99 0.75 -0.24 1.13 1.19 0.06 5

CMBS 0.44 0.00 1.14 0.10 2.87 3.67 0.57 0.00 0.00 0.00 5.02 3.77 -25 0.24 0.25 0.00 0.24 0.19 -0.05 -20

ABS 0.23 0.39 0.28 0.22 0.15 0.15 0.06 0.00 0.01 0.00 0.72 0.76 5 0.02 0.02 -0.01 0.02 0.03 0.00 7

Corporates

IG 2.94 1.15 6.63 10.54 7.58 9.48 3.10 0.71 4.96 5.87 25.22 27.74 10 1.48 1.56 0.08 1.45 1.53 0.08 6

HY 0.38 0.65 1.39 1.54 2.77 2.55 0.22 0.06 0.29 0.00 5.04 4.79 -15 0.23 0.20 -0.03 0.23 0.20 -0.03 -15

EMG 0.10 0.00 0.21 0.82 0.63 0.21 0.18 0.00 0.58 0.59 1.70 1.62 -5 0.12 0.09 -0.02 0.10 0.09 -0.01 -10

Municipals 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2.00 0.00 0.00 0.00 5.00 - 0.00 0.00 0.00 0.00 0.00 0.00 -

Total 23.50 29.11 33.51 31.63 26.63 22.12 6.92 5.84 9.44 11.30 1 00.00 100.00 4.39 4.34 -0.05 3.48 3.55 0.06

% Over (+) /Under (-) Weight 24 -6 -17 -16 20

9+


Total0-2 2-4 4-7 7-9 OAD Spread Duration

Contribution to

Recommended Portfolio by Duration Range Portfolio Allocation by Asset Class

24

-6

-17-16

20

-20

-10

0

10

20

30

0-2 2-4 4-7 7-9 9+

Duration Range

% Relative

to Index

-22

5 5

-25

10

-15

-5

5

-30

-15

0

15

Tsy Agy Mtg.

Passthroughs

CMBS ABS IG HY EMG

% Relative

to Index

Contribution to OAD by Asset Class Contribution to Spread Duration by Asset Class

-2

-24

26

-12

-20-22

17

-30

-20

-10

0

10

20

Tsy Agy Mtg.

Passthroughs

CMBS ABS IG HY EMG

Relative to

Index

Option-Adjusted Duration

99%

5 5

-20

6

-10

-15

7

-25

-20

-15

-10

-5

0

5

10

Agy Mtg.

Passthroughs

CMBS ABS IG HY EMG

% Relative

to Index

Spread Duration

102%

Market Value and duration contribution statistics reflect values as of the prior business day. Overweight/underweight percentages highlighted in shaded arearepresent current date recommendations.

99% 102%

Option-Adjusted Duration Spread Duration


8/120


March 17, 2008 8

Global Relative Value

“A Time for Calm”:

Market Overshoot/Risk Paranoia Overdone,but Not Done; Past Recessions SuggestLong-Term Yields, Spreads, and Equities OnlyHalfway to the Cyclical Turning Point

LEHMAN BOND SHOW WITHCHIEF U.S. POLITICAL STRATEGIST KIM WALLACE

Washington “white horse” rescue proposals are galloping out of the Beltway. To help us

make sense of these uncoordinated and ideologically distant plans, Kim Wallace joins Joe

Di Censo on this week’s Bond Show. Please catch our program on www.lehmanlive.com.In addition, you can now listen to or watch the Bond Show on your iPod by subscribing to

Lehman Brothers podcasts. Easy-to-follow instructions are available under Fixed Income

Webcasts on LehmanLive (Keyword: fiwebcasts).

VOTE IN THE WEEKLY GRV SURVEY QUESTION

What will be most effective in ending this credit recession?

1) Use of the Fed’s balance sheet to buy outright mortgage-backed securities

2) Lowering the fed funds rate to 1% or less

3) The end of financial institution write-offs

4) Major real money investors buying assets

5) A bi-partisan, coordinated, speedy homeowner rescue package

6) Just time

For responses to last week’s survey question and many more, please vote here to see real-

time results or consult our capital market “daily opinion” summary at the end of this

article.

A TIME FOR CALM

Given the recent paucity of good news, let’s first savor a few uplifting developments.

U.S. headline and core CPI were both flat in February—the first such month for the non-food and energy component since November 2006. Spring also arrives next week, at least

in the northern hemisphere. And baseball fans await Opening Day in less than two

weeks. Unfortunately, the high spirits stop there.

Like a classic 19th or early 20th century credit crisis, markets seem keen to devise new

anxieties about any and all, real or imaginable, ills. There are legitimate concerns about

this credit recession of 2008. But bereft of anti-agita Zantac treatment, asset price

discovery has given way to “anxiety wilding expeditions.” Contrary to some recent

National Geographic/Discovery specials, mass extinction or planetary destruction is not

Jack Malvey, CFA

212-526-6686

[email protected]

Joseph Di Censo, CFA, CAIA212-526-2288

[email protected]

Philip Lee, CFA

212-526-7820

[email protected]

Kishlaya Pathak

212-526-4570

[email protected]

http://www.lehmanlive.com/https://live.lehman.com/go/RSR/cgi-bin/GO?To=Vote_GRVD&QuestionId=3038mailto:[email protected]:[email protected]:[email protected]:[email protected]://live.lehman.com/go/RSR/cgi-bin/GO?To=Vote_GRVD&QuestionId=3038http://www.lehmanlive.com/


9/120


March 17, 2008 9

likely imminent. Although a few hands may need to be convinced otherwise, a global

Great Depression assuredly is not in the offing either.

Like a vicious loop, anxiety breeds consternation and introduces novel trepidations.

During such episodes of dismay, investors cling to the negatives and assume that their

pessimism will prove justified. Exactly converse to peak bull market mentality, the

despondent bear market mindset knows only anxiety, fear, and negativity.

Though often misattributed to Aesop, the “sky is falling” fable traces back to a Buddhist

Indian folklore—quite fitting in our view because a time for calm has demonstrably

arrived. Risk-aversion flagellation of U.S. capital markets reached one of those renowned

convulsive pinnacles, in our opinion.

Figure 1. Three-Stage Credit Sector Damage—June 30, 2007-March 12, 2008

OAS (bp) OAS (bp) OAS (bp)

U.S. Jun. 29, 2007 Sep. 18, 2007 % Change Oct. 31, 2007 Dec. 31, 2007%

Change Jan. 30, 2008 Mar. 12, 2008%

Change

Universal 71 100 40 98 126 28 141 190 35 Agency 34 45 31 38 43 12 54 81 49

MBS 65 72 12 79 87 9 91 144 59

ABS 74 161 117 141 242 72 250 381 53

CMBS 82 127 56 133 170 28 234 452 93

IG Credit 89 142 59 130 181 40 200 250 25

HY Corp 292 433 49 421 569 35 656 779 19

EM 165 223 35 203 265 30 288 327 14

Pan-European

Universal 20 36 77 33 41 23 49 64 29

Agency 16 28 76 25 30 17 33 44 33

ABS 47 84 78 79 96 22 111 133 21

CMBS 63 104 66 94 110 17 130 143 10

Covered 20 38 90 35 43 23 47 65 36

IG Credit 50 93 87 84 111 33 130 168 29

HY Corp 210 391 87 356 466 31 604 726 20

Asia-Pacific

Aggregate 3 5 53 5 6 21 6 8 24

MBS 60 71 18 73 102 39 99 159 61

ABS 41 50 21 49 52 5 54 56 4

Credit 24 35 46 36 48 36 52 69 34

Portfolio Products

ABX AAA 75 230 206 644 853 32 930 1480 59

CMBX AAA 63 84 33 104 139 33 190 353 86

CDX IG 98 127 30 126 151 20 180 277 54

CDX HY 393 424 8 482 564 17 660 842 28

ITRAXX Corp 48 78 63 91 125 37 144 249 73

Source: Lehman Brothers Fixed-Income Research; Markit

A time for calm has

demonstrably arrived


10/120


March 17, 2008 10

Thankfully, market sentiment rarely endures any extreme; clarity and reason quickly

prevail. Despite the frenzy, Mach 2008 bears no resemblance to October 1929. In our view,

markets have arrived in classic overshot territory. Their stay will be brief. Here’s why:

Dollar deterioration is overdone, but not done. At a record low to the euro ($1.56) and

Swiss franc (parity) as well as the first double-digit yen handle since September 1995,

the dollar broke significant historical ground in a week. Even with this technicalmomentum for further deterioration, there are fundamental limits to this semi-repudiation

of all U.S. assets. Most analysts would concede that a $2.00 euro, $2.50 pound, and ¥75

reside far in the “tails” of most forecast distributions. Already oversold, the dollar may

well keep weakening, but consider us cautious about a near-term reversal. The pound’s

home economy doesn’t appear that dissimilar to the U.S. And the March 31 Japanese

fiscal year-end can amplify directional moves on the dollar-yen cross.

Counterparty risk paranoia is also overdone, but not done. As the hedge fund tolls mount,

broker-dealer spreads widen, and concerns of systemic financial instability proliferate,

specters of past banking crises understandably haunt risk managers. Continental Illinois

was a quarter century ago (Figure 1) and Bank of New England failed in 1991. And yet the

financial system survived. Then, like now, most predictions will prove to be hyperbole.

With Washington on the move (see this week’s Bond Show), this bout of counterparty risk

will also fade after the “books” open over the next month’s first-quarter reporting.

Shocked by Bear Stearns, but also cognizant of the history of Fed/private sector rescues

and bank consolidations, financial institution anxiety also is overdone, but not done.

First-quarter financial revelations by the 2/29 brigade (Bear, Goldman, and Lehman

Brothers) followed by the 3/31 cohort will at least bring clarity to any potential write-

downs, potentially even signaling an inflection point in future balance sheet impairment

as suggested by S&P.

Yield curve lows are overdone, but not done. With an inflation reprieve in February, the

Fed’s more aggressive course will likely deliver fed funds to 1%--meaning more room

for the front-end to descend. Less cooperative inflation readings in the eurozone (at a 14-

year high of 3.3% in February) may temporarily stay the ECB’s hand, but we maintainthat more easing has to get priced in the front-end of the euro curve. By contrast, long-

end rates do not fully reflect the reflation risk following this monetary policy cycle.

Expect more steepening.

High-grade spread expansion is overdone, but not done. As seen in Figure 2, this third-

stage burst in risk premia already eclipses the first two episodes in August and late 2007

for most sectors. Segments of credit (specifically, agency MBS, CMBS, and ABS) have

all priced in the next Great Depression in 2008. Unequivocally, the magnitude of spread

reset exaggerates the default risk implicit in these high-quality assets.

This is not the case in lower-quality credit. The HY corporate bond market’s default

statistics only include the last two recessions, the mildest of the post-World War II era.

The greater concentration of lower-quality HY corporate debt combined with a moresevere downturn spells higher overall default rates than in either 1990-91 or 2001.

According to calculations presented by Marty Fridson at the Fixed-Income Analysts

Society on March 11th, a recession 75% as potent as the median of the past two would

produce a 10% default rate because Caa-C debt make up more of the HY universe

(currently 13%). A 1990-91 style recession would deal a 17% default rate. By that

reasoning, even a low probability of an early 1980s-style contraction suggests that HY

spreads have more room to expand from 793 bp.

Commodity appreciation is overdone, but not done. At $110 for a barrel and $1,000 an

ounce ($1,000), oil and gold typify speculatively-driven commodity peaks. Yet as seen in

Dollar deterioration is

overdone, but not done

Counterparty risk paranoia is

also overdone, but not done

Financial institution anxiety

also is overdone, but not done

Yield curve lows are overdone,

but not done

High-grade spread expansion is


Commodity appreciation is



11/120


March 17, 2008 11

Figure 2, these primary inputs aren’t alone. Our 20-member commodity index gained

another 3% in the month to March 14, upping the cumulative 2008 return to 18% and the

12-month appreciation to 49%. Over the past year, wheat (131%) and biodiesels (113%)

more than doubled. Despite the admitted supply constraints and “green policy”

distortions, such rapid surges smack of speculative momentum.

In contrast, central bank generosity is neither overdone, nor done. European, Australian,and some Asian central banks may fret over inflation, but monetary authorities cannot

indefinitely overlook growth downside risks. We maintain that rates cuts will become

more geographically diverse than over the past nine months. Our economics team now

expects a 75 bp ease on March 18, though more cannot be ruled out. And along the

ideological continuum of the TAF then TSLF plans, the next Fed effort may include

outright purchases of mortgages, private label included. In our opinion, the requisite

policy course will include greater direct use of the Fed’s balance sheet.

Similarly, Washington’s “white horse” plans are neither overdone, nor done. In concert

with the Fed’s quasi-surgical approach to intervention, Washington needs to catch up

with acutely targeted plans to forestall the foreclosure/home price depreciation freefall.

As discussed on this week’s Bond Show, our Kim Wallace sees a window of opportunity

for bi-partisanship in the pre-election third quarter.

Figure 2. Global Index Returns—2H07 versus January 1, 2008-March 13, 2008

Index 2H 2007 March 13, 2008

U.S. Excess (bp) Total (%) Excess (bp) Total (%)

Universal -243 5.34 -306 0.60

Aggregate -176 5.93 -253 1.04

Treasury - 7.92 - 3.85

Agency -21 6.51 -130 2.25MBS -115 5.79 -164 1.29

CMBS -366 5.12 -1,351 -8.71

ABS -596 0.65 -498 -1.23

Investment-Grade Credit -466 4.31 -424 -0.15

High-Yield Corporate -917 -0.97 -873 -4.31

Emerging Markets -520 4.11 -403 0.19

Index 2H 2007 March 13, 2008

Non-U.S. Excess (bp) Total (%) Excess (bp) Total (%)

Pan-European Aggregate -92 3.17 -108 1.86

Pan-European Credit -314 1.67 -316 -0.25

Pan-European High-Yield Corporate -777 -3.81 -1,054 -7.17

Euro-Aggregate -73 2.81 -94 2.42

Euro-Aggregate Credit -268 0.93 -260 0.96

Asian-Pacific Aggregate -9 2.44 -7 1.36

Asian-Pacific Credit -73 1.26 -72 0.54

Source: Lehman Brothers Fixed-Income Research

In contrast, central bank generosity is neither overdone,

nor done

Similarly, Washington’s “white

horse” plans are neither

overdone, nor done


12/120


March 17, 2008 12

And tactical portfolio defensiveness is not done or overdone. After the most challenging

year for U.S. active managers since 1983, the first third of 2008 is also shaping up as the

worst launch for equities since 1939 (-16%) and the most egregious 1Q spread sector

underperformance since 1980, when the U.S. Aggregate lagged Treasuries by 326 bp.

The S&P 500 has retreated 12%, inclusive of dividends. Our U.S. Universal Index has

just a 0.60% year-to-date nominal return and a 306 bp underperformance versus

Treasuries. At least the second half of 2007 provided decent absolute bond returns of

5.34% even if with a -243 bp excess return. By most measures, 2008 already surpasses

the pain of endured in the second half of 2007.

So what’s the timeline from here? The next couple of weeks, absent of some markedly

potent intervention, breeds significant doubts. The cycle of 2/29 and 3/31 earnings

reports from broker/dealers means that this uncertainty limbo will carry over into mid-

April. Though May represents the first reprieve from write-down headlines, we’re not

looking for a substantive halt in risk premium escalation until the summer. Yet even this

window of tranquility opens up to potentially dire third-quarter revelations from the

traditional cyclical industries, by then encumbered after several months of constrained

consumption and tighter credit conditions.

The third-quarter may well present yet a fourth stage to this credit recession, emanatingfrom traditional corporate downgrades and an uptick in defaults on the one-year

anniversary of the start. When to back up the truck on risky assets? We’d nominate 3Q

2008. Along the way even bear markets can call timeouts: the summer and late

November/December may be the only two for 2008. Yet eventually this staccato pattern

will give way to discounting the recovery of 2009-2010.

Complete perfect timing is a rare joyous event for any asset manager and strategist, but

we maintain that these dislocations will be recalled as preferred entry points for high-

quality debt assets. Portfolio conservatism is still very much in order. Accordingly, we

recommend further reducing our HY underweight from 5% less than the benchmark to

15% short and reiterate our March 12 decision to increase agency MBS passthrough

holdings from 3% underweight to 5% overweight.

Even the most effective public policy solutions will not immediately regenerate liquidity.

Let’s heed this “time for calm.”

HOW FAR ALONG ARE CAPITAL MARKETS ON THE RECESSION TRACK?USING PAST ECONOMIC DOWNTURNS, RATES/SPREADS/EQUITIESROUGHLY HALFWAY TO THEIR CYCLICAL TURNING POINTS

As the founder of the NBER’s formal business cycle dating committee, Marty Feldstein’s

assessment that the U.S. economy entered a recession should stifle any further debate,

but his subsequent qualification that this downturn could be the worst in the U.S. postwar

experience introduces more questions than answers. How deep, protracted, or painful for

capital markets could this recession be? With history as the only, albeit imperfect, guide

we scored each of the past seven recessions according to their duration, impact on macro

economic parameters, and severity in terms of 30-year Treasury yields, Baa-industrial

spreads, and equity prices. When constructing a hypothetical downturn of various

magnitudes, equity and debt values may just be near the midpoint of their ultimate

correction in the 2008(-?) recession.

In addition to quarterly real GDP, NBER devotes particular attention to four monthly real

macro variables when defining an official recession: personal income (less transfers),

payroll employment, industrial production, and wholesale retail and manufacturing sales.

As seen in Figure 3, we calculated the recession trough value for each monthly

And tactical portfolio

defensiveness is not done

or overdone

When constructing a

hypothetical downturn of

various magnitudes,

equity and debt values may just

be near the midpoint of their

ultimate correction in the

2008(-?) recession


13/120


March 17, 2008 13

parameter, as well as the percentage change in 30-year Treasury yields, Baa industrial

spreads, and the S&P 500 from the official start of each recession. Note the

correspondence between severe recessions (as determined by employment, IP, income,

sales, and duration) and the correction in long Treasury yields, spreads, and equities.

By all economic and market-based measures, the last two recessions were relatively mild.

Employment contracted less than 2% in the 1990-91 and 2001 recessions, compared withmore than 3% in 1981-1982 and over 2% in 1960-61. Similarly, incomes never fell as

much as in 1973-1975 (-6%) or even 1980 (-3%). The decreases in industrial production

and sales were a fraction of shocks featured in the 1960s/70s/80s. Most obvious, the past

two recessions were the shortest of post-World War II era (1980-1982 was really one long

recession and the omitted 1957 recession was also eight months).

Figure 3. Percent Change from the Beginning of NBER Recession

Empl Inc IP SalesDuration(months) 30yr Baa S&P 500

1960-61 -2.3% -0.9% -6.2% -5.3% 10 -11% 48% -2%

1969-70 -1.2% -0.2% -5.8% -4.1% 11 -13% 53% -21%

1973-75 -1.9% -5.7% -13.1% -12.9% 16 0% 161% -34%

1980 -1.1% -2.7% -6.9% -6.8% 6 -7% 131% -11%

1981-82 -3.1% -1.1% -9.6% -6.2% 16 -22% 99% -18%

1990-91 -1.4% -2.6% -3.9% -4.1% 8 -11% 36% -15%

2001 -1.8% -1.2% -4.2% -3.0% 8 -13% 9% -30%

4Q 2007- -10% 40% -13%

Median -1.8% -1.2% -6.2% -5.3% 10 -11% 53% -18%

Avg. -1.8% -2.1% -7.1% -6.1% 11 -11% 77% -19%

As % of Median

1990-91 82% 205% 63% 77% 80% 100% 68% 80%

2001 100% 100% 68% 56% 80% 117% 17% 163%

Hypothetical

50% worse than median -2.6% -1.9% -9.2% -8.0% 15 -16% 79% -27%

75% worse -3.1% -2.2% -10.8% -9.4% 18 -19% 92% -32%

100% worse -3.5% -2.5% -12.3% -10.7% 20 -22% 105% -36%

1973-75 -1.9% -5.7% -13.1% -12.9% 16 0% 161% -34%

How far are we along? (% of the trough)

50% worse 59% 51% 48%

75% worse 51% 44% 41%

100% worse 44% 38% 36%

1973-75 - 25% 38%

Source: NBER, Lehman Brother Fixed-Income Research

By all economic and market-

based measures, the last tworecessions were relatively mild


14/120


March 17, 2008 14

Though the past two recessions were the most benign for the real economy, they were

still relatively pronounced for financial markets. The 11%-13% decrease in 30-year

Treasury yields was the sharpest since 1981-1982 (-22%). And the 30% decrease in the

S&P 500 during the 2001 recession rivalled the 34% collapse during 1973-1975. Yet

credit spreads escaped both 1990-1991 and 2001 rather unscathed (2002 was another

matter) compared with their more than doubling in the mid-1970s and early 1980s.

How far to the bottom of this cycle? We hypothesize four recessions of increasing

intensity from the median of the past seven recessions: 50% worse, 75% worse, 100%

worse, and a replay of 1973-75. By scaling the impact on rates, spreads, and equities by

these factors, we hypothesize the corrections in financial assets. The so far undated

current recession likely began in late 2007/early 2008; we assumed 4Q07 for

conservatism. As such, the 10% fall in 30-year Treasury yields to 4.36% is between 44%

of the ultimate decrease (the 100% worse case recession) and 59% of the way (under the

50% intensity recession. A replay of 1973-75 means significant curve steepening such

that rates have to rise. The same exercise for credit spreads demonstrates that industrial

bond risk premia (already 40% wider at 265 bp) are less than half way to their ultimate

peak. Depending on the magnitude of contraction, the 13% slide in equities represents

just one-third to half of historical recession price bottom in the S&P 500.History is always an incomplete guide, but we’d place capital markets only about half-

way along the recession price track in early 2008.

RESPONSES TO GLOBAL RELATIVE VALUE SURVEY QUESTION

1) Looking back from March 2010, which asset class exhibited the most distress

during 2008 and hence the greatest “rebound bargain?”

A. Financial institution equity/debt......................................................................29%

B. U.S. dollar…………........................................................................................12%

C. CMBS…………………..................................................................................24%

D. Agency MBS passthroughs…...………............................................................5%

E. Leveraged loans…….......................................................................................15%

F. Munis………………………...........................................................................15%

We agree with the consensus on a strategic basis, but favor CMBS, leveraged loans, and

munis for great “comeback” candidates over the balance of 2008. Let’s review this

survey question in late December.

2) What’s the best Washington policy option to enhance systemic liquidity?

A. More Fed eases..................................................................................................7%

B. FHA expansion................................................................................................15%

C. Explicit U.S. gov’t guarantee of Fannie/Freddie debt.....................................24%D. Expanded use of Fed balance sheet.................................................................54%

The Fed partially pre-empted this question with the new Term Securities Lending

Facility (TSLF), but this arrangement to accept private-label mortgage collateral for U.S.

Treasuries still doesn’t constitute a direct expansion of the Fed’s balance sheet. If the

evolution of TAF to TSLF provides any guidance of future actions, the Fed’s next step

could be more akin to the majority’s preferred policy option: expanded use of the SOMA

portfolio to own mortgages outright.

Though the past two recessions

were the most benign for the

real economy, they were still

relatively pronounced for

financial markets

Industrial bond risk premia

(already 40% wider at 265 bp)

are less than half way to their

ultimate peak


15/120


March 17, 2008 15

3) What medium-term effect will the Fed’s new Term Securities Lending Facility

(TSLF) have for improving liquidity?

A. Terrific...............................................................................................................9%

B. Modest improvement.......................................................................................73%

C. No effect at all...................................................................................................4%D. Ultimately harmful for normalization..............................................................14%

We agree with the consensus, but a renewed sell-off in the U.S. dollar (to an all-time low

versus the safe-haven Swiss franc), a new peak for oil at $110, and counterparty risk

anxiety suggest that markets are more skeptical. Still this program is having some effect.

While 3-month OIS spreads are back above 80 bp (from 60 bp), 2-year swap spreads

tightened from 112 bp last week to 88 bp and 30-year FNMA CC OAS compressed 28

bp since March 7, to 51 bp (-36%).

4) Which U.S. economic cycle does the current downturn most resemble?

A. 2001...................................................................................................................2%

B. 1990-91............................................................................................................24%

C. 1980-82............................................................................................................10%

D. 1973-75............................................................................................................34%

E. The Great Depression......................................................................................24%

F. There is no recession.........................................................................................5%

As discussed above, this current downturn will likely surpass both 1990-1991 and 2001

in magnitude and duration. Yet we’re very confident another Great Depression remains a

highly remote outcome, even though some prominent pundits continue to raise this

analogy.

If you haven’t responded to our surveys, click here to vote and receive real-time responses.

SUMMARY OF LAST WEEK’S DAILY GLOBAL RELATIVE VALUES

Staying overweight U.S. munis: Even after early March rally (3.02% total return),

still historically cheap; “normalization” could deliver another 5.85% price

appreciation. As the best performing asset class in early March (even topping

commodities, 2.32%), U.S. munis are rallying handsomely from all-time wide yields

relative to U.S. Treasuries at the end of February. Our fixed-rate Municipal Bond Index

generated a 3.02% total return in the first seven days of March alone, bringing this asset

class to a flat position over the past three months. Yet munis still present historically

cheap valuations relative to taxable U.S. Treasuries and could deliver another 5.85%

price return if their percent yields revert back to one-year averages. March 11, 2008

From TAF to TSLF: Another acronym for liquidity; Raising U.S. MBSrecommended allocation from 3% underweight to 5% overweight. The new Term

Security Lending Facility (or TSLF) represents the Fed’s most recent liquidity

countermeasure. As with past borrowing programs, capital markets cheered. Unlike the

Term Auction Facility (or TAF), which the Fed expanded to $100 billion last Friday, or

serial term repos (also announced on March 7), this latest proposal contains provisions

especially targeted to mortgages (bond-for-bond lending that accepts AAA/Aaa private

label MBS collateral) and operates among primary dealers instead of depositary

institutions. After a tactical move to 3% underweight MBS in our U.S. Aggregate

portfolio on February 15, we captured 160 bp of this asset class’s 260 bp

https://live.lehman.com/go/RSR/cgi-bin/GO?To=Vote_GRVD&QuestionId=3034https://live.lehman.com/go/research/content?contentPubID=FC1117158https://live.lehman.com/go/research/content?contentPubID=FC1117158https://live.lehman.com/go/RSR/cgi-bin/GO?To=Vote_GRVD&QuestionId=3034


16/120


March 17, 2008 16

underperformance vs. Treasuries year-to-date to March 10th. The cumulative effect of

Fed easing, new lending programs, and wider spreads will eventually begin to attract

unleveraged investors to this high-quality asset class. March 12, 2008

One measure of liquidity diminution: Global gross debt origination down 14%

year-over-year to $780 billion in February; Not yet the sharpest contraction ever,

but fixed-income primary markets still running at just 75% of pre-July 2007 pace. Now in month nine of this “credit recession,” primary debt market liquidity is rapidly

approaching a contraction associated with past downturns. After just $780 billion of

supply in February, new issue volume has fallen 14% year-over-year for the first

decrease in the trailing 12-month supply tally since July 2005. In addition, the past eight

months since last July represent a 24% reduction in issuance vis-à-vis the pre-crisis

period (Nov. 2006-June 2007). Yet illiquidity still remains fairly concentrated in a few

asset classes, especially non-agency securitized products and lower-quality credit. March

13, 2008

For a further treatment of these topics, consult our Daily Global Relative Value archive

at www.LehmanLive.com.

https://live.lehman.com/go/research/content?contentPubID=FC1117677https://live.lehman.com/go/research/content?contentPubID=FC1118305http://www.lehmanlive.com/http://www.lehmanlive.com/https://live.lehman.com/go/research/content?contentPubID=FC1118305https://live.lehman.com/go/research/content?contentPubID=FC1117677


17/120


March 17, 2008

17

Equity Strategy

Can Japan De-Couple?

In the current environment, good news comes at a premium. We are thus a little surprised

that the market has not responded more positively to some of the recent data in Japan, at

least on a relative basis. In no sense can we describe the economic outlook there as

“good,” but with expectations already low and the speed with which sentiment regarding

the U.S. economy has deteriorated in recent weeks, we think a better relative

performance is justifiable. We remain overweight.

Of course, one’s description of performance trends in Japan this year depends crucially

on whether we are talking about common currency or local currency returns. Our

approach in recommending an overweight position is a common currency one, and

Figure 1 indicates that the Japanese market has now stopped underperforming the rest of

the world.

However, given the improved tone to the macro data of late, there is a case for

outperformance rather than this in-line showing. First, sentiment among the small

business community has turned upward in the past two months. The popular Shoko

Chukin Index of sentiment among small and medium-sized businesses has recovered to

47.4 from its plunge during 2007. The recovery in sentiment is also evident in an

improvement in machinery orders, which rose by 4% in January compared with the same

period a year ago (on a three-month moving-average basis).

On the financial side, too, there have been some slightly more encouraging signs from

bank lending statistics. Having begun growing again in 2006, lending growth slowed in

2007. Statistics for February indicate a rise in lending of 0.9% compared with the same

month a year ago. Small comfort, perhaps, but improved loan growth rates have been a

key driver for relative earnings growth among the Japanese banks.

Figure 1. Japan versus World ex-Japan Relative Performance (Dollar Terms)

75

80

85

90

95

100

105

110

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

Jan 2007 = 100

Source: Lehman Brothers Research

Ian Scott

44-207-102-2959

[email protected]

Paul Danis, CFA

44-207-102-2545

[email protected]

Although the Japanese market

has stopped underperforming

(in dollar terms), we think the

recent data support a more

positive response


18/120


March 17, 2008

18

Figure 2. Small/Medium-Sized Business Confidence and Machinery Orders

35

40

45

50

55

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

-40

-30

-20

-10

0

10

20

30

40Core DomesticMachinery Orders (RS)

Small & MediumSized BusinessConfidence (LS)

y/y %%

Source: Shoko Chukin Bank, Cabinet Office

Figure 3. Japanese Bank Lending and Bank Sector Relative Earnings

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

1992 1994 1996 1998 2000 2002 2004 2006

0

10

20

30

40

50

60

70

80

90

100

12-month ForwardEarnings: Japanese Banks

/ Japanese Market (RS)

Aggregate BankLending ExShinkin Banks(LS)

y/y % Ratio

Source: Lehman Brothers Research, Bank of Japan

Figure 4. Japanese Consumer Spending

-6.0

-4.0

-2.0

0.0

2.0

4.0

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08

y/y %

Household Living Expenditure

Source: Statistics Bureau of MIC

Some key macro indicators

have shown signs ofimprovement in recent months

Japanese bank lending is

growing more strongly again

The Japanese consumer is

showing signs of life…


19/120


March 17, 2008

19

Consumer spending has also shown some signs of improvement recently. While

consumer sentiment has declined, wage growth has been accelerating. Accordingly,

while Lehman Brothers’ Japanese economics team forecasts sluggish GDP growth of

1.6% in 2008, a recession is unlikely, and this compares favorably with just 1% growth

in the U.S.

As mentioned above, none of this adds up to a “positive” outlook, but given the lowlevel of expectations, we think it represents at least a relative improvement. Moreover,

analysts’ earnings revisions have deteriorated at a rapid pace in recent weeks. In the

past, such negative revisions have been followed by a recovery and, with it, a jump in

market performance. The recent rise in business confidence also suggests that revisions

are close to a turn.

So, in the search for areas of the global equity market with the potential to de-couple

from the currently bearish sentiment, we think the Japanese market merits an overweight

position.

Figure 5. Japanese Wage Growth

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08

y/y%

Average Monthly ScheduledCash Earnings*

Source: Ministry of Health, Labour and Welfare

Figure 6. Japanese Earnings Revisions andSmall/Medium-Sized Business Confidence

37

39

41

43

45

47

49

51

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

-18

-13

-8

-3

2

7

EarningsRevisions

Balance (RS)

Small & MediumSized BusinessConfidence (LS)

Net Earnings Revisions % (Up – Down) / Total%

Source: Shoko Chukin Bank, Lehman Brothers Research

…probably as a result of some

better wage growth

Although the strength of the yen

has led to some aggressive

downgrades, the improvement

in sentiment suggests to us that

we may be close to a turn


20/120


March 17, 2008

20

Global Economics

Liquidity Lesson

The Fed is not so much “injecting liquidity” as trying to improve “market liquidity.”

The actions by the Fed and other G-10 central banks in the past week to “address

heightened liquidity pressures in term funding markets” (March 7 Fed statement) marked

another milestone in the unfolding credit crunch. But how exactly do such actions by

central banks promote liquidity?

The term “liquidity” is used, often in the same breath, to refer to three distinct

phenomena. The first is the common but surprisingly subtle notion of central banks

“injecting liquidity into the banking system.” The second refers to the difficulty that

troubled financial institutions can experience in funding themselves, as when they are

said to face a “liquidity crisis.” The third relates to the volume, and associated ease,

of transacting in financial markets (without affecting prices), as when liquidity is said

to “dry up.”

The “liquidity” in the first case refers to the reserves created on the liability side of the

central bank’s balance sheet and the asset side of banks’ balance sheets when the central

bank buys government debt and other assets from banks (“open market operations”) or

lends funds to banks against collateral provided (discount-window lending or the Fed’s

new Term Auction Facility [TAF]).

The TAF expansion and the term repurchase transactions announced by the Fed last

Friday add no more net additional reserves to the banking system than had the schemes

not been announced. That is, any reserves supplied this way will need to be offset by

fewer reserves supplied another way. The Term Securities Lending Facility (TSLF)

announced by the Fed this week not does even involve any supply of reserves; rather, it

just involves the exchange of one kind of security (Treasuries) for another (federal

agency debt and residential mortgage-backed securities [MBS]). So the idea that central

banks are “injecting liquidity” in the first sense is a bit of a red herring.

There can be a link between the provision of liquidity by the central bank and a liquidity

crisis at a bank or in the banking system (the second sense). If a bank experiences a run on

its deposit base, its reserves will be depleted and the central bank will likely act as “lender

of last resort” by supplying these reserves. But in the current episode, other than in

isolated cases such as Northern Rock, this is not a live issue. Something else is going on.

Recent central bank actions appear to be aimed at improving liquidity in the third sense.

But the capacity of central banks to have much impact here is limited and indirect. Under

the TSLF, the Fed does not buy MBS outright, so the price risk continues to reside in the

market. True, by taking MBS onto its balance sheet as collateral, and to the extent that itrolls over the operations, the Fed is providing a “warehousing” function analogous to

another source of buying. By taking assets out of the market, it is also altering the

relative supplies of these assets, making MBS scarcer, for instance. However, given the

relatively small scale of the operations and the fact that they do not directly alter

fundamentals, they are likely to have only “second order” effects.

As with any central bank action, there can be positive announcement effects. Such action

can have a disproportionately large beneficial effect on market liquidity by serving as a

Paul Sheard

212-526-0067

[email protected]


21/120


March 17, 2008

21

circuit breaker and restoring the willingness of counterparties to trade. But the chances of

a central bank pulling off this “confidence” trick are slim.

None of this is to suggest that central banks should not be trying everything in their

power to re-liquefy financial markets. They should. But given the scale of the problems,

we should not expect too much from any one move—and for that reason, we should

expect many more policy moves before the current problems are resolved.


22/120


March 17, 2008

22

U.S. Economics

Street-Fighting Man

As it seeks a way to unclog capital markets, the Fed is making the best of a tough situation.

Capital markets have continued to sell off despite a series of aggressive monetary and

fiscal policy moves. The latest example: on Monday, the Fed announced a new Term

Securities Lending Facility (TSLF)—essentially a way for primary dealers to lend

illiquid assets, such as MBS, to the Fed in exchange for liquid Treasury securities. This

sparked a sharp market rally on the day of the announcement, but true to form, the

markets have already given back much of the gains on news of the collapse of the

Carlyle Capital fund, broker counter-party risk, the breaching of the 100 JPY/USD

barrier, and record USD prices for gold and oil.

This episode underscores not only how aggressive the Fed wants to be, but how tough it

will be for policymakers to bring about a sustainable market turnaround. For both these

reasons, we expect further Fed action, including aggressive rate cuts. Chairman Ben

Bernanke understands that without aggressive policy, a major recession is likely. Thus, if

one attempt to unclog the markets fails, try another. In a street fight, the more aggressive

fighter—the guy willing to escalate the stakes—usually wins.

Ethan Harris

212-526-5477

[email protected]

Outlook at a Glance

% 1Q07 2Q07 3Q07 4Q07 1Q08 E 2Q08 E 3Q08 E 4Q08 E 2007 2008 E 2009 E

Real GDP 0.6 3.8 4.9 0.6 -0.5 -1.0 2.0 1.0 2.2 1.0 0.7

Private Consumption 3.7 1.4 2.8 1.9 0.5 0.0 3.5 1.5 2.9 1.4 0.2

Government Expenditure -0.5 4.1 3.8 2.2 1.4 1.8 1.8 1.5 2.0 2.1 1.2

Non Res Fixed Invest 2.1 11.0 9.4 6.9 1.0 -2.0 -2.7 -3.3 4.8 2.3 -2.5

Residential Fixed Invest -16.3 -11.8 -20.5 -25.2 -28.0 -22.0 -10.0 -5.0 -17.0 -21.1 -3.1

Exports 1.1 7.5 19.1 4.8 6.0 6.0 6.5 6.5 8.0 7.5 6.3

Imports 3.9 -2.7 4.3 -1.9 4.0 3.0 3.8 3.5 1.9 2.2 1.9

Contributions to GDP

Domestic Final Sales 1.7 2.1 2.5 1.1 -0.5 -0.7 2.1 0.9 1.9 0.7 0.0

Inventories -0.6 0.2 0.9 -1.6 0.0 -0.4 -0.3 0.0 -0.3 -0.2 0.2

Net Trade -0.5 1.3 1.4 0.9 0.0 0.2 0.1 0.2 0.6 0.5 0.5

Unemployment Rate 4.5 4.5 4.7 4.8 4.9 5.2 5.5 5.8 4.6 5.3 6.2

Non-Farm Payrolls, 000 109 105 71 80 -37 -40 -60 -50 91 -47 13

Consumer Prices 2.4 2.6 2.4 4.0 4.2 3.5 3.4 2.4 2.9 3.3 1.8

Core CPI 2.6 2.3 2.1 2.3 2.5 2.6 2.6 2.5 2.3 2.5 2.2

Core PCE Deflator 2.4 2.0 1.9 2.1 2.2 2.4 2.4 2.2 2.1 2.3 1.8Federal Deficit (Fiscal Year, $ billion) -163 -350 -375

Current Account Deficit (% GDP) -5.4 -5.0 -4.3

Fed Funds 5.25 5.25 4.75 4.25 2.25 1.25 1.25 1.25 4.25 1.25 1.00

3-Month USD LIBOR 5.35 5.36 5.23 4.70 2.75 1.75 1.65 1.50 4.70 1.50 1.20

TSY 2-Year Note 4.58 4.86 3.98 3.05 1.45 1.45 1.55 1.55 3.05 1.55 1.65

TSY 5-Year Note 4.54 4.92 4.24 3.44 2.35 2.35 2.45 2.45 3.44 2.45 2.55

TSY 10-Year Note 4.65 5.02 4.59 4.02 3.55 3.55 3.65 3.65 4.02 3.65 3.65

Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemployment rate is a percentage of the labor force. Inflationmeasures and CY GDP are y-o-y percent changes. Interest rate forecasts are end of period. Payrolls are monthly average changes.Table last revised March 14.

All forecasts are modal forecasts (i.e., the single most likely outcome).

The Fed is likely to

combat the risk of a major

recession aggressively


23/120


March 17, 2008

23

With this in mind, we have, yet again, cut our funds rate forecast. We now expect the Fed

to cut by 75 bp on March 18, 50 bp in April, 50 bp in June, and by a final 25 bp in early

2009, bringing the funds rate back down to 1%. Who says history does not repeat itself?

Bernanke Bashing

Ben Bernanke must be feeling a bit of déjà vu these days. In a speech on January 7, 2005,

he recalled his days on a local school board: “Six grueling years during which my fellow

board members and I were trashed alternately by angry parents and angry taxpayers.” In

the past two years, a similar trashing is occurring, this time by people who think the

Bernanke Fed has eased too much and those who think it has eased too little.

One view is that aggressive Fed easing is rewarding risk takers, laying the groundwork for

another asset bubble and a serious bout of inflation. Alan Meltzer, an economic historian of

the Federal Reserve System, writes: “Is the Federal Reserve an independent monetary

authority or a handmaiden beholden to political and market players? Has it reverted to its

mistaken behavior in the 1970s? Recent actions and public commitments…leave little

doubt on both counts.”1 And the Wall Street Journal notes that the dollar and commodity

markets are giving a clear vote of no confidence in the Fed’s anti-inflation resolve.

2

The bottom line seems clear: the Fed has made a major mistake by ignoring

inflation/growth risks and “rewarding risk takers”/“allowing the markets to collapse” and

easing too little/too much. Why can’t they get it right?

A No-Win Situation

Before we draw and quarter Bernanke and his buddies, it is important to recognize that

the Fed is in a no-win situation: it cannot ease and tighten at the same time. The real

question is, has the Fed found the right balance between trying to revive growth and

trying to resist inflation? With persistent problems in the housing and credit markets, we

think that Fed easing is unlikely to revive growth enough to create a serious inflation

problem. Indeed, in 2008 and 2009, we look for cumulative growth of just 1.7%, marking

the fourth-weakest two-year growth rate of the post-war period (Figure 1).

1 “That 70’s show,” Wall Street Journal, February 28, 2008.

2 “The Bernanke Reflation,” Wall Street Journal, February 29, 2008.

We look for the Fed to cut rates

to 1% by early 2009

The Bernanke Fed has been

under intense criticism

One of which is that aggressive

Fed easing is rewarding

risk takers

It is important to recognize that

the Fed is in a no-win situation

Figure 1. Annual GDP Growth Figure 2. Consensus Forecasts

-2

0

2

4

6

8

10

1949 1956 1963 1970 1977 1984 1991 1998 2005

% y-o-yForecasts

Forecast

Date GDP CPI Fed Funds

% Q4/Q4 % Q4/Q4 %

Jun-07 2.8 2.3 5.00

Sep-07 2.5 2.3 4.75

Dec-07 2.2 2.3 4.00

GDP and CPI are growth over next four quarters, funds rate is four quartersahead

Source: Commerce Dept, Lehman Brothers Source: Bloomberg


24/120


March 17, 2008

24

If anything, we think the Fed is behind the curve and should have eased earlier. However,

the Fed’s actions should not be judged relative to the views of the most pessimistic

forecasters, but relative to conventional forecasts. Had the Fed eased back in 2005 or

2006, when perma-bears first warned of an impending collapse, it would likely have

stoked an even bigger bubble in the housing and credit markets and even more inflation.

The Fed has moved faster than the vast majority of economists had expected. In the June2007 Bloomberg survey, just before the crisis escalated, economists expected solid

growth and just one rate cut in the next four quarters (Figure 2). Even the worst

pessimist—an economist at a home-building company—expected 0.4% GDP growth and

the Fed cutting to 3.25%. Three months later, with the capital markets crisis heating up,

most economists expected a replay of the 1998 financial crisis, when three 25 bp Fed

eases restored markets and the economy continued to grow. Even in December 2007, the

consensus was expecting 2.2% GDP growth and a 3.5% funds rate a year ahead. The

most pessimistic forecast assumed a small -0.5% per quarter recession and expected the

funds rate to fall to 3% in the year ahead. In fact, the Fed cut to 3% just a month later.

The obvious lesson from this review of history is that the Fed did no worse than most of

the economics profession in anticipating the depth and economic impact of the financial

crisis. We believe there were two reasons for the poor forecasts. First, as the first test ofthe modern financial market architecture, historical experience offered no guidance as to

the depth or even the nature of the crisis. Second, economic models have a hard time

quantifying credit crunches. Even today, the consensus believes that U.S. GDP growth

will be weak or slightly negative for only a few quarters.

The Fed has moved fasterthan the vast majority of

economists had expected

The Fed did no worse than most

of the economics profession in

forecasting the economy


25/120


March 17, 2008

25

The Week Ahead

We look for the Fed to cut rates 75 bp, to 2.25%, this week while stressing downside risks

to growth stemming from housing and financial markets. We expect the data to show an

economy in a mild recession with a decline in industrial production and housing starts.

Current Account Balance (Monday)

On a nominal basis, the current account likely deteriorated slightly in 4Q, as a pickup in

import prices should offset an improvement in real trade flows. Specifically, we look for

a widening of the current account deficit to -$181.3 billion, or 5.2% of GDP. Despite the

setback in the current quarter, however, fundamentally the current account looks set to

improve: the dollar continues to depreciate, and U.S. growth looks to be slipping into

recession, while foreign demand remains robust. The current account deficit has already

narrowed from a peak of 6.8% of GDP in late 2005, and we expect it to fall to just 4.0%

of GDP by the end of next year.

Empire State Survey (Monday)We look for a minor improvement in the Empire State survey after a nearly 21-point

decline last month. For February, we expect a reading of -9.0, versus the -11.7 reported

in January. Manufacturing activity across the country is likely to be weak in February,

with the exception of export-driven manufactured goods producers.

Net International Capital Flows (Monday)

Overall net capital inflows are expected to rise to $75 billion in January, a modest

acceleration from the growth in December. We expect continued growth in money market

asset accumulation from foreign investors after a period of dollar repatriation late last year.

Industrial Production (Monday)

We look for industrial production to fall 0.3% in February after rising for the past three

months. This decline should drag the capacity utilization rate down to 81.4%.

Manufacturing production, which accounts for roughly 80% of total output, should also

Figure 1. Current Account Balance Figure 2. Industrial Production

-250

-200

-150

-100

-50

0

Mar-95 Mar-98 Mar-01 Mar-04 Mar-07

-8.0

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

Balance, LHS % GDP, RHS

$bn %

-1.2

-0.8

-0.4

0.0

0.4

0.8

1.2

Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08

Total Manufacturing

% m-o-m Forecast

Source: Commerce Department, Lehman Brothers Global Economics Source: Federal Reserve, Lehman Brothers Global Economics

Drew Matus

212-526-9878

[email protected]

Michelle Meyer

212-526-7977

[email protected]

Zach Pandl

212-526-8010

[email protected]

We look for a minor

improvement in the

Empire State survey

Overall net capital inflows are

expected to rise to $75 billion

We expect a weak industrial

production report


26/120


March 17, 2008

26

fall 0.3%. Survey data have been decidedly weak, with the national ISM pointing to a

contraction and some regional surveys, such as the Philadelphia Fed and Chicago

NAPM, in recession territory. In addition, the manufacturing sector shed 52,000 jobs in

February, and aggregate hours fell 0.5%, suggesting a decline in output. Elsewhere, we

look for an increase in mining output to be offset by a decline in utility production.

NAHB Housing Index (Monday)

The NAHB housing index, which measures homebuilder sentiment, has edged higher from

a record low of 18 in December to a still-depressed 20 in February. We look for the index

to hold steady at 20 in March as homebuilders continue to struggle with weak demand and

high cancellations. The deterioration in financial markets has exacerbated the problems in

the housing market by tightening credit and pushing up borrowing costs. Even the agency

market has started to show stress, as rates on conforming (Fannie Mae and Freddie Mac

guaranteed) mortgages have jumped over the past few weeks. In addition, the economic

outlook has continued to worsen, with a decline in payrolls and consumer confidence.

Attention should be on the buyer traffic index, which inched higher in February. A

sustained increase in this index is suggestive of future sales and hopeful for builders.

However, given the huge inventory overhang of homes on the market for sale, we believe builders will not feel comfortable increasing construction until next year.

PPI (Tuesday)

We look for the February Producer Price Index (PPI) to have risen by 0.5%, following a 1.0%

increase in January. The core PPI is likely to rise by 0.2%, or 2.1% year-over-year. As the PPI

is released after the CPI this month, we expect it to garner little market attention.

Energy and food prices should continue to boost headline PPI, as they have in most

recent months. We look for the energy component to rise by 1.4%, close to last month’s

rate of increase. The food component is expected to cool slightly, rising just 0.5%. Food-

related commodity prices have turned lower in March, which should lead to lower

finished food prices in time.The core PPI, excluding food and energy, is expected to increase 0.2%. The core PPI has

recently surprised on the upside, with no special factors behind the acceleration. We judge

that the pickup in price pressure reflects pass-through from surging commodity prices. With

Figure 3. Core PPI and CPI Figure 4. Housing Starts and New Home Supply

-1

0

1

2

3

4

5

6

Jan-85 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05

Core PPI Core CPI

% y-o-y

3

4

5

6

78

9

10

11

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

0.5

1.0

1.5

2.0

New Home Supply, LHS

Single Family Starts, RHS

m, saar months

Source: Bureau of Labor Statistics Source: Census Bureau, Lehman Brothers

Homebuilders are likely to

remain depressed

Energy and food prices should

continue to boost the

headline PPI index

We look for core PPI

to rise 0.2%


27/120


March 17, 2008

27

both futures prices and Lehman Brothers’ official commodity forecasts suggesting that these

price pressures should begin to subside, core PPI should decelerate in a lagged fashion.

Housing Starts (Tuesday)

We look for housing starts to fall just over 4%, to 970,000, in February, as both single- and

multi-family starts edge lower. Multi-family starts have been quite volatile of late, causingswings in the headline number. The attention should be on single-family starts, which have

contributed to the bulk of the decline in construction. Single-family starts have already

fallen 60% from the January 2006 peak and are likely to continue to decline given the glut

of inventory in the new home market (Figure 4). The supply of homes on the market

reached a new cyclical high in January of 9.9 months, as home sales continued to fall

sharply while inventory only slipped. Builders should slash construction as a result.

FOMC Meeting (Tuesday)

We look for the FOMC to match market expectations and cut the Federal funds rate by

75 bp, to 2.25%. Continued aggressive rate cuts are consistent with the Fed’s attempts to

re-open the credit channel through the expansion of the TAF program, the recently

announced term repurchase agreement program, and the Term Securities LendingFacility. The new programs are designed to restore the effectiveness of the Fed’s primary

policy tool—the Federal funds rate—in stimulating the economy. We expect the Fed to

continue to note the obvious downside risks to growth in the economy while also

continuing to pay lip service to inflation concerns—even though these concerns are far

removed from the Fed’s immediate worries.

Initial Jobless Claims (Thursday)

We look for claims to hold above 350,000 and for the four-week average to remain

between 350,000 and 360,000 as labor market weakness continues. This reading should

translate into a 25,000 decline in payroll employment for March.

Philadelphia Fed Survey (Thursday)Like the Empire State survey, we look for the Philly Fed survey to post a modest

improvement to -19.0 in March from -24.0 in February. After plunging sharply in

January, this index has remained close to -20.0, and we see no reason to expect a

significant improvement. We will pay particular attention to the CapEx outlook series: a

sharp deceleration last month put the current quarterly average for this series nearly eight

points below the average seen in 4Q. We view this series as helpful in predicting

business investment on a national scale. Last month, the series printed at 1.7 after posting

a respectable 19.0 reading the previous month. A further decline in March would suggest

that businesses dramatically reduced CapEx spending during the quarter.

Leading Indicators (Thursday)

The index of leading economic indicators is expected to decline 0.3% in February,

marking its fifth consecutive monthly decline. As the economy may have already slipped

into recession, the leading index should begin to stabilize in the months ahead. Indeed,

following the decline in payroll employment in February, we believe the first significant

decline in the coincident index—which tracks current economic activity—will be

reported this month.

Good Friday Holiday

U.S. markets are closed for the Good Friday holiday.

We look for the FOMC

to cut rates 75 bp, to 2.25%

Philly Fed survey expected to

show modest improvement but

to stay in recession territory

The index of leading economic

indicators is expected

to decline 0.3%


28/120


March 17, 2008

28

European Economics

Re-coupling with Decoupling

Genuine decoupling of the European economy from that of the United States remains a

remote possibility. We are now alert to the risks of a sudden and sharp drop in growth.

Even as fears about the outlook for the U.S. economy intensify, a batch of unexpectedly

healthy European data has resurrected talk of possible “decoupling.” Is it really possible

that just as the U.S. enters recession, Europe can provide some comfort to the rest of the

world by standing on its own two feet?

Materializing Risks

We examined in some detail the issue of decoupling in a report last July. 3 The analysis it

contained suggested that the main risk to the decoupling thesis was a global inflation

shock that constrained the ability of central banks to provide offsetting policy stimulus. A

second risk was a financial shock that was propagated from the U.S. to elsewhere in the

world. We concluded that a U.S. recession would have very different implications for the

rest of the world than a U.S. slowdown would.

Nearly nine months on, both of these major risks have materialized, and the U.S. economy

seems to have moved from slowdown to outright recession. In short, even as the European

data may seem to be casting doubt on a synchronized global slowdown, from an analytical

perspective, decoupling in the current environment appears to be about as unlikely a

prospect as it gets. So was the analysis contained within that report wrong-headed? Or are

the data a red herring on the path to much lower growth in Europe? We side with the view

that recent figures are a red herring. In fact, we are becoming increasingly concerned that a

sudden and sharp drop in European growth could be around the corner.

Global Transmission

The concern about a global inflation shock was certainly not misplaced. The logic that lay

behind that was that a global inflation shock would constrain the ability of central banks to

offset an autonomous weakening of demand by lowering interest rates. While the Federal

Reserve has acted aggressively even as inflation pressures have risen, two unexpected

developments have outweighed this piece of good news as far as Europe is concerned.

First, in the currency markets, the Fed’s emphasis on core inflation within a risk

management framework has jarred with the ECB’s emphasis on headline inflation within

a policy framework based on a baseline scenario. It has driven the dollar down sharply

against the euro and means that more of the U.S. shock is being transmitted to Europe via

the exchange rate. Second, the pernicious nature of the financial shock means that there

are now serious doubts as to whether lower U.S. interest rates will have their usual

demand-boosting effect. That would be the worst of both worlds for Europe: a U.S.economy that does not respond to monetary easing combined with a U.S. dollar that does.

In this context, to take the latest domestic data as a sign of decoupling places more weight

on them than they can bear. For example, the positive surprises that have emerged

continue to be loaded toward the manufacturing sector. To summarize, the manufacturing

PMI has held up better than its services equivalent, and industrial production at the

3 1. Hume, M., Global Decoupling: Does the rest of the world still catch a cold when the U.S. sneezes?, LehmanBrothers Global Economics, July 6, 2007.

Michael Hume

44-207-102-4191

[email protected]

Some optimism about

decoupling has returned…

…but the main transmission

risks have materialized

U.S. rate cuts could be

bad news for Europe…

…given that the ECB is

unwilling to help


29/120


March 17, 2008

29

beginning of 2008 jumped unexpectedly (Figures 1 and 2). But for decoupling to take

place in an environment of a U.S. recession, a switch away from export-led growth in

manufacturing to consumer-led growth in services would be needed. In our view, it is

unrealistic to expect the manufacturing sector to live with a euro-dollar exchange rate of

over $1.55, a recession in the U.S. economy, and the prospect of weaker U.K. economy,

too. Our expectation is that this combination of influences will lead to clear signs of

weakness in exports and manufacturing within the next three to six months.

Hopes Pinned on Germany

The great hope is that the German consumer is now ready to come out of his shell and

start spending again, propelled by strengthening wage growth, lower unemployment, and

the fading of the effects of both the VAT hike and the new rules on depreciation for theself-employed. Optimists argue that the German economy is not at the forefront of this

financial crisis. Although German banks were exposed to subprime losses, the damage has

not been extensive, and credit growth has remained strong. Furthermore, turning back to

the latest industrial production figures, it has been argued that Germany’s competitiveness

has improved enough to withstand recent exchange rate shifts. Furthermore, exports to the

oil exporters and the Asian economies now matter more than those to the U.S.

There is some truth in all of these ar

all sections combined 101151513

Documents