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Macro Commodities Forex Rates Equity Credit Derivatives
Please see important disclaimer and disclosures at the end of the document
26 April 2010
EconomyBeyond the cycle
www.sgresearch.com
Stephen GallagherChief US Economist
(1) 212 278 [email protected]
Aneta MarkowskaSenior US Economist
(1) 212 278 [email protected]
Martin RoseResearch Associate(1) 212 278 [email protected]
The US private sector has undergone significant de-leveraging in the past two years.Households and businesses have succeeded in cutting their debt burdens. The US government,as an offset, has added on a substantial debt position. Further deleveraging is expected, butnow the private sector paydowns should slow. In phase two, greater deleveraging is likely tooccur as incomes and profits grow faster than the private sector credit. We do not anticipate atragedy as deleveraging plays out. But in Act II, the plot thickens in two ways. First, does theresumption of private sector credit growth imply crowding out? Government debt growthremains substantial. Second, will foreign investors continue to finance large US deficits? Thedeficit is now being financed almost entirely via foreign purchases of Treasury debt.
Q Households half way there Debt burden has declined to 2000 levels on the back of lowerinterest rates, spending cuts and debt write-offs. At current consumption levels, debt loads
are set to decline further. Timing is uncertain, but policy is targeting a gradual rise in savings.
Q Corporate sector gone too far This was one sector of the US economy that didnt reallyneed to de-lever, but companies responded to the crisis by bullet proofing their balance
sheets. Corporations have been replacing hard assets with cash which is very abnormal.
Q Small business more work ahead Unlike the corporate sector, small businesses enteredthe crisis with much more leverage and much higher concentration in real estate assets. The
contraction in asset prices was therefore far more damaging for the small business sector
which will likely continue to face de-leveraging pressures.
Q Government piling on debt The government has picked up where the private sector leftoff and is now largely responsible for the US external savings deficit. Public spending was
needed to prevent an economic downward spiral, but it came at a substantial cost that further
burdens fiscal finances. Unfortunately, the longer term fiscal outlook is a train-wreck waiting to
happen.
American ThemesUS deleveraging Intermezzo. The plot thickens in next act.
Leverage migration where is the end game?From corporates To households and small businesses To public sector
0
10
20
30
40
50
60
55 60 65 70 75 80 85 90 95 00 05 10
%of GDP
Corporate business
0
10
20
30
40
50
60
70
80
90
100
55 60 65 70 75 80 85 90 95 00 05 10
%of GDP
Household sector
Noncorporate business
0
10
20
30
40
50
60
70
80
90
100
55 60 65 70 75 80 85 90 95 00 05 10
%of GDP
Government
Source: Federal Reserve, SG Cross Asset Research
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US households deleveraging via savings, lowerinterest, and to some extent via debt forgivenessHouseholds appear to be doing all the right things in terms of repairing their balance
sheets. The savings rate has increased notably from secular lows and debt levels are
declining. However, more work needs to be done based on the savings rate which is still
below the long-term target. Timing is uncertain, but policy is fully calibrated in support
of a gradual rise (offset by income growth) in savings.
Over the past 2 years, households have made some notable progress toward repairing their
balance sheets. There are many different metrics that measure the extent of leverage, but our
preferred measure for households is the debt service ratio which compares debt payments
(interest + principal) to disposable income. As of Q4, the ratio stood at 12.6%, the lowest
since 2000, and importantly pre-dating the housing bubble.
How did households achieve such a quick reduction in debt burden? It took a lot of sweat
and tears (i.e. savings), some debt forgiveness, and some help from policy. All three have
contributed to a notable reduction in debt levels. Additionally, policy helped by serving up
ultra-low interest rates which presented many households with refinancing opportunities.
Household debt burden lowest in 10 years!
50
60
70
80
90
100
110
120
130
140
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
10.0
10.5
11.0
11.5
12.0
12.5
13.0
13.5
14.0
Household Debt, % of Disp. Income (LHS)
Debt Servi ce, % of Disp. Pers. Income (RHS)
Decline in debt
burden due to debt
reduction
Decline in debt
burden due to lower
interest rates
Source: Federal Reserve, SG Cross Asset Research
In fact, lower interest rates explain about two-thirds of the reduction in debt burden. This ishelpful today, but the benefit to households will be partially reversed out as interest rates
begin to rise. Another temporary boost has come from tax cuts which have lifted disposable
income, boosted the savings rate and reduced the debt service ratio. As these cyclical and
one-off factors begin to fade, debt levels will have to decline further to maintain/reduce debt
service ratios.
The speed of debt reduction depends on two factors: the level of savings and charge-off
rates. While higher savings/lower spending has contributed to debt reduction, our estimates
suggest that debt forgiveness has played a significant role. Indeed, looking the Feds data on
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American Themes
26 April 2010 3
charge-off rates at commercial banks, we calculate that principal write-downs explain almost
all of the reduction in mortgage debt and about half of the reduction in consumer credit
outstanding.
How much de-leveraging through defaults and debt forgiveness?
-150
-100
-50
0
50
100
150
200
250
300
350
99 01 03 05 07 09
USD bln
Mtg Charge-offs (above norm)
Change in Mtg Debt Outstanding
Charge-offs explain almost all of the reductionin mo rtgage debt outstanding
-60
-40
-20
0
20
40
60
80
99 01 03 05 07 09
USD bln
Cons Credit Charge-offs (above norm)
Change in Consumer Debt Outstanding
Charge-offs explain about 50% of reduction
in consumer debt outstanding
2000
3000
4000
5000
6000
7000
8000
9000
10000
11000
99 01 03 05 07 09
USD bln
Mortgage Debt Outstandin gPro-forma without charge-offs
1000
1200
1400
1600
1800
2000
2200
2400
2600
2800
99 01 03 05 07 09
USD bln
Consumer Credit Outstandin gPro-forma without charge-offs
Charge-off estimates are based on bank charge-off rates from the Federal Reserve. We assume that the performance of bank assets is a
good proxy for the entire universe of mortgage and consumer debt (including debt that has been securitized).Source: Federal Reserve, SG Cross Asset Research
To be sure, organic debt reduction is also taking place and is set to continue. That s because
gross borrowing, determined by current levels of spending, is running below scheduled
principal repayments which are determined by past spending. In other words, the substantial
contraction in spending that occurred over the past 2 years will ensure that household debt
levels continue to shrink for the next several quarters. This is true even while allowing for some
nominal growth in spending.
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Lower spending also contributing to debt decline more to come
0
100
200
300
400
500
600
700
800
900
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
USD bln
Residential Investment (proxy for gros s borr owing)
7yr mov avg (proxy for pr incipal repayments)
-600
-400
-2000
200
400
600
800
1000
1200
1400
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
USD blnChange in Mtg Debt Outs tanding
0
200
400
600
800
1000
1200
1400
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
USD bln
Durable Good Spending (proxy for gross borrow ing)
5yr mov avg (proxy for pr incipal repayments)
-200
-150
-100-50
0
50
100
150
200
250
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
USD blnChange in Consumer Debt Outstanding
Source: Federal Reserve, BEA, SG Cross Asset Research
Will more spending cuts be required to complete the de-leveraging process of households?
This is the million dollar question, but without an obvious answer. While the savings rate is still
below long-term equilibrium and will eventually have to rise toward 7%, there are many ways
of getting there: lower consumption, higher income, lower effective tax rates or lower interest
payments. In a best-case scenario, we will get there via income growth, which would allow
consumption to grow modestly at the same time (with income being subsidized by exports).
This scenario is implicitly embedded in the current consensus thinking, and fully supported bycurrent policy efforts. Of course the risk is that policy efforts are derailed (or withdrawn
prematurely), triggering another wave of disorderly de-leveraging. In addition, we must
consider the long-term outlook for taxes and interest rates, both of which are likely to move
higher in the 3-5yr time frame. All else being equal, this will require further spending cuts
relative to income.
More work to be done
-1.0
1.0
3.0
5.0
7.0
9.0
11.0
13.0
52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
multiple3.5
4.0
4.5
5.0
5.5
6.0
6.5
Savings Rate (LHS)
Household Wealth/Disposable Income - Inverted (RHS)
Policy has stabilized the savings rate by:
1. Reflating asset prices2. Boosting disposable income (tax cuts)3. Restoring credit flows
Source: Federal Reserve, SG Cross Asset Research
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Corporate sector saving too much and replacinghard assets with cashThis was one sector of the US real economy that didnt really need to de-lever, yet
corporate America too has been busy bullet proofing its balance sheets. In addition to
hoarding cash, businesses are allowing their tangible assets to shrink for the first time
in history. Putting the two facts together suggests that businesses are replacing
physical capital with cash. For an economy with positive potential growth, this situation
is abnormal. Normalization supports more capital spending in the coming quarters.
The US corporate sector as a whole did not have a serious leverage problem going into the
crisis. Yes, corporate debt levels have risen relative to GDP or revenues, but unlike in the
household sector, corporate sector debt growth can be fully explained by declining interest
rates. Interest payments on debt have in fact shrunk as a percentage of revenues since
peaking in the early 1990s. Debt affordability does not seem to be a problem for the corporate
sector, at least not at current levels of interest rates.
Corporate leverage: debt vs. interest payments
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
55 60 65 70 75 80 85 90 95 00 05 10
0
20
40
60
80
100
120
Interest/GVA (LHS)
Debt/GVA (RHS)
Source: Federal Reserve, BEA, SG Cross Asset Research
Yet, despite relatively healthy corporate finances going into the crisis, businesses have spent
the last 5 quarters bullet proofing their balance sheets.
Corporate cash positions are abnormally high. In Q4, the non-financial corporate sector held
5.9% of its assets in cash-like instruments. This is up from 4.4% in late 2008 and the highest
share of cash assets on record. In the immediate aftermath of the credit crunch, it is notsurprising that corporates are hoarding cash. Typically businesses use bank credit lines to
fund their inventory positions and many found their credit lines cut off or reduced following the
financial crisis. They simply do not want to find themselves in the same position again.
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Corporate cash holdings at record high Debt swapping away from short-term
1.0
2.0
3.0
4.0
5.0
6.0
7.0
54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
% of Assets ST FINANCIAL
ASSETS
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
% of Assets
CORPORATE BONDS
BANK LOANS + CP
Source: Federal Reserve, SG Cross Asset Research Source: Federal Reserve, SG Cross Asset Research
Significant changes have also been made on the liability side of corporate balance sheets.
Between Q308 and Q409, nonfinancial businesses reduced their bank loans and commercial
paper outstanding by about $200 bln while increasing corporate debt by $430 bln. This has
reduced their reliance on short-term debt and the vulnerability associated with debt rolls.
While this bullet proofing of corporate
balance sheets is understandable in
the wake of the crisis, we believe that
businesses are now overdoing it. They
are saving too much, and not investing
enough. We draw this conclusion from
the fact that tangible corporate assets
measured at historical costs have
contracted for the first time on record.
This is a result of allowing capex to fall
below depreciation. This means that
corporate America is currently
replacing physical assets with cash.
Putting the pieces of the puzzle
together, we come to the conclusion
that businesses are replacing physical capital with cash. From a micro-standpoint, this is a
potentially self-destructing behavior because it reduces a companys long term earnings
growth potential which is not the best way to maximize shareholder value. For an economy
with positive trend growth (which we still deem to be a very safe assumption for the US), thissituation is abnormal. As businesses gain confidence about the recovery and about their
access to funds, they will be pressured to deploy the abnormally high cash cushions.
Another differentiating factor between households and businesses is income generation which
can go a long way in aiding the de-leveraging process. Whereas personal income growth is
still tentative, the corporate sector has already seen four quarters of very strong cash flow
generation which should continue in 2010. This is adding to the already large pile of corporate
cash which is screaming to be deployed. We see the corporate sector as being in the best
position to resume spending and contribute positively to US domestic demand.
Tangible assets at historical cost
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
USD trillion
TANGIBLE ASSETS AT COST
The first decline on record
Source: Federal Reserve, SG Cross Asset Research
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Small businesses still too much debtSmall business balance sheets look more like those of households, less like corporate
business. The slow recovery in small business activity is being blamed on poor access to
credit, but perhaps there is a reason. Small businesses have entered the crisis with
much more leverage than corporate America. Additionally, their asset base was much
more concentrated in real estate, most of it in residential real estate. The contraction in
asset prices was therefore far more damaging for the small business sector which is in
a much worse position to resume borrowing and spending.
The US small business sector has been a laggard in the recovery cycle. In fact, judging from
the NFIB confidence survey, it has not participated at all in the pickup in economic activity.
This underperformance is generally being attributed to lack of credit. Unlike corporate
America, which was able to turn to the credit markets to contend with tighter bank lending
standards, small businesses did not have that option. Additionally, small regional banks which
are the bloodline of small business loans remain heavily burdened by their commercial real
estate holdings and are not in a position to resume lending. While this is certainly an important
part of the story, we think that there is a more fundamental reason for small business
underperformance.
Unlike corporate America, small businesses entered the crisis in a much more leveraged
position. More importantly, their assets were much more heavily concentrated in real estate
(much of it residential), which made them more vulnerable to the historic price declines in
home prices. As prices declined, the already high leverage positions increased further.
Small business has more leverage and higher asset concentrations in real estate
Debt/Asset Ratio
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
55 60 65 70 75 80 85 90 95 00 05
Non-financial corporates
Non-corporate Business
% of Assets in Real Estate
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
55 60 65 70 75 80 85 90 95 00 05
Non-financial corporates
Non-corporate Business
Source: Federal Reserve, SG Cross Asset Research
In an effort to reduce leverage, small businesses have been shedding debt, but until recently
their efforts were being undermined by further price declines. Debt/asset ratios appear to have
stabilized in Q4, but further debt reduction will likely be needed to restore them to normal
levels.
Another difference between small and large businesses is cash positions. Whereas corporate
America has been generating a lot of cash, and hoarding most of it, small businesses have
sharply reduced their cash positions in recent quarters. This cash-bleed is unprecedented,
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and likely reflects a combination of poor profit performance but also the inability to access
credit which has forced small businesses to dip into their cash cushions for inventory
financing and other working capital needs.
Net changes in cash assetsSmall business sector (non-fin non-corporate)
-100
-80
-60
-40
-20
0
20
40
60
80
100
120
90 92 94 96 98 00 02 04 06 08
USD bln
Net change in cash positions (2 qtr moving average)
Corporate business sector (non-fin)
-200
-100
0
100
200
300
400
90 92 94 96 98 00 02 04 06 08 10
USD bln
Net change in cash positions (2 qtr moving avg)
Source: Federal Reserve, SG Cross Asset Research
Despite the high debt levels in the small business sector, interest payments on debt have
declined substantially in recent quarters. As a share of revenues, interest expense has
dropped from 12.3% in 2007 to 6.2% currently. Though debt reduction and interest rate
declines may explain the increase in debt affordability, the magnitude of the improvement
appears to be disproportionate. One explanation is that small businesses have shifted their
debt to shorter maturities (as their variable rate mortgages reset to Libor). If so, they will be
vulnerable to a reversal of the Feds easing cycle.
Small business leverage: debt vs. Interest payments
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
65 70 75 80 85 90 95 00 05 10
Interest /GVA (LHS)
Debt/GVA (RHS)
Source: Federal Reserve, BEA, SG Cross Asset Research
Though asset prices have likely stabilized, we believe that debt levels in the small business
sector remain too high and will continue to restrain demand for credit from the sector. Supply
remains an issue as well, although the Small Business Administration (SBA) can use stimulus
dollars to support certain small businesses which are in a position to borrow, but cannot get
access to credit. The bottom line, however, is that small businesses remain too leveraged and
too cash strapped to be in a position to resume spending and support economic activity.
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Government picking up where the private sectorleft off While the private sector has been working hard to reduce its debt burden, the US
government has done the opposite. Unfortunately for now, the economy remains
dependent on government stimulus policies and even in recovery it may be vulnerable if
fiscal policy is tightened too quickly. However, the longer term fiscal outlook is a train-
wreck waiting to happen if consolidation programs are not adopted in the next few
years. The risk is that investors move ahead of Congress, forcing another leg of dis-
orderly deleveraging.
Fiscal expansion is always a double-edge sword, particularly the historically large fiscal
stimulus that was put in place following the financial and economic meltdown of 2008. Public
spending was needed to prevent an economic downward spiral, but it came at a big cost.
Currently, the government is financing record debt levels at a very low cost, but the interest
burden is likely to increase substantially as the economy recovers. In addition to cyclical
pressures on interest rates and debt affordability there is the additional risk associated
with a potential demand-supply imbalance in the Treasury market. Issuance will remain
substantial in the coming years, but foreign demand for Treasury debt is in question,
particularly if the government fails to undertake structural fiscal reform in the next few years.
The problem is not current debt but future growth
0
2
4
6
8
10
12
14
16
18
20
22
50 55 60 65 70 75 80 85 90 95 00 05 10
%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Interest/Gov't Budget
Interest/GDP
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
Civil
War
Debts
incurred
during
Revolutio
nary War
WWI
WWII
Depression
spending
War of
1812
SG
Projections
Source: Federal Reserve, BEA, Cross Asset Research
To be sure, debt affordability is not a problem today. The US government is currently financing
its debt at an effective rate of 2.3%, the lowest since the 1950s. This explains why interestexpense as percent of budget or GDP has not changed at all in the past 3 years despite a
sharp increase in debt levels. However, that doesnt mean that it wont change in the future.
First, interest rates are likely to rise from these historically low levels, which alone could
substantially reduce debt affordability. Secondly, the debt level (as percent of GDP) is also
likely to rise in the next few years, particularly if temporary tax cuts are extended beyond their
planned expiration at the end of 2010. As a result, interest expense is almost certain to rise
substantially in the next few years, which raises some concern about downgrade risk.
For ratings agencies, the key metric in evaluating downgrade risk is the share of government
budget that goes toward interest expense. For the US, the Aaa demarcation zone is seen at
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18%, more than double the current level. The US is expected to stay clear of that threshold in
the next three years in all but the most adverse economic scenarios the adverse scenario
involving much larger deficits than are currently projected. Another risk is an interest rate
shock, but it would have to be substantial. Based on current debt projections, the effective
interest rate paid by the government would have to rise by about 250 bps (with 3m Tbills near
3% and a 10yr yield near 6%) in order to trigger the debt affordability threshold.
While we see limited risk of a US sovereign debt downgrade in the next 2-3 years, beyond that
we cannot be so certain. For now, the economy needs public support, but at some point the
government will have to consolidate its finances which may require spending cuts and/or tax
increases. Additionally, the longer term fiscal outlook is a train-wreck waiting to happen if
serious consolidation efforts are not adopted by Congress. Under current law, i.e. without
serious reform of the entitlement program, fiscal finances are set to explode around 2020-
2030. For now, Treasury investors have given the government the benefit of doubt, but it is not
clear how much more time the government can buy. The risk is that investors move ahead of
Congress, forcing another leg of dis-orderly deleveraging.
The impact of entitlements on government debt
-20%
30%
80%
130%
180%
230%
280%
330%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 2030 2050
Path 1: Based on current law (i.e. temporary tax cuts expire)
Path 2: Alternative scenario (tax cuts extended)
2
1
Source: US Treasury, CBO
For a more detailed discussion of the US fiscal outlook, supply and demand, see March 22,
2010 American Themes, US recovery now fiscal consolidation later if there is still time.
Putting it all together Have we really made anyprogress?Though the private sector has done a significant amount of de-leveraging in the past 2
years, the economy as a whole has not made much progress at all. Indeed, it continues
to run a significant savings deficit which is adding further to its national debt.
Depending on what data we use, the US savings imbalance is anywhere between 3% of
GDP (current account) and 6% of GDP (savings-investment approach). As a whole, the
US economy has made little progress toward de-leveraging and re-balancing.
De-leveraging and re-balancing by definition have to go hand in hand. De-leveraging implies
reducing the debt, which can only be done by eliminating the savings-investment deficit. The
other side of that deficit is the current account. Both imply that the US economy as a whole
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26 April 2010 11
remains highly dependent on foreign capital. Foreign willingness to finance this deficit is a key
source of vulnerability for the US economy.
US is still dis-saving!
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
52 57 62 67 72 77 82 87 92 97 02 07
% of GDP
Savings - Investment Imbal ance
Current Account Balance
The difference is a
statistical discrepancy
Source: OECD, Bloomberg, SG Cross Asset Research
So, how much progress have we made? Some, but there is more work to be done. The private
sector has done a lot of work toward reducing its savings-investment imbalance, but the
public sector has undone most of the work. As a result, gross national savings are still falling
short of domestic investment to the tune of 6% of
GDP. Theoretically, this figure should equal the
current account balance, since the savings deficit
has to be financed externally, but statistical
discrepancies can lead to large gaps in these two
measurements. According to the current account,
the US is running a savings deficit of 3% of GDP.
We tend to believe the current account numbers,
because they are reaffirmed by a similar pattern in
foreign capital flows. Even so, the US economy
still has a long way to go toward closing the
savings deficit and stabilizing US external debt.
Savings-investment imbalances by sector
-15
-10
-5
0
5
10
52 57 62 67 72 77 82 87 92 97 02 07
% of GDP
Savigns-Investment Imbalance in the Household Sector
Savigns-Investment Imbalance in the Business Sector
Savings-Investment Imbalance in the Public Sector
Source: OECD, Bloomberg, SG Cross Asset Research
Savings falls faster than investment
0
5
10
15
20
25
78 83 88 93 98 03 08
% of GDP
Gross Domestic InvestmentGross National Savings
Source: SG Cross Asset Research
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In the meantime, the external deficit is the Achilles heel of the US economy because it makes
it vulnerable to disruptions in foreign financing. We learned this the hard way in mid-2007
when foreign purchases of US structured credit assets stopped abruptly and triggered dis-
orderly de-leveraging of the private sector. Prior to the crisis during 2006 and early 2007,
these purchases had financed more than half of the US external deficit. Today, Treasury debt
is playing a similar role, not only by attracting large amounts of foreign capital, but by doing so
despite the very unsustainable fiscal outlook. In 2009, foreigners purchased 36% of net new
supply, or $502 bln. This amounts to 120% of the US current account deficit, suggesting that
the US government is now solely responsible for the entire external deficit. If foreign demand
for Treasury debt were to stop abruptly, similarly to the sub-prime experience of 2007, the
implications for the US economy would be catastrophic.
US capital inflows external deficit now financed largely via Treasuries
6m averages
Forei gn Pri vate Purchases of US Assets Forei gn Offi ci al Purchases of US Assets
-20
-10
0
10
20
30
40
50
60
00 02 04 06 08 10
Treasury
Agency
Corp Bonds
Equity
-15
-10
-5
0
5
10
15
20
25
95 97 99 01 03 05 07 09
Treasury
Agency
Corp Bond
Source: Federal Reserve, BEA, SG Cross Asset Research
ConclusionsOur analysis of sector financials suggests that households and the government have further to
go in terms of boosting their savings and reducing debt levels. Among those two, the
government has a lot more heavy lifting to do. In contrast, the corporate sector appears to be
saving too much and not investing enough.
Financial markets can remain complacent for long periods of time, but sooner or later
investors have a way of forcing necessary adjustments. If there is a second chapter of the
disorderly deleveraging/rebalancing of the US economy, its beginning would likelyoriginate in the Treasury market. This is where investors should look for warning sings.
All sectors of the US economy even the healthy corporate sector have increased their
sensitivity to interest rate increases in the past decade. Any problems in the Treasury market
would substantially increase the debt burden for the entire economy.
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American Themes
26 April 2010 13
SG Forecasts
Economic forecastsAnnual year/year
2008 2009 2010 2011
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 A A E E
Real GDP -6.4 -0.7 2.2 5.9 3.8 3.5 2.9 3.1 0.4 -2.4 3.5 2.9
Real Final Sales -4.1 0.7 1.5 1.9 3.0 3.2 2.9 3.0 0.8 -1.7 2.5 2.9
Consumption 0.6 -0.9 2.8 1.7 2.5 2.9 2.9 3.0 -0.2 -0.6 2.3 2.9
Non-Resid Fixed Investment -39.2 -9.6 -5.9 6.5 6.7 7.7 4.5 6.1 1.6 -17.7 3.8 6.2
Business Structures -43.6 -17.3 -18.4 -13.9 -12.0 -10.0 -10.0 -5.0 10.3 -19.6 -12.6 -2.3
Equipment and Software -36.4 -4.9 1.5 18.2 15.0 15.0 10.0 10.0 -2.6 -16.7 11.6 9.1
Residential -38.2 -23.2 18.9 5.0 10.0 15.0 15.0 15.0 -22.9 -20.4 9.5 11.4
Inventories Chg, % contibut to GDP -2.3 -1.4 0.7 3.8 0.8 0.3 0.0 0.1 -0.3 -0.6 1.0 0.1
Net Trade, % contri but to GDP 2.6 1.7 -0.8 0.3 -0.1 -0.3 -0.3 -0.4 0.7 0.9 -0.3 -0.5
Exports -29.9 -4.1 17.8 22.4 16.0 7.0 7.0 6.5 5.4 -9.6 12.5 6.3Imports -36.4 -14.7 21.3 15.3 14.0 8.0 8.0 8.0 -3.2 -13.9 10.8 8.0
Government Spending -2.6 6.7 2.7 -1.2 2.1 1.7 1.6 1.5 3.1 1.9 1.7 1.6
Federal Govt -4.3 11.4 8.0 0.2 5.3 2.7 2.5 2.2 7.7 5.2 4.0 1.9
State & Local -1.6 3.9 -0.6 -2.0 0.0 1.0 1.0 1.0 0.5 -0.2 0.2 1.3
PCE Deflator -1.5 1.4 2.6 2.7 2.1 -0.7 2.2 2.1 3.3 0.2 1.7 1.5
PCE Core 1.1 2.0 1.2 1.4 0.9 0.9 0.9 1.1 2.4 1.5 1.1 1.1
CPI -2.2 1.9 3.7 2.6 1.6 -0.9 2.6 2.5 3.8 -0.3 1.8 1.8
CPI Core 1.6 2.3 1.5 1.5 0.8 0.9 0.9 1.0 2.3 1.7 1.2 1.1
Unemployment Rate 8.2 9.3 9.6 10.0 9.7 9.5 9.3 9.2 5.2 9.3 9.4 8.6
Personal Income -8.9 3.3 -1.4 3.7 4.5 4.5 4.9 5.1 2.9 -1.7 3.6 4.8
Disposable Personal Income -1.2 7.7 -1.2 4.3 4.5 4.5 4.4 4.6 3.9 1.1 3.9 4.3
Real Disposable Pers. Income 0.2 6.2 -3.6 1.9 2.4 5.2 2.2 2.5 0.5 0.9 2.3 2.7
Savings Rate 3.7 5.4 3.9 4.1 4.9 5.4 5.3 5.3 2.7 4.3 5.2 5.2
Corp Profits 22.8 15.7 50.7 18.8 13.3 13.1 11.4 15.3 -11.8 -4.7 18.2 10.9
Quarterly Annualized Growth Rates
2009 A/ E 2010 E
Source: BEA, SG Cross Asset Research
Rates and FX forecastsCentral Bank Rate Forecasts current 3 mths 6 mths 9 mths 1 yr
US 0.25 0.25 0.25 0.50 1.25
Canada 0.25 0.50 0.75 1.00 2.00
10 year bond yields current 6 mths 1 yr US 3.74 4.25 4.75
Canada 3.72 4.25 5.00
FX rates current 6 mths 1 yr
USD per EUR 1.33 1.30 1.22
USD per GBP 1.54 1.49 1.44
CAD per USD 1.00 0.95 1.01
JPY per USD 93 100 110
Source: SG Cross Asset Research
The US economy is currently
in a key transition period frominventory led growth to
demand led growth.
Inventories have added
substantially to growth in the
past 3 quarters, but we
believe that production is
now roughly realigned with
demand. Questions on
sustainability linger, but so far
all the pieces are falling into
place for a successful
transition.
1. Employment is turning
positive. If continued, this will
support organic
consumption growth without
relying on credit creation
which is likely to be slow in
this cycle.
2. Consumption has gained
momentum since March and
could very well exceed 3% inQ1 and Q2 (upside risk to our
forecasts shown in the table).
Importantly, this acceleration
coincides with a turn in
employment, which supports
sustainability.
3. The capex cycle is also
gaining momentum. Business
have cut spending excessively
during the downturn and are
now in a catch-up mode.
The Fed has remained dovish
until now, but the data should
pressure the Fed to change
its tone. We look for the Fed
to drop the extended
language on April 28 and to
hike in December 2010. 10yr
Treasury yield to rise to
4.50% by year-end.
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American Themes
21 April 20104
SG Proprietary IndicatorsSG Business Cycle Index
-15
-10
-5
0
5
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
-4
-3
-2
-1
0
1
2
3
4
5
6
SG US Business Cycle Index (LHS)
GDP , y/y (RHS)
SG Real-Time Recession Probability Model
Real-time recession pro babities are derived from a regime switching model using the same four co incident inditarors used by NBER cycle
dating co mmittee. These include: employment, real income, real sales (retail + business) and industrial productio n
-
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10
NBER recessions
Modeled Rec. Prob
Probabili ty derived from a probit model b ased on employment, core inflation, ISM index and a li quidity index
Historical Perspective - 6 month ahead probability
SG Fed ModelRate Cut Probability Rate Hike Probability
Latest Probabilities
100%100%97%48%
0%
20%
40%
60%
80%
100%
3M 6M 9M 12M
probability of at least one rate cut within the next 3,
6, 9 and 12 months
0% 0% 0% 0%0%
20%
40%
60%
80%
100%
3M 6M 9M 12M
Probability of at least one rate hike
within the next 3, 6, 9 and 12 months
0%
20%
40%
60%
80%
100%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
rate cutsProbability of at least one rate cut w ithin next 6 months
0%
20%
40%
60%
80%
100%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
rate hikes
Probability of at least one rate hike within next 6 months
Source: SG Economic Research
The US economy has
clearly moved out of a
recession regime, as
demonstrated by our real-
time probability model.
Our US business cycle
index reinforces the call for
a sustained recovery and
suggests limited risks of a
double dip. The index is
pointing to GDP growth
near 4.0%, not too far from
our Q1 forecast for 3.8%
annualized growth.
Our fundamental Fed
probability models have
been showing a somewhat
distorted picture since
policy hit the zero bound
on the overnight rate.
Taylor rule-type equations
currently prescribe a
negative, which is why our
model points to substantial
odds of further rate cuts
and zero odds of rate
hikes. Importantly, the
model does not capture
the effects of quantitative
easing which have
compensated for the
inability to go below zero.
We believe that the Fed will
hike a bit faster than the
model implies in an effort
to keep inflation
expectations well anchored
in light of a ballooning
monetary base.
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American Themes
26 April 2010 15
Rates and Short-term FundingFed Funds Expectations
Real Treasury Yields
A1/P1 Nonfin CP vs. OIS (3m)
Inflation Expectations
Treasury Yield Curve (10y - 2y)
Short Term Funding
ABCP vs. OIS (3m)
Rates
Libor vs. OIS (3m) - Historical and Implied
0.00
0.25
0.50
0.75
1.00
4/10 6/10 8/10 10/10 12/10
%
Latest
Week ago
Month ago
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1/09 4/09 7/09 10/09 1/10 4/10
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
1/09 4/09 7/09 10/09 1/10 4/10
0.0
0.5
1.0
1.5
2.0
2.5
1/09 4/09 7/09 10/09 1/10 4/10
5yr real
10yr real
1.0
1.5
2.0
2.5
3.0
3.5
1/09 4/09 7/09 10/09 1/10 4/10
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1/09 4/09 7/09 10/09 1/10 4/10
10yr breakeven
5yr 5yrs forward
0.0
0.5
1.0
1.5
2.0
2.5
3.03.5
4.0
J an-
07
Apr-
07
J ul-
07
Oct-
07
J an-
08
Apr-
08
J ul-
08
Oct-
08
J an-
09
Apr-
09
J ul-
09
Oct-
09
J an-
10
Apr-
10
J ul-
10
Oct-
10
%
Source: Bloomberg, SG Economic Research
Market expectations forrate hikes are broadly in
line with our own. We look
for the Fed to hike rates
just once this year, in
December. After that, our
own path is somewhat
faster than that implied by
the market. We think that
the Fed, after giving the
market plenty of warning,
will move relatively fast in
2011. We look for a 2.50%target by end of 2011, a
much faster pace of
tightening than in the
previous cycle. The
measured pace of
tightening in 2005-2006 is
though to have contributed
to complacency and the
property bubble.
The Treasury yield curve
remains very steep andoffers very attractive carry
to investors. This positive
carry is keeping a lid on
10yr yields for now, but it
will probably change when
the Fed starts signaling
rate hikes. We see bond
yields moving sideways in
the next few months on the
back of continued carry
trade activity. However,
yields should start movinghigher in the second half
as we get closer to the rate
hike cycle.
Inflation breakevens in the
Treasury market have
largely normalized,
consistent with well-
anchored expectations.
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American Themes
21 April 20106
Credit AvailabilityMortgages & Consumer CreditConforming Mortgage Rate
ABX AAA Tranches
Corporate Credit
Swap Spread (10yr)
HY Spreads(Lehman HY - 10yr Swap)
Inv Grade Corp SpreadDJ Inv Grade CDX Index
Sector CDS Spreads
Fannie/Freddie MBS Spreads
Consumer ABS Spreads
0.40
0.80
1.20
1.60
1/09 4/09 7/09 10/09 1/10 4/10
Fannie/Freddie MBS vs. swap
20
30
40
50
60
70
80
90
100
1/08 4/08 7/08 10/081/09 4/09 7/09 10/09 1/10 4/10
index 2006-1
2006-2
2007-1
2007-2
3.5
4.0
4.5
5.0
5.5
6.0
1/09 4/09 7/09 10/09 1/10 4/10
30yr Fannie MBS
30yr Conforming Mortgage Rate
0
200
400
600
800
1000
1200
1/09 4/09 7/09 10/09 1/10 4/10
bpcredit cards
autos
0
50
100
150
200
250
300
1/09 4/09 7/09 10/09 1/10 4/10
-20
-10
0
10
20
30
40
50
1/09 4/09 7/09 10/09 1/10 4/10
600
800
1000
1200
1400
1600
1800
2000
2200
1/09 4/09 7/09 10/09 1/10 4/10
0
50
100
150
200
250
300
350
400
450
1/09 4/09 7/09 10/09 1/10
Financials
Industrials
Source: Bloomberg, SG Economic Research
Mortgage spreads have
not responded adversely to
the end of the Feds
purchases. This is very
good news, and a reason
why mortgage rates have
remained in the 5%-5.25%
range. These are near-
historic lows that should
support housing
affordability and sales
activity.
The values of sub-primemortgage CDOs have risen
notably in recent weeks.
The rise - to highest levels
since late 2008 - reflects
growing confidence that
the housing recovery will
be sustained beyond the
period of tax incentives.
Corporate credit continues
to perform well. Although
the pace of spreadtightening has slowed in
recent months, the
tightening has continued,
particularly in the high-
yield market. Corporate
default rates have peaked
and profit generation has
been very strong, both
factors supporting the
credit markets.
Importantly, profit growth
is increasingly being drivenby revenues, rather than
cost cutting, which is good
news for sustaining the
cycle. Sustained
employment gains which
would drive consumption
will be the key factor for
risky assets in the coming
months.
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American Themes
26 April 2010 17
FX MonitorDollarMajor Dollar Index
USD/EUR
Carry Trade Index
FX Volatility (G10 avg)
JPY/USD
Carry-to-Risk Ratio
Yield Differ ential
Implied Vol
5
10
15
20
25
30
1/09 4/09 7/09 10/09 1/10 4/10
70
72
74
76
78
80
82
84
86
88
1/09 4/09 7/09 10/09 1/10 4/10
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
99 00 01 02 03 04 05 06 07 08 09 10
%
+/- 1St Dev range
More
attractiv
Less
attractiv
1.0
2.0
3.0
4.0
5.0
6.0
00 01 02 03 04 05 06 07 08 09 10
5
15
25
35
00 01 02 03 04 05 06 07 08 09 10
100
110
120
130
140
150
160
170
1/00 7/00 1/01 7/01 1/02 7/02 1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10
80
85
90
95
100
105
1/09 4/09 7/09 10/09 1/10 4/10
1.1
1.2
1.2
1.3
1.3
1.4
1.4
1.5
1.5
1.6
1/09 4/09 7/09 10/09 1/10 4/10
Source: Bloomberg, SG Economic Research
Since November, the dollar
has rallied substantially
against the Euro. The
Greek debt woes have
been a big driver, but more
fundamentally the US
economy is facing better
cyclical prospects than the
euro area due to pent-up
demand and much better
employment prospects.We see Europe leading the
way on fiscal consolidation
while the Fed moves ahead
of the ECB on monetary
tightening. All else being
equal, these trends should
support further dollar
strength.
The dollar should also
outperform the yen in the
next 12 months given thedivergent paths on growth
and monetary policy. We
see the yen as the next
carry trade funding
currency.
Carry trade activity has
been supported by
declining FX volatility. Rate
differentials have not been
very attractive, but that
should begin to change as
commodity economies
accelerate their tightening
cycles.
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American Themes
21 April 20108
Commodities and EquitiesCrude Oil (Nymex WTI)
Copper
Co nsumer Discretionary 6.7%
Industrials 5.2%
Energy 5.0%
Financials 4.8%
IT 3.6%
Materials 1.3%
Utilities 1.3%
Co nsumer Staples -0.3%
Telecom -2.3%
Health Care -4.2%
VIX
GoldCommodities
Volatili ty Skew(25 delta put - 25 delta call, SPX Index)
Sector Performance - 4 wk chg
Equities
Baltic Dry Index
20
40
60
80
100
1/09 4/09 7/09 10/09 1/10 4/10
500
600
700
800
900
1000
1100
1200
1300
1/09 4/09 7/09 10/09 1/10 4/10
0
10
20
30
40
50
60
1/09 4/09 7/09 10/09 1/10 4/10
0
2
4
6
8
10
12
14
16
18
1/09 4/09 7/09 10/09 1/10 4/10
0
50
100
150
200
250
300
350
400
1/09 4/09 7/09 10/09 1/10 4/10
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1/09 4/09 7/09 10/09 1/10 4/10
Source: Bloomberg, SG Economic Research
Commodities continue to
be supported by the
cyclical outlook, although
the gains may slow in the
near-term as the
manufacturing cycle starts
to lose momentum. The
transition to demand-led
growth, however, should
sustain the upward trend.
Equity markets are moving
ahead of the economy.
Employment gains
evident in the March
payroll report were an
important trigger for
extending the equity rally.
Employment turns have
historically triggered
significant declines in
market volatility (implied
and realized) and that is
precisely what has
occurred in the past
month.
We see equity gains
reinforced by the profits
cycle which should
maintain strong
momentum in the coming
quarters. While revenue
gains will be modest
relative to other recovery
cycles, we see room forsubstantial margin
expansion even with
employment growth.
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American Themes
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