July 21, 2008

By John Reddan, Managing Director

The Perfect U.S. Economic Storm: Asset Deflation, Commodity Inflation and the Expiration of the Greenspan Put.
Goldilocks does not live here anymore. The US economy today is the mirror image of the late 1990s so-called Goldilocks economy which was characterized by low commodity inflation and relatively strong growth. Today, we have high commodity inflation combined with very slow growth. It is the Bad Wolf economy. In the late 1990s, the US economy experienced asset inflation combined with commodity deflation, while today it is experiencing commodity inflation combined with asset deflation. This is a lethal combination for US consumer spending and current high corporate profit margins (Chart 1). It will likely tip the US economy into a recession and erode those record profit margins. Chart 1: Corporate profits before tax as a share of GDP
14.0% 13.0% 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: Bureau of Economic Analysis, Merrill Lynch

US Consumption is unsustainably high. Consumption spiked to more than 70% of GDP from the mid-60% range during the now popped, massive credit and housing bubble during the first half of this decade (Chart 2). Chart 2: Consumer spending as a share of GDP
(percent)
71 70 69 68 67 66 65 64 63 62 61 60 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07

Source: Bureau of Economic Analysis, Merrill Lynch

The US consumers legendary spending prowess has been fueled by record borrowing and declining savings (Charts 3 & 4). Chart 3: Household Debt-to-Income Ratio
(percent)
150 130 2001 = 101% 110 90 70 50 30 52 56 60 1962 = 63% 64 68 72 76 80 84 88 92 96 00 04 08 Peak = 139%

Source: Federal Reserve Board, Merrill Lynch

Chart 4: Personal Saving Rate

(percent)

NIPA Measure
12 10 8 6 4 2 0 -2 85 87 89 91 93 95 97 99 01 03 05 07
Source: Bureau of Economic Analysis, Federal Reserve Board, Merrill Lynch

Now with US house prices falling at an unprecedented rate, banks tightening credit at a record rate, consumer confidence at a multi-decade low and unemployment climbing, the US consumer is facing hurricane-force headwinds (Charts 5,6,7). Chart 5: U.S. House Price Index (Case-Shiller)
U.S. HOUSE PRICE INDEX (CASE-SHILLER) S.A. by ISI Y/Y % Apr -16.3% 25 20 15 10 5 0 -5 -10 -15 -20 88 90 92 94 96 98 00 02 04 06 08

S.A. by ISI Y/Y % Apr-16.3%

Source: ISI Group

Chart 6: Bank Tightening Consumer Loan Approvals

(banks)
25

20

15

10

0 97 98 99 00 01 02 03 04 05 06 07 08

Shaded areas represent period of US recession Source: Federal Reserve Board, Merrill Lynch

Chart 7: University of Michigan Index of Consumer Sentiment

(index level)
115
Asian Crisis Begins

105
Mexico/ Orange County The crash Recession

LTCM/ Russia Tech Wreck

Subprime Collapse

95

Enron World Com 9/11 Iraq War II Katrina

Credit Squeeze

85
Desert Shield

75

65

War I

Iraq

55 Oct Jul Aug Jan Dec Jul Sept Mar Sept Jan Sept Mar Aug Jan Jul Jun 1987 1990 1990 1991 1994 1997 1998 2001 2001 2002 2002 2003 2005 2007 2007 2008
Source: University of Michigan, Merrill Lynch

Consumption as a percent of GDP is likely to correct to the mid-60% range from 70%+. This 3-4 percentage point decline is roughly 1.5-2.0x the 2 percentage point decline in capital spending as percent of GDP that the US economy experienced after the bursting of the Internet bubble early in this decade (Chart 8). Chart 8: Capital spending as a share of GDP
(percent)
9.5 9.3 9.0 8.8 8.5 8.3 8.0 7.8 7.5 7.3 7.0 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Bureau of Economic Analysis, Merrill Lynch

That decline caused a recession. Exports are increasing as a percent of GDP and are a mitigating factor this time (Chart 9). However, it is likely that the admonition dont bet against the US consumer will prove as fallacious as housing prices dont fall.

Chart 9: U.S. Exports

13 12 11 10 9 8 7 6 5 1970 1975 1980

U.S. EXPORTS % NOMINAL GDP 2008:1Q 12.7%

% Nominal GDP 2008: 1Q 12.7%

1985

1990

1995

2000

2005

Source: ISI Group

The Greenspan Put has expired. Since the Feds first rate cuts early last fall, the price of oil has doubled, most major U.S. stock indices have entered into bear markets (down 20% from their highs reached shortly after the first rate cut), banks have continued to sharply curtail lending as their stock prices have plunged amid a continuous stream of losses and capital raisings, and most interest rates are higher while most credit spreads are wider (Chart 10). Chart 10: Spreads
Current PDCF announcement Start of Fed easing cycle (as of Jun. 13, 2008) (March 17, 2008) (September 18, 2007) (option adjusted spread, unless otherwise noted: bps) 302 360 166 309 348 180 264 320 136 283 352 186 639 862 446 121 102 87

ML US Aggregate Bank Spread 5-10 years duration 10-15 years duration ML US BBB Corporate Bond Spread ML US High Yield Bond Spread Jumbo mortgage minus 30-year FRM*

Yields
Current (as of Jun. 13, 2008) ML US Aggregate Bank Rate 5-10 years duration 10-15 years duration ML US BBB Corporate Bond ML US High Yield Bond Jumbo mortgage rate Private Sector Interest Rate** 6.92 7.24 7.16 6.86 10.23 7.53 6.49 PDCF announcement Start of Fed easing cycle (March 17, 2008) (September 18, 2007) (yields, percent) 6.19 5.97 6.45 6.17 6.74 5.97 6.34 6.25 11.12 8.76 6.70 7.18 6.39 6.87

*30-year fixed mortgage rate is weekly data (not option adjusted spread) ** An equal weighting of jumbo mortgage rates, new car loan rate, home equity loan rate, 5-year ARM, 3month LIBOR rate, high yield bond rate, and bank rate (5-10 year duration) Source: Bloomberg, Haver Analytics, Merrill Lynch

Ever since the announcement of the Primary Dealer Credit Facility (PDCF) in response to the collapse of Bear Stearns in March of this year, yields have trended higher. Although credit spreads are modestly narrower, they remain wider than they were at the time of the first rate cut. In short, the rate cuts have backfired. They have not helped the financial system. They have contributed to a doubling of oil prices which has acted as a massive tax hike on the US and the world economy and has brought the auto, airline, and trucking industries to their respective knees (Chart 11). Chart 11:
150 135 120 105 90 75 60 45 30 15 0 01 02 03 04 05 06 07 08

Crude Oil
($ per barrel)

*University of Michigan 5-10 year median inflation expectations; **Price of crude oil Source: Bloomberg, University of Michigan, Merrill Lynch

Instead of inflating the stock market by cutting rates, the Feds actions sharply expanded the commodity bubble which has had deleterious effects on the US economy and financial markets. There is more pain to come in the financial system. To date, we have experienced real estates effect on the economy and the financial system. Now we are about to experience the economys effect on real estate and the financial system. The first wave washed out the speculators, the unscrupulous and the over-leveraged. As gas and heating oil prices soar and unemployment rises, more prudent consumers are falling behind or defaulting on auto and credit card loans as well as HELOCs (home equity line of credit) and mortgages. The CEO of American Express said recently that credit indicators continue to weaken beyond their expectations. Although it is likely due for a technical bounce, the 7

continuing plunge in the Bank Stock Index (BKX) seems to bear this out. Despite the unprecedented actions of the Fed (front loading an aggressive 325 basis points of rate cuts and instituting the PDCF), the BKX has plunged below its March lows. This is an historic anomaly (Chart 12).
BANK STOCK INDEX (WEEKLY DATA) Chart 12: Bank Stock Index (Weekly Data)
110

100

90

80

70

60

ISI Group Inc. - Technical Analysis Research 50 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Cycle of Avg. Financial Crisis

BSC Failure/Current

In past crises, the Bank Stock Index has never failed to respond to aggressive Fed actions (Chart 13). Hence this price action signals the end of the Greenspan Put.
BANK STOCK INDEX RETURNS (Weekly data) Chart 13: Bank Stock Index Returns (Weekly data) -8wk -4wk +4wk +8wk +13wk (3m) -23.6% -21.8% -20.6% -1.5% 23.8% -8.3% 5.2% 1.5% 5.5% 10.9% -24.4% -1.7% 25.0% 20.2% 13.7% 6.3% 2.0% 7.5% 11.8% 9.5% -6.5% -2.4% -14.9% -14.9% -2.5% -24.0% -8.7% 10.3% 26.4% 22.8% -30.0% -8.5% 4.4% 16.4% 18.9% -15.8% -14.5% -5.1% -2.3% 1.9% 9.1% 5.6% 10.9% 2.5% 5.2% 13.9% 12.2% -13.5% +26wk (6m) 6.3% 8.0% 30.7% 1.7% 7.6% 52.4% 27.1% 19.1% 21.3% -25.6%* *16 weeks

3/3/1933 6/19/1970 10/4/1974 5/2/1980 5/18/1984 10/26/1990 9/25/1998

1933 Bank Holiday Penn Central Bankruptcy Franklin National Insolvency First Penn Assistance Continental Ill. Assistance S&L Crisis & CCI low LTCM Average Average (ex. 1933)

3/14/2008

BSC merger (announced)

-0.7% -12.0%

Source: ISI Group Inc. - Technical Analysis Research

Operation Barn Door Closing will likely be a further impediment to a financial system recovery. A predictable outcome of any financial crisis is for regulators, politicians and companies to prohibit practices and policies that contributed to the crisis, to close the barn door after the horse is out. For example, Wachovia Corp. recently announced that it would discontinue Option-Arm Mortgages, the key product of Golden West Financial, which Wachovia acquired in a now disastrous $25B acquisition just two years ago at the peak of the housing bubble. Similarly, banks came into this credit crunch with historically low levels of reserves as regulators responding to the accounting scandals of the Internet bubble forced the banks to do away with cookie jar reserves and the asset appreciation of the recent housing and credit bubble artificially suppressed credit problems. Now regulators are pushing banks to increase reserves as delinquencies accelerate. Reserves to loans peaked at 2.50% during the commercial real estate bust in the early 1990s. They are a little over 1.50% today (chart 14). Chart 14: Allowance for Loan Losses as a Percentage of Loans

Allowance for Loan Losses as a Percentage of Loans

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%
1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 Q1 2008
Source: Federal Reserve data, ISI Accounting & Tax Group Research

The Financial Accounting Standards Board (FASB) is also proposing securitization accounting changes (FAS 140) that will force consolidation of special purpose entities, conduits and SIVs. This will force banks to raise more capital or sell-off more assets. For example, if the rule were in effect at the end of the first quarter, Citibank would have had to consolidate $1 trillion of additional assets! Finally, the elimination of pooling of interest accounting makes it much more difficult for good banks to acquire bad banks. 9

Purchase accounting forces the write-down of the bad banks assets. This reduces tangible equity and capital ratios and may require the acquirer to raise more capital. High developing country inflation threatens the world currency regime. Particularly since the Asian Financial Crisis of the late-1990s, many countries throughout Asia and the Middle East fixed their currencies to the dollar and followed Mercantilist economic policies in order to build-up foreign exchange reserves to prevent a repeat of the catastrophic devaluations and defaults that wracked the region. These reserves were channeled back into the US as shown by the substantial increase in foreign official holdings of US Government securities (chart 15). Chart 15: Foreign Official Holdings of U.S. Govt Securities at the Fed FOREIGN OFFICIAL HOLDINGS
OF U.S. GOVT SECURITIES AT THE FED Jul 2 $2345.7 2500

Jul 2 $2345.7

2000

1500

1000

500

0 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
Source: ISI Group

However, the recent US Federal Reserve rate cuts since the bursting of the housing/credit bubble threaten to undermine this so-called Bretton Woods-2 monetary regime. Asian and Middle Eastern countries have continued to print their currencies to maintain their peg to the dollar even though their economies are booming (Chart 16).

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Chart 16: M1- Money Supply

(year-over-year % change)
80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 Saudia Arabia Singapore India China Pakistan Malay sia Hong Kong Thailand Phillipines 29.0 20.5 17.9 16.2 72.2

15.6

14.8 8.6 8.1

*Latest monthly data available from Bloomberg Source: Bloomberg, Merrill Lynch

Negative real interest rates combined with strong growth have ignited high-to-virulent inflation throughout the developing world (Chart 17). Chart 17: Consumer Price Inflation
(year-over-year % change)
30.0 25.2 25.0

20.0 15.1 15.0 10.5 10.0 10.4 9.1

7.7 6.0 5.0 4.2

5.0

0.0 Vietnam Russia Saudi Arabia Indonesia Argentina China India Mex ico USA

*Latest monthly data available from Bloomberg Source: Bloomberg, Merrill Lynch

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It seems as though these countries have no choice, but to loosen or break their dollar pegs in order to prevent destabilizing inflation. This could potentially end the ultra-low interest rates the US has enjoyed over the past decade. What will break oils rise? It is likely that a significant and sustained global economic slowdown will be necessary to break the price of oil as supply constraints have resulted in a muted response to the rapid run-up in prices and developing country subsidies have prevented the rationing of demand. Despite declining OECD demand, spare capacity is a still tight 2-3 million barrels per day in an 85mm barrel per day market. The significant decline in many emerging stock markets this year may be forecasting such an economic slowdown (Chart 18). Chart 18:
6500 6000 5500 5000 4500 4000 3500 3000 2500 2000 1500 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08
WTI Crude Oil ($/barrel, lagged 7 months, RHS) r = 0.95

150 140 130 120 110 100 90

Shanghai Composite Index (index level, LHS)

80 70 60

Source: Bloomberg, Merrill Lynch

A sizeable decline in the price of oil would act as a tax cut and help stabilize the US and world economies, but it may only come at the cost of significantly slower world growth, which would undermine US export growth.

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Conclusion While the US seems to have skirted an official recession for the time being, due in part to the one-time boost from the recent income tax rebates, it faces extraordinary challenges. These include a doubling of oil prices, a broken financial system still reeling from a credit and housing bust, and an over-leveraged, savings-short consumer that has no choice but to cut-back spending. It is quite possible that the worst is still to come as the lagged impact of higher oil prices and the absence of tax rebates could make this winter particularly difficult. The traditional monetary response of cutting rates has backfired by contributing to the run-up in oil prices. Financial services and consumer discretionary stocks should continue to under-perform. Companies with strong balance sheets, non-cyclical businesses and strong free cash flows that can fund dividends and/or share repurchases should do relatively well.

Epoch Investment Partners, Inc. NEW YORK 640 Fifth Avenue, 18th Floor New York, NY 10019 Main: 212-303-7200 Fax: 212-202-4948 www.eipny.com

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