GaveKal Research

A Quick Review of the Cyclical Indicators

A Look at MV=PQ

GaveKal Research

Presentation to Euro92 Alain Madelin

Septembre 25 2003, Paris

GaveKal Research 3

An Expansionist Monetary Policy=M is Going UP

• Central banks all around the world have been printing money aggressively to either fight off the deflation/depression demons (USA, UK, EMU…) or to prevent their currencies from rising too quickly (Japan, China, India…). The recent level of monetary activism is reflected by the up-tick in our Global M Indicator.

• An expanding global money supply is usually good for stocks and bad for bonds. In light of the major central banks’ activism, the recent behaviour of bond and equity markets is understandable.

Money Supply Growth (M2) in Major Countries

USA M2 Annual Growth Japan M2 Annual Growth Euroland M2 Annual Growth China M2

97 98 99 00 01 02 03

YoY

% C

hang

e

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

Rebound in China, US, & EMU M2 growth

Mild rebound in Japan M2 growth

GaveKal M Indicator & US Bond Market

USA government bond index in local currency all matur. daily GaveKal Indicator of Liquidity (M)

93 94 95 96 97 98 99 00 01 02 03 04

M In

dica

tor

-9

-7

-5

-3

-1

1

3

5

7

9

YoY

% C

hang

e

-18.0

-16.0

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

Liquidity expanding on a global scale

GaveKal Research 4

V is Rebounding very Strongly• Our velocity indicators

bottomed in September 2002 and returned to positive territory in March 2003.

• With the continued contraction in quality spreads and the pick-up in bank lending, we do not fear a new contraction in velocity.

• The question today is not whether velocity will once again collapse, but whether the velocity rebound is already priced into the market?

The GaveKal Velocity (V) Indicator & Vix Index

Velocity Indicator - USA CBOE Volatility (VIX) index, close daily

99 00 01 02 03

Indi

cato

r

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

14

16

Vix

Inde

x

10.0

12.5

15.0

17.5

20.0

22.5

25.0

27.5

30.0

32.5

35.0

37.5

40.0

42.5

45.0

47.5

50.0

Irrational exuberance

Velocity Falling

GaveKal Research 5

No inflation Risk on the Horizon.• Our P indicator

indicates that there will be very little inflationary pressures over the coming months.

• As such, central banks will be able to continue their anchoring of short rates and their aggressive printing of money.

GaveKal P Indicator & USA ECRI Future Inflation Gauge

P Indicator United States, Inflation n.i.e., ECRI Future inflation gauge, USD P Indicator

Source: EcoWin

94 95 96 97 98 99 00 01 02 03 04

95

100

105

110

115

120

125

1992=

100

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

P Indicator leads by four months

R= 0.84

GaveKal Research 6

Conclusion: Q will Boom

GaveKal Quantity (Q) Indicator & OECD GDP

Q Indicator OECD Gross domestic product, Volume, sa RHS Q Indicator

92 93 94 95 96 97 98 99 00 01 02 03 04

Q In

dica

tor

-20

-16

-12

-8

-4

0

4

8

12

16

20

YoY

% C

hang

e

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

R=0.8, lead time three months

• For most of the past year, the predominant concern of financial markets has been whether economic activity would pick-up following the end of the Iraq War. In July, policy makers, economic data, and the financial markets seem to have put these fears to rest!

• Our indicator of daily economic sensitive prices is now announcing a solid economic rebound; as is our monthly growth (Q) indicator. And so is the data: last week, US GDP increased by a much higher than expected 2.4% in the second quarter and jobless claims over the past two weeks have been coming in better than expected.

• The recovery is there. And it will be strong.

Daily Indicator of Economic Sensitive Prices & OECD Ind. Prod.

GaveKal Indicator of Daily Economic Senstive Prices GaveKal Indicator of Daily Economic Senstive Prices OECD IP total industry, Volume, sa

92 93 94 95 96 97 98 99 00 01 02 03 04

Inde

x

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

GaveKal Indicator leads by 100 days

GaveKal Research 7

Back to the Deflationary Boom Prices

++

Inflationary Boom Buy: Scarcity Assets & Cyclicals

Sell: Bonds, Interest Sensitive Stocks

Deflationary BoomBuy: Efficiency Shares

Sell: Price Inelastic

Inflationary BustBuy: Gold, Cash

Sell: Financial Assets

Deflationary BustBuy: Government Bonds

Sell: Equity, Negative Cash Flow Assets

++

Economic activity

• Accelerating growth, accelerating liquidity and tame prices: we are back to the glory days of the deflationary boom.

• A deflationary boom is a very exciting, and dangerous, investment environment (see Theoretical Framework for the Analysis of A Deflationary Boom on our website).

• It is very propitious to over-investments, over-excitements, and bubbles. Where will the next bubble be? Our guess is Asia…and we want to participate in it!

• In any event, the markets’ recent moves make sense in light of economic fundamentals.

GaveKal Research

Who will benefit structurally from the Boom

A Wicksellian Analysis of the World

Central Banks, Inflation, Deflation and

Financial Markets

GaveKal Research 9

Introduction.• Wicksell, the Swedish economist had a very powerful intuition. His view was that

economic cycles could be explained by the divergences between what he called the ‘’ natural’’ interest rates, and what he called the ‘’market’’ rates. (More on those two later)

• If the ‘’market rates’’ were too low i.e. if money was too cheap, it led to a boom centred on excess capital spending, excess borrowing, excess consumption.

• These ‘’boom conditions’’ led eventually to a rise in the market rates above the natural rate, and this changes in the price of money eventually brought about a bust, which would lead in due time to a fall of the market rates below the level of the natural rates.

• And on and on…

• With every country (at the time of his writing) operating under the Gold Exchange Standard, there was little that could be done to stem these periodic booms and busts, more a function of gold discoveries and international capital flows than the results of conscious decisions by the central bankers.

• This is not the case anymore: central bankers do control market rates at the short end.

GaveKal Research 10

Wicksell’s ChildrenThree economic schools can be traced to Wicksell.

1. The Keynesians. Their view is very simple: since the rise of the market rate above the natural rate creates the bust, the central bank should prevent the market rate from ever going above the natural one. Their view was developed during a depression, and was dominant up to the end of the seventies.

2. The Austrians. They believe that preventing the market rate from going up distorts the price mechanism and that the central bank should leave the interest rate as close as possible from the natural rate all the time. Their view, represented by the Bundesbank was developed during an inflationary period and prevailed from the end of the seventies to the end of the nineties.

3. The Fischerians, who after Irving Fischer considered that the role of the central bank was to manage short rates contra-cyclically. Their views were developed into a historical period full of potentially very dangerous financial accidents (Oil shocks, Banking collapses, countries going bankrupt etc…) Their best representative is of course the Fed with Mr Greenspan

GaveKal Research 11

The Goal of this PresentationOnce in a while, we indulge in a little bit of theoretical work. Not because we want to bore our readers to death, but simply to ‘’reposition’’

ourselves intellectually. We believe it leads afterwards to better understanding and thus better advice.The work that we have done over the last few years (in fact since the re-

emergence of our research effort in 1998) has in fact convinced us that the Wicksellian analysis is the correct one.

Thus we will:1. Present our own definitions of what the ‘’natural’’ rate is2. Show that divergence between the natural and the market rate is indeed

at the origin of the economic cycle.3. Show that the ‘’core beliefs’’ under which a central bank is operating,

leads almost naturally to a series of economic and financial consequences over time, always the same for the same set of core beliefs.

4. Show that when a central bank changes it sets of core beliefs, (from Keynesian to Austrian etc…), it has a huge influence on the underlying financial markets.

5. Identify the sets of beliefs under which the main central banks are operating today, and draw some investment conclusions.

GaveKal Research 12

Identifying the ‘’ Natural ’’ rate

USA IP Total Index & GDP : 10 Years Averages Annual Increases

USA IP total index, Volume, sa USA Gross Domestic Product, Volume, AR, sa

72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

12

Mo

nth

s V

ari

atio

ns

Ten

Ye

ars

Ave

rag

e

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

The US Natural Rate must be around 3%

Average Growth Rate of the GDP

Average Growth Rate of the US IP

• Over the last twenty five years, the US GDP has grown by 3% per year on average, and the Industrial Production by 2.7%.

• So the ‘’natural rate for the US economy must be slightly below 3% real

• Why?

GaveKal Research 13

Reasoning ‘’ad absurdum’’US GDP (Volume) & US Cash--Flows

USA Gross Domestic Product, Value, AR, sa US Corporate cash-flows, Base 100 in 1982 Short Rates Capitalised (US T Bills)

74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

US

GD

P &

Ca

sh-F

low

s B

ase

10

0 in

19

82

40

90

140

190

240

290

340

Trend Line at 3.3 % / Year

• Over the long term, the growth rate of the US GDP=the growth rate of the US Corporate cash-flows (profits).

• If short term rates capitalised (the green line) grew faster than corporate profits or the GDP, overtime the system would implode.

• Ergo, the upper limit of the natural rate must be the growth rate in volume of the economy,

GaveKal Research 14

Defining ‘’Real’’ RatesSo, the upper limit of the ‘’Natural‘’ rate is 3 %. Interest rates should not stay above 3 % for a sustained period of time real without

creating substantial damages to the economy. Big help indeed.It leaves us with more questions than answers.The question we have to address now are:1. Which market interest rates are we going to use as a proxy for our market interest

rates?2. Which inflation rate are we going to deflate these interest rates with?Fortunately, we have done over the last few years quite a lot of work on these topics, and

have come to the following conclusions.When it comes to interest rates, we cannot introduce a ‘’risk’ ’element in the picture, so

we will have to use Government related tools. We cannot use short rates only (too short a period), nor can we use long rates (volatility in

inflation expectations). So we will use the average of three months T Bills and 10 Years bonds.

As far as inflation is concerned, our readers know that we have always favoured the average inflation of the last ten years, as the best proxy for the ‘’perceived’’ inflation rate.

Results

GaveKal Research 15

Our Measure of Real Rates

• We are reasonably happy with our market rate proxy.

• It moves between 0 and +3 %, which is what we were expecting, and there is no discernible trend, a sign that we are using the right inflation rate to deflate the nominal interest rates.

• Next question of course: does it work ?

Market Rates in the US

Real Rates in the US

62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

Re

al R

ate

s

-1

0

1

2

3

4

5

6

7

8

Favours the Entrepreneur

Proxy for the Wicksellian Market Rates

GaveKal Research 16

The Proof• Every

recession since 1968 in the US took place after a rise in real rates above 3% (Gray boxes above zero).

• When market rates were below the natural rate, the US economy grew ‘’normally’’.

• So it works…

US GDP Variations & Market Rates vs Natural Rates

USA Gross Domestic Product, Volume, AR, sa 0 Market Rates Above or Below Natural Rate

68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

Y/o

/Y %

Ch

an

ge

s

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

-5

-4

-3

-2

-1

0

1

2

3

4

5

Market Rates Below Natural Rates

Market Rates Above Natural Rates

Every Recession Took Place AFTER

Market Rates rose ABOVE Natural Rate

Recessions

GaveKal Research 17

The Keynesian Central Bank

• The characteristic of a Keynesian central bank is that short rates will be maintained all the time below the growth rate of the economy.

• This always leads to everybody and his brother borrowing, money supply exploding and inflation going up structurally…US 1958. 1979

USA T Bills Yields & US GDP Annual Growth Rate

Market Rates Nominal GDP Growth Rate (Value) USA CPI 12 Months Variations four Years Moving A verage

58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

Per

cent

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

Interest rates lower than GDP Interest rates higher than GDP

Inflation Desinflation/Deflation

?

GaveKal Research 18

Moving from Keynesian to Austrian

• A Keynesian monetary policy is aimed at what Keynes called the ‘’euthanasia of the Rentier’’.

• It can work only if the financial markets are heavily regulated (regulation Q, credit controls, foreign exchange controls etc...)

• When the Futures markets in Chicago invented the contracts on the US interest rates, then this policy was doomed.

• The futures allowed the investors to hedge against the future inflation, thereby leading to a massive rise in real rates immediately.

• This rise in real rates brought those way above 3 % (the natural rate) for an extended period of time and killed the incentive to borrow.

• And the US moved from inflation to des-inflation-deflation.• This move has huge financial consequences, which we are going to study

now using the Japanese example.

GaveKal Research 19

The Japanese Drama in Three Acts

• At the end of a Keynesian period, real rates are deeply negative, and nominal rates are high.

• In the first phase (boom, bubble), we see a gradual fall in nominal rates and a gradual rise in real rates., at the same time. Since nominal rates are used to discount future cash-flows, we have an incredible boom cum bubble.

• Eventually (second act), real rates (market rates) rise above the long term growth rate of the economy, even though nominal rates keep falling. This is when the bubble bursts. As long as real rates (Market Rates) remain above the structural growth rate of the economy (which might be falling due to the liquidation of the bad investments of the bubble period), the economy keeps stalling or falling.

• The wave of bankruptcies destroy the banking system, Velocity collapses, and deflation kicks in (third phase)

• See next graph for the three phases…

GaveKal Research 20

A Graphic view of the Japanese Drama

Japan GDP & Real Interest Rates (Structural Inflation)

12 Months Variations GDP in Volume [ma 12] Market Rates Real Market Rates Nominal

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

%

-2

-1

0

1

2

3

4

5

6

7

8

9

Bubble Bust

Banking CrisisMarket Rates > Natural Rates

Velocity Collapses

Market Rates < Natural Rates

GaveKal Research 21

Preliminary Conclusion

• A French Politician once confronted with a very favourable development in France said ‘’ Let’s feign to be the organisers of these phenomena that we do not understand’’. This is a luxury that a central bank cannot afford.

• The most dangerous phase when a central bank moves from Keynesian to Austrian is after a few years of boom when real (market) rates start moving above the structural growth rate of the economy (natural rate), when everybody has understood and borrows to buy financial assets…

• This usually coincides with the peak of the bubble (Japan 1989).• The central bank must then talk tough, but be willing to cut short rates

aggressively and very quickly to prevent a collapse of the house of cards, i.e. it must move from Austrian to Fischerian in no time…

• Maintaining real rates above the structural growth rate of the economy during more than five years as the BOJ did was suicidal.

• If such a mistake is made then the third phase unfolds, centred around a collapse of the financials in general and the commercial banks in particular…and monetary policy becomes ineffective.

GaveKal Research 22

What about a Central Bank being Austrian since its Origin ?

The reader still with us may then ask: OK, then I should keep my money all the time in a country ruled by a central bank which has operated for ever under the Austrian theory. If only life was that simple…

• Because to operate efficiently, this central bank must have a pretty good idea of what the structural growth rate of the economy is .

• If this structural growth rate of the economy moves down for one reason or another, and if the central bank does not adjust downwards the short rates target, then the economy will move, over time, into a deflation-depression…

• The same is true on the other side if the growth rate moves up…We could have an inflation boom emerging

• Moreover the mandate of the central bank may change from one country to a group of countries, and if the central bank follows a policy aimed at the average of all those countries, then all those with a below average natural rate will go bust, eventually.

• This is what is happening in EuroLand.

GaveKal Research 23

Incompetence & Arrogance

France: Market Rates and Natural Rate

France GDP total, Vol, sa [ma 3, c.o.p 12] Market Rate in Real Terms France GDP total, Vol, sa [ma 3, c.o.p 12]

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

Pe

rce

nt

-3

-2

-1

0

1

2

3

4

5

6

7

Market Rate below Natural Rate= Growth

Market Rate above Natural Rate = Bust

• Rates in France are 200 bp too high.

• The French Economy should continue collapsing.

• Question: is it going to be saved by a positive movement in foreign trade (boom in exports)?

• See next pages

GaveKal Research 24

The French Example

France Deflationary Pressure Index (DPI)

Using IP*CPI 0 French DPI

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

Pe

rce

nt

-5

-3

-1

1

3

5

7

9

11

13

15

Market Rate Above Natural Rate

Market Rate Below Natural Rate

• Markets rates have been above the natural rate 95 % of the time since 1987.

GaveKal Research 25

Back to Purchasing Parity

Purchasing Parity: Adjusted for the differences in Productivity

France Exchange rate USD/FRF Purchasing Parity One Standard Deviation UP One Standard Deviation Down

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

US

D/F

RF

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

0

1

2

3

4

5

6

7

8

9

10

US Dollar Over Valued

US Dollar Undervalued

• On a PP adjusted for the differences in productivity, the Euro is overvalued by at least 15 %...and this is not to mention the PP with China, Korea etc…

GaveKal Research 26

France is not Price Competitive

Productivity Differences & Euro vs Dollar

Productivity Europe-Productivity US Taux de Change

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

Diff

ere

nce

s

-6.0

-5.5

-5.0

-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

Exc

ha

ng

e R

ate

0.8

0.9

1.0

1.1

1.2

1.3

1.4

Tendances

The Euro should be at .84

• The EuroLand economy is not benefiting from the rise in productivity which we are seeing in the US.

• In fact productivity keeps decelerating in Europe (UK included)

GaveKal Research 27

The Rise of the Euro Will Keep Hurting

Euro vs Dollar & French Exports

EMU Exchange rate USD/EUR France Exports of goods and services, Volume, sa, Right Scale

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

12

Mon

ths

Var

iatio

ns

-20

-15

-10

-5

0

5

10

15

20

12 M

onth

s V

aria

tions

-20

-15

-10

-5

0

5

10

15

20

Exchange Rate leads by 6 Months

• The collapse of French (read EuroLand) exports is just starting.

GaveKal Research 28

Who is going to Pay?

Purchasing Parity Yen Euro & Added Value in French Industry

France Value added, by sector, industry, Value, sa Deviation From Purchasing Parity with the Yen

Jul 95 Jul 96 Jul 97 Jul 98 Jul 99 Jul 00 Jul 01 Jul 02 Jul 03 Jul 04

Va

lue

Ad

de

d

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

EU

R/J

PY

-20

-15

-10

-5

0

5

10

15

20

PP Using Export Prices

90% Confidence Interval

French Corporate Profits to Collapse

• Who else but the French companies?

• After all, we have a Government which has not repealed one of the stupid Socialist laws

• Like the UK conservatives before Mrs Thatcher, they are ‘’managing’’ the decline.

GaveKal Research 29

The EuroLand Drama: End of Act 1, Moving Towards Act 2

• From 1970 to 1991, the German Industrial production grew on average by 2.5 % per year.

• From 1992 to 2003, this growth rate has fallen to 1.2% per year. (Our objective here is NOT to explain this decline, but simply to mention it).

• In the 80’s real rates in Germany were most of the time above 3% when the growth rate was at 2.5%. Tight but not unbearable.

• Those rates are still close to 3%, even though the growth rate has fallen to 1.25%. The difference between the natural rate and the market rate has seldom been higher.

• An Austrian central Bank by gravely misreading the long term structural growth rate of its economy can create a disaster about as bad as anything a Keynesian central bank has achieved in the past.This state of affairs cannot not lead to the collapse of the Euro. We are not sure that the Euro will survive in its present format.

GaveKal Research 30

The Economy is very Sensitive to the Variations in Short Rates

Fed Funds vs. Industrial Production in the US

USA IP total index, Volume, sa [ma 3, c.o.p 12] Changes in Fedeal Funds Rates RHS Inverted [ma 3, c.o.p 12, lag 12]

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Yo

Y %

Ch

an

ge

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

Fe

d F

un

ds

Va

ria

tion

s in

vert

ed

-75

-50

-25

0

25

50

75

100

125

fed funds + 9 months

Lead Time 12 Months

War+Tax Increases

• Twelve months after a fall in US rates, Economic activity picks up, the reverse being also true.

• As a result the US central always maintain the fed funds rates between the long term growth rate of the US economy and 0 (in real terms)…

GaveKal Research 31

A Fischerian Central Bank

Real Rates & US GDP

US GDP in Volume 12 Months Variations Real Rates on T Bills Using 10 Y Inflation 2.3 0

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Rea

l Rat

es

-2

-1

0

1

2

3

4

5

Boom. the Fed Tightens

Bust, the Fed Eases

Real Rates Remain Between -1 and +3...

• There is no alternative (TINA as Mrs Thatcher was fond of saying) , but to be a Fischerian central bank, manipulating short rates, putting them above the growth rate of the economy when the economy is booming, and putting them at zero or below when the economy is busting.

GaveKal Research 32

Conclusion• Of all the countries which we follow, the biggest positive spread between the

natural rate and the market rate are to be found in Asia in general and China in particular. (see our Research on Asia & China) A new boom there has started or is imminent. The way the local central banks will manage the passage from Keynesian orthodoxy to Fischerian pragmatism will be the key between a new boom and bust cycle or a sustained period of economic growth.

• In the US the fundamentals have seldom been better for risks takers and corporate profits. The US companies are back to positive cash flow. In the US, we should see a massive depreciation of the US dollar vs. the Asian currencies, and an export surge, accompanied by a boom in capital spending. The Fed will have to tighten pretty soon, or run the risk of inflation accelerating markedly.

• No hope for EuroLand, except if the Euro collapses and brings about a surge in nominal activity through exports, allowing the market rates to move below the natural rate at least temporarily. Unfortunately, we tend to believe that if the Euro were to fall the ECB might be raising rates…

• The procedures of the ECB are economically incoherent, and cannot work. We are not sure that the Euro is going to survive in its present format. It could very well disappear. EuroLand is entering into a massive political crisis.

GaveKal Research 33

For more information, please contact Louis-Vincent Gave

at louis@gavekal.com or call us on 852- 2869 8363, fax: 852- 2869

8131.

This presentation is available on our website:www.gavekal.com