Quite contrasting Industrial Production data for July was released in the
US and Brazil this morning. The US data rose by a stronger than expected
2.4% (consensus was 2.0%) while June's contraction was trimmed to -0.4%
from the original -0.8%. This combination keeps US Industrial Production
moving higher by approximately 14% YoY and shows this measure continuing
to fill in the deep drawdown that occurred during the 2008/9 collapse of
industrial activity. Today's data throws another questioning glance at the
consensus view that a material slowdown in US industrial activity took
place earlier this summer, although tomorrow's ISM report will undoubtedly
have the final say on this matter.

Meanwhile in Brazil the growth of Industrial Production does appear to have
moderated significantly in 2011. July saw a modest contraction of -0.3% in
the seasonally adjusted data. We never read too much into single monthly
reports particularly for Industrial Production data, which (apart from
China's suspiciously inert reports) tend to fluctuate markedly from month
to month. However, in Brazil's case this is the latest in a string of
tepid reports that have taken the YoY change down to 1.33%. We would
suggest that this figure is much lower than most foreign investors in this
country would imagine, and certainly clashes with the image of rampant
economic growth that so many investors seek to benefit from. Put in this
light, the radical under-performance of Brazilian equities compared to their US
counterparts in recent months becomes a little easier to understand. -
M-TMNOTOT_Index.gif - M-BZIPTLSA_Index.gif -

The Chicago PMI report for August came in somewhat better than expected at 56.5
compared to consensus of 53.3. This is still a modest drop from July's 58.8 but
not one suggestive that any significant change has occurred in the Chicago
region's industrial sector. As the attached chart shows a reading of 56.5 is
typical for the middle of an expansionary period and certainly well above the
readings seen in either a recession (pink areas on chart) or the build up
towards one.

The sub-indexes confirm the overall data. New Orders (red) fell slightly to
56.9, but are still comfortably positive, as was Production (blue) at 57.8.
Inventories (green) nudged higher to 52.9, which shows only a gradual rebuild
underway. Employment (pink) was flat at 52.1 confirming that no acceleration in
the pace of hiring is underway.

Should tomorrow's nation ISM data look anything like the Chicago PMI this would
represent a major upside surprise to the consensus call for a 48.5 reading,
which strikes us as too low given other data released in recent weeks. -
chicagopmiaug11.gif

The burst of monthly payroll data got underway this morning with the
release of Challenger Job Cuts and ADP Payroll Data. The headlines show
Challenger Job Cuts rising 47% YoY, but this is really a reflection of how
low the data fell in 2010 when companies had simply run out of employees
to fire. August's total job cuts reached 51,100 which as the attached
chart shows, is still a very low level. Challenger Cuts of 50K have previously
been associated with Initial Claims in the 300 - 325K range, far lower than the
current 400K rate. Thus it is fair to say that new lay-offs are not a
source of stress for US employment data at the current time, it is far
more a failure of corporations to re-hire aggressively that is keeping the
improvement of employment data from accelerating in the manner we would
have hoped to see.

The ADP Payroll data confirms this with August's print of 91K falling
slightly below the 100K consensus (but well within the error tolerance of
this data). This takes the 6 month ma down to 127K which still is
equivalent to the level recorded in Q1 2004. This of course gives us no
insight as to what the BLS data will show on Friday since although the two
series follow closely in terms of trend, the monthly variations can be
significant (see chart). The consensus target of 100K for Private Sector
payrolls seems a reasonable enough guess but we would not be shocked or draw
any conclusions should we see data fall 50K either side of this figure. Our
view remains that employment growth is sufficient to allow the US consumer
to continue its steady improvement in retail purchases, which is a key
underpinning for the US recovery that is very much still in place. -
D-CHALTOTL_Index.gif - D-ADP_CHNG_Index.gif -

Link: http://www.federalreserve.gov/monetarypolicy/fomcminutes20110809.htm

The August 9th minutes provide the background for the somewhat strange decision
to use a specific time frame as a guide for FRB interest rate policy. Reading
through the long minutes (the first 5 Bloomberg © screens consist of the names
and titles 61 participants, assuming we counted them correctly) one gets a
strong sense that this was a classic case of a committee consensus being
reached around the "least worst" alternative.

The only surprising thing about the August Conference Board Consumer Confidence
report was that consensus estimates had only been trimmed to 52 from last
month's reading of 59.5. The University of Michigan poll had already shown a
much greater decline in sentiment earlier this month and this was reflected in
this morning's Conference Board print of 44.5. Thus although the headlines will
show this to be a large shortfall versus consensus it is really a repeat of two
week old news and a reflection of the conservatism of economic research (which
is true in both directions).

Clearly consumer sentiment has been deeply damaged in recent weeks, but this is
much more correlated to investment decisions and political choices than it is
to retail activity. We have seen no evidence of a collapse in the latter over
the last 6 weeks (although the East Coast hurricane may disrupt some August
sales) and we do not expect to see one going forwards. As to the data itself,
there is also nothing historically abnormal about a collapse in sentiment
roughly 2 years into a recovery (see Q4 1993 for instance). Given the daily
diet of depressing headlines and deep losses in equity portfolios (although
these will have largely come from US financial and non-US equity exposure) it
would have been highly surprising to see sentiment hold up. Again it should be
noted that it is Future Expectations (green) which saw the brunt of the decline
in this month's poll falling from 74.9 to 51.9. The Current Condition index
(blue) never really recovered from its 2009 nadir (we have described this
"recovery denial" a number of times before) and dropped far more moderately
from 35.70 to 33.30, indicating that consumers' are depressed regarding the
future rather than actually sensing a deterioration of current conditions. -
consumerconfaug11.gif

Interview with Bloomberg TV August 29th 2011.

Link for non Bloomberg users:

http://www.bloomberg.com/video/74541293/

US Pending Home sales were reported to have dropped -1.3% in July compared
to consensus estimates of a -1.0% drop. This minor shortfall has generated
a number of stories suggesting that the US housing market may once more be
slowing, but looking at the data a little closer it is hard to make any
conclusion from such a minor deviance in estimated activity.

Attached is the monthly chart of the overall index (2001 = 100) which shows
that the swing in monthly data is a fraction of recent volatility. Using the 6
month ma we see that Pending Sales remain flat around the 88 level (July's
reading was 89.7). A more accurate description of today's data would be the
latest in a string of data that shows the overall US housing market continues
to bumble along at the level of activity seen in the late 1990's. We would
agree that this represents a slow pace of activity but not a DETERIORATING one,
which is an important distinction to make. Although we do not see the housing
market boosting aggregate US economic activity in the near term we do not
see it hurting either. - D-USPHTOTL_Index.gif -

We have spent much of the last few weeks arguing that too much attention
is being focused on the state of the US economy ("good enough for
corporate earnings" is our opinion) and not enough on Europe's woes. While
this may be the case at the level of media and professional commentary,
global equity markets have been somewhat more discerning. Consider for
instance the differing performance of Germany's DAX index and the NDX
index since the start of the correction. The former was one of the
favorite developed markets at the start of the year with the strength of
the local German economy added to the powerful export drive of its
industrial companies (particularly to EM countries) and yet it has
radically underperformed the NDX index, which represents 100 large
non-financial issues 93% of which are US based (by market cap). In fact
as of Friday's close the NDX was down a mere 2.5% YTD compared to a drop
of 20.2% by the DAX. We are surprised that this performance gap has not
resulted in a greater level of appreciation for the NDX but we suspect
that should it continue it will not remain a secret for much longer.

In any case we believe that the danger of a US slowdown is overstated at
present, while the problems surrounding liquidity within the Eurozone are
all too real. Thus while global markets may be temporarily calmed by the
sensible comments of Chairman Bernanke at Jackson Hole, these had no effect
on a solution to the Europe's problems. It is the ECB that now needs to
show imagination and leadership that has really been absent for much of
the 12 years of its existence. - D-NDX_Index.gif -

Chairman Bernanke's speech at Jackson Hole came as a disappointment to
those looking for the announcement of a new bout of quantitative easing
although as we argued in yesterday's Weekly Speculator the FRB is already
running an extremely loose monetary policy that has created very favorable
liquidity and interest rate conditions within the US economy. While
through much of QE2 liquidity simply pooled on the balance sheet of the
FRB, in recent weeks we have seen a very sharp increase in monetary
aggregates in the wider economy. Both M1 and M2 have risen at near record
pace over the last 13 weeks and as a result their YoY increases are 19.9%
and 10.12% respectively (see attached chart of M2). While the source of
this monetary surge may partly be from a liquidation of financial assets (which
show up as a surge in bank deposits) it has been accompanied by actual credit
creation in the key areas of consumer credit and C&I lending, both of which
have now expanded on a YoY basis.

As for interest rates, the attached chart of the US LIBOR curve (as priced
in by the Euro$ futures) shows the extent to which they have moderated across
the US yield curve. On the day that Bernanke spoke at Jackson Hole last year
LIBOR in December 2012 was expected to be 1.70% (corresponding to a FDTR of
approximately 1.50%), compared to 0.90% when QE2 commenced and 0.52% today
(following the recent FOMC commitment to keep the FDTR static until mid 2013).
June 2013 has seen the implied rate decline from 2.04% in August 2010 to 0.63%
today. Chairman Bernanke is therefore entitled to believe that monetary
stimulus within the US funding zone is already sufficient to enable a continued
recovery. The fact that this may be happening slower than many would wish to
see is a source for regret, but not for recrimination at the activism of the
FRB, which if anything has erred on the side of excess.

If we have any criticism of the speech it is that instead of focusing his
ire on the political process in Congress (as justified as this may be), he
remained silent about the stunning failure of the ECB to follow in his
path. If Bernanke believes that the FRB is following a suitable monetary
policy following a financial crisis then this implies that in his
judgement the ECB is not. Clearly the etiquette of Central Banking (and
Bernanke's own sense of decency) prevented any public pronouncement of
this nature. Ironically it should be remembered that many central bankers
in the emerging market complex were much less reticent in criticizing QE2 in
the impolitest terms when it was launched in late 2010.

From our perspective we are pleased to put Jackson Hole and a potential
launch of QE3 behind us, since this has been a distraction from what we
view to be the core problems besetting global asset markets, namely a
liquidity crunch within the Eurozone and clear signs of deterioration
within the emerging market complex. - W-M2_Index.gif - eurocurve82611.gif

We have been following India's SENSEX index since it peaked last November,
at which time it represented the most popular destination (as measured by
our unscientific monitoring of media and professional commentary) for
global equity investments. It should be remembered that emerging market
equities were expected to be primary beneficiaries of QE2 and significant
flows were directed towards them between Bernanke's Jackson Hole speech in
late August and the launch of QE2 in early November. In India's case the
official measurement of foreign institutional investment showed
approximately $18 bln being invested in that 10 week period, by some
distance the fastest flows on record (see lower chart).

As we had expected, 2011 has proved to be a much more difficult period for the
Indian market which started its decline somewhat earlier than the rest of the
EM complex. Although the fact that it had already declined sharply from its
peak served to shield it from the first wave of losses in early August,
recent sessions have seen the SENSEX probe steadily lower. This morning's
close at 15,848 is the lowest weekly close since September 2009 and takes
the index below its 200 week ma for the first time since the collapse of
late 2008. Although there is still some support between the current price
level and 15,000, the danger is growing that the SENSEX will experience a
further sharp decline, which would bring our long standing "deep support"
target on 12700 - 13500 into play. Although this may seem to be an
aggressive target it should be noted that the sharp declines registered
this year have not yet led to substantial foreign outflows. Official data
shows them to have fallen to -$178mln in recent days from a peak of $2,300
mln in late July. Given that 2009 and 2010 total flows were $18,000 mln
and $29,300 mln respectively and the vast majority of these flows will now
be carrying losses, it would not be surprising to see a more aggressive
liquidation take place in the event that support is breached. -
W-SENSEX_Index.gif -

One of the notable things about the deep correction within the emerging market
complex is how little internal or external angst it has generated. We have seen
a significant volume of sell side upgrades generated by the drop in prices and
our sense is that most see this episode as a blip on the road to long term
prosperity. To the extent that observers have concerns, these are directed
towards the effect of weak US or European growth on export industries. Absent
is the sense that the internal economies in many countries may be experiencing
an abrupt deceleration typical of the end to a long expansionary period.

Consider for instance the reaction of Brazilian consumer confidence to the
sharp drop in the local IBOV index (down 22.5% YTD as of last night). August's
consumer confidence report showed a confidence drop to 118.7 from July's all
time high of 124.4, which keeps the index at a very elevated level.
Interestingly the response of confidence to a declining market was much sharper
back in 2008 when confidence fell to 105.30 in July. 3 years later consumers
have become accustomed to global volatility and have learned to either ignore
it or embrace it as a buying opportunity.

This situation may sound familiar to US readers, since it is very reminiscent
of the state of affairs in the summer of 2000. Attached is a chart of the
University of Michigan Sentiment index together with the NDX index for the
period leading up to and following the 2000 peak. As can be seen, although the
NDX made its high in March, it was only in December 2000 that confidence really
started to crack, by which time the NDX had already fallen by approximately
50%. We do not believe that the IBOV is anything like as overvalued as the NDX
was in 2000, but the pattern of denial is a key similarity that suggests that
the August low will not mark the end of what we consider to be a bear market
that is already 12 months old. - brazilconfidence.gif - ndxconfidence2000.gif

US Initial Jobless Claims rose by 5K to 417K last week, somewhat above
consensus estimates of 405K, while last week's data was revised slightly
higher at 412K. However, it would appear that claims are being boosted by
the ongoing Verizon dispute, which the BLS estimates caused 12.5K of
filings last week and 8.5K this week. Backing this out of the data leaves
claims close to the 400K level where they have settled over the course of
the summer. We do not expect to see much change prior to the Labor Day
holiday but we will be very interested to see the extent to which the
normal seasonal patterns of US employment are followed in the virtual
absence of a home building industry this cycle. At present employment
seems to be stable rather than deteriorating which is somewhat better than
much commentary supposes. - D-INJCJC4_Index.gif -

July's loan data for Brazil shows that credit continues to be being freely
granted but that delinquency levels are starting to send a clear signal
that distress is building within the consumer sector. Total Private Sector
Loans grew by 10 bln (0.9%) to 1,072, which keeps the annual RoC at a
little over 20%. The 3 month RoC is building a little slower at 16.5%
indicating that a moderate slowdown in lending activity may have started
to take place. Unsurprisingly mortgage credit issuance continues to
dominate, growing 3.49% in July to a new record of 173.3 bln, an increase
of 49.2% over the last 12 months. Industrial and Personal sector credit
grew substantially less at 0.68% and 0.86% for July, showing the degree to
which mortgage credit has started to dominate credit growth in Brazil. None of
this data suggests that bank credit has started to be substantially curtailed
by the multiple tightening moves made by the local central bank.

What is more troubling is the fact that delinquency metrics continued to
deteriorate, suggesting that the quality of local underwriting has started
to be substantially compromised. Total Personal Sector loans in default
(i.e.: more than 90 days overdue) rose to 6.6% in July (6 month ma moved up
to 6.2%), the highest level since May 2010. Loans that are classified as
"delinquent" (30 to 90 days late) have moved even more quickly reaching
13.5% in July (blue line). This is a clear indication that a substantial
portion of Brazilian consumers are starting to become stretched by their
attempt to service debt. It is starting to seem increasingly clear that
Brazil faces a default cycle of some magnitude in the months ahead and
that the sharp drop in local bank equity prices in recent weeks is largely
warranted by the increased risk for local lending activity. -
D-BZLNPTOT_Index.gif - D-BRCDDEFT_Index.gif -

US New Home Sales came in pretty much as expected, with another extremely
low level of volume being recorded. Total sales were estimated at 298K,
virtually unchanged from June's level of 300K (revised down from 312K) and
a little below the consensus estimate of 310K. The non-seasonally adjusted
single month sales were 27K, again showing no fluctuation from the prior
month. Inventory continues to creep lower at 165K or 6.6 months of sales
at their current depressed volume. With summer now drawing to a close
there is little other than a "seasonally adjusted bounce" to expect prior
to next spring's selling season at least as far as national sales are
concerned. The only comfort to be taken is that this comes as little
surprise to any observer, and for the home building industry itself the
stronger players have managed to adapt to the current subsidence-level
activity. - D-NHSLNFS.gif -

Several months ago we commented on the unusually positive readings being
registered in the ZEW Current Conditions Survey (which monitors Investor
sentiment towards Economic Conditions within Germany) and explained that
this was a clear danger sign for the DAX index based on the prior history
of this series. It therefore came as little surprise to us that Germany's
DAX index has been at the forefront of the current liquidation or that the
index's total decline for 2011 is now over 20%, or approximately double
that of the SPX index. August's poll showed that the collapse in equities
has put a sizeable dent in the ECONOMIC assessments of investors, with the
ZEW survey falling by 37.1 points (its largest ever one month fall) to
53.5, the lowest reading since August 2010. As the attached chart shows
this sharp decline has blown the froth off this index but still leads it
at a historically elevated level (unlike US consumer confidence which hit
a 30 year low this month). Given that sentiment tends to have its own
momentum the likelihood of further significant decline in subsequent
months is fairly high (although we would allow for some volatility given
the abruptness of this month's fall), and this has fairly troubling
implications for the local equity market given the broad correlation
between equities and sentiment (the former leads the latter in both
directions). It is our belief that the DAX has begun a prolonged period of
underperformance versus the US equity market, with the sizeable difference
in the YTD performance marking a change in their relative fortunes. -
M-DAX_Index.gif -

The Chicago Fed National activity survey is the sort of minor report that we
typically observe and discard without comment in the monthly data cycle,
particularly in a month like July when the index indicates little change
visible in the US economy.

However these are hardly normal times with investors fretting over and
professional observers cutting estimates of US growth aggressively in recent
days. We sense that last week's Philly Fed report was something of a breaking
point for many, and we would grant that it was an extremely poor report, but
hardly one that itself represented killer evidence that a sustained down-shift
in activity is taking place. Today's Chicago Fed report (which we would class
in the same tier as the Philly Fed in terms of pedigree) shows no obvious
deterioration, and is not exhibiting the decline seen at the start of prior
recessions (see chart). This in itself proves nothing, but it is a useful
reminder that the data has actually been quite two-sided in recent weeks,
despite the increasingly negative spin being placed on it by the media and Wall
Street commentary.

Our view remains that a lack of Euro-zone liquidity is the key issue troubling
capital markets today, and behind that increasing evidence of a slow down in
emerging markets. Although most who have noticed the latter blame it on a lack
of US demand we note that it has been internal domestic issues (housing, retail
sales, automobile demand and credit quality) that have unhinged local capital
markets. It should be understood that the greatest risk to global growth
emanates outside these shores. The US recovery may be slow and fitful but it
still appears to be intact.

One of the open questions worrying the marketplace is the current state of the
US economy. Although most data has actually been fairly steady in recent months
(provided at least 3 months of data is used to smooth for noise) there have
been some troubling reports coming out of the industrial sector, including
today's Philadelphia Fed survey. Our hope would be that the bulk of the
weakness seen in such reports comes from the after effect of the Federal Debt
ceiling fracas. This certainly had a significant effect on Federal contracts
during July and the early part of August as programs were put on hold in
preparation for a prolonged impasse. While some permanent damage may accrue
from this process the vast majority of this shortfall will be made up for in
the coming weeks.

In the meantime it pays to look for other metrics that typically usher in a
period of weakness. One is retail sales which have apparently remained intact
through the start of August. The success of the important "back to school"
season will once more be very important. Other data to watch will be hard
measurements of activity, such as the weekly rail shipment data which came out
this morning. As the attached chart of Intermodal Car Loads (which is sensitive
to Finished Goods shipped rather than commodities) shows, there is no sign of a
sudden dip in goods being shipped in the current data. The August 13th report
was in line with seasonal expectations and rail shipments continue to show a
moderate level of growth over the first half of the year.

US Existing Home sales for July dropped slightly to 4.67mm units, missing
consensus estimates of 4.90mm. About a third of this shortfall was made up
for by a positive revision to June's data which has been raised to 4.84mm
from the original reading of 4.77mm. Single Family Sales fell to 4.12mm
units (see chart) which took the 6 month ma slightly lower to 4.29mm.
Total Inventory was once more steady at 3.05mm units while the Average
Price of homes sold fluctuated by a negligible -0.7%. This is therefore an
unremarkable report that suggests that the summer continues to see the
existing home market bouncing around close to its cycle lows (ignoring the
artificial crash following the expiration of tax credits). As we have
argued before, although this may make for dull viewing, the long term
recovery of US housing does not require more than a continuation of current
activity. Provided delinquency metrics continue to improve at their
current pace (see last week's note on NY Fed data) even the current level
of sales should eventually lead to a significant drop in home inventory.
In the meantime, the collapse in long dated yields has once more driven the
30 year GSE mortgage rate to a new record low of 4.19%, pushing home
affordability to a new modern day record for those who qualify for a loan.

Although we do not view the monthly Philly Fed data as one of the more
important or reliable metrics on the monthly calendar, the extremely weak data
contained in August's report certainly gives pause for thought. The headline
index came in at -30.7, the sort of reading one would associate with a deep
recession and far worse than consensus expectations. To give some perspective,
the current reading is close to that of March 2009 and even though direct
comparisons of levels in a diffusion index are not possible, a reading below -30
signals a broad contraction of activity even if the DEPTH and DURATION of this
contraction is open to question. Weakness was seen in the various sub-indexes
with New Orders dropping sharply to -26.80 (from 0.10) and Shipments to -13.90
(4.30). Inventory moved back into draw-down at -9.30 and Employment turned
moderately negative at -5.2 (8.90).

Unlike the ISM (which highlighted very weak Federal government demand in July)
the Philadelphia Fed does not go into details as to the cause of the sudden
shortfall. Although some individual company reports have pointed to a drop of
end-demand in late July, we have not seen any other data which would support the
sort of decline demonstrated in this report. Clearly the current fragile
market-place will not simply sit around and wait for confirmation or refutation
and the Philly Fed report will help feed the negative sentiment currently
driving prices lower. - phillyfedaug11.gif

Initial Claims data showed a modest deterioration this week with claims
moving back up to 408K from 399K last week (revised up from 395K). While
this move is not statistically significant, any miss in key data
will be poorly received by the current market. More patient observers
track the 4 week ma of claims and this actually fell to 402K, a level that
undermines the notion that the employment situation in the US has worsened
in recent months. What remains missing is the impetus to push claims
substantially below the 400K level, and this is required if job
growth is to become a meaningful factor to the current recovery. The key
period is likely to be the weeks following Labor Day at which time the
seasonal adjustment process should start to favor the headline data. For
the remaining weeks of August we do not expect to see a substantial shift
in data, but would expect readings coming in close to the current 4 week
ma. - D-INJCJC4_Index.gif -

Although it is another volatile session there is little in either the news
flow or market action that warrants special attention today and so we will
take this opportunity to re-iterate our belief that one of the major
causes of current asset market weakness is monetary tightness within the
Eurozone. Previously we have demonstrated this using the relative changes
of the FRB and ECB balance sheets but it also makes sense to go one step
beyond this and look at the pace of money supply growth in the actual
economy. Attached is a chart that compares US M2 Annual growth to that of
the ECB (note the ECB data goes back to before the actual creation of the
Euro). As can be seen in the US M2 has finally started to be created at
the sort of pace typically seen during a strong recovery. This does not in
itself guarantee that a strong recovery will take place, but it does
suggest that ample liquidity is in place and that some of the FRB's
largesse is finally seeping out of its own balance sheet and into the
wider economy.

In the Euro-zone however M2 growth remains pathetically low at 2.4%. This
may be an improvement over the crisis low of 1.2% seen in April 2010 but
it is still a historically very depressed level of monetary growth. This
suggests that local liquidity may be an encumbrance to local economic
activity and certainly has put a strain on local asset markets. To an
extent very low interest rates can ameliorate some of this damage but
certainly not all, especially after the implementation of 50bp of hikes
earlier in 2011.

The real story however is the relative position of these tow areas. At
5.8% the spread between US and ECB M2 growth is the widest it has been
since at least 1981 (when the ECB data starts). This represents a very
considerable handicap for European asset markets compared to their US
brethren. It is therefore no surprise to see much better relative
performance thus far in 2011 by US equity and credit markets compared to
European equivalents. It also helps explain the inability of the USD to
take advantage of the Euro-zone's woes and mount a decent rally since the
supply of new USD liquidity even after the end of QE2 is comfortably
outpacing that of the Euro-zone.

As we had expected, the Building Permit and Housing Start data showed no
sign of improvement in July with the extremely low level of construction
activity remaining in place for yet another month. Housing starts came in
at 604K and Building Permits at 597K, both close enough to consensus to be
considered in line and both effectively unchanged from last month's data.
Our favored metric of Single Family Permits (see chart) was unchanged at
404K which caused the 36 month ma "signal" to track lower to 438K, a new
all time low. About the only positive thing that can be said is that the
New Home industry has defined its cycle low, with the recent data
indicating that homebuilders are constructing the bare minimum of homes
needed to satisfy existing depressed demand. We continue to see this as a
long term source of growth acceleration for the US economy overall, but
with summer rapidly drawing to a close this looks to be an issue for 2012
rather than 2011. - D-NHSPA1_Index.gif -

Each quarter the NY Fed publishes a report:

(Link to full report:
http://www.newyorkfed.org/research/national_economy/householdcredit/DistrictRepo
rt_Q22011.pdf)

that looks at delinquency and issuance trends in US Household credit and with
much concern currently being shown over a possible deterioration in US
employment and the household budgets, it is interesting to note that the Q2
report shows a straightforward improvement in conditions throughout the report.
We have chosen 5 sample slides (see link below) out of the whole 26 slide package

These show:

1. Total Balance by Delinquency Status (Percentage)
2. Percent of Balance 90+ Days Late By Loan Type
3. New Seriously Delinquent Balances By Loan Type
4. Quarterly Transition rates for Current Mortgage Accounts
5. Quarterly Transition for 30-60 Day Late Mortgages

As can be seen on the attached PDF, each of these slides show a steady
improvement in a trend that remained intact in Q2 2011 (it should be noted
that these stats will be unaffected by foreclosure moratoria in place in
several states). Of particular note is the fact that total Current
Accounts (slide 1) are now back over 90% and are their highest since the
middle of 2008. Unsurprisingly, this closely matches the "Employment Rate"
(100 - Unemployment Rate) and can be expected to be broadly sensitive to
ongoing changes in Employment (if rather more accurate on a month by month
basis). As can be seen from Chart 2, both Credit Card and Mortgage
delinquency have recovered significantly but remain historically very
high. The small Student Debt category continues to deteriorate (a
reasonable proxy for the graduate jobs market) while Auto and HELOC rates
are stable but never reached crisis territory.

Finally, Charts 4 and 5 show a very favorable change in trend in the
Transition of Current Mortgages to Delinquent loans (Chart 4) and From
moderately Delinquent Loans to Current or 90+ Day late (Chart 5).
Interestingly for the first time since 2007 a loan that is 30-60 days
Delinquent is now MORE LIKELY to turn Current than Seriously Delinquent.
This strikes us as something of a turning point in the current cycle,
since it indicates a willingness and ability of home-owners under stress
to "right the ship" that was absent for several years. Granted these
metrics are still far from normal, but the improvement in trend is
substantial and ongoing, and shows that we are somewhat further along the
process of cleaning up the mess on US Households balance sheets than most
people understand. - 2975_001.pdf -

The NAHB Sentiment Index continued its dreary run of readings with the overall
index staying at 15 in August. Little movement was visible in the sub-indexes
with Present Sales ticking up to 16 (from 15) and Traffic to 13 (12) while
Future Sales went down to 19 (21). All of these are well within the error
tolerance rate and so August goes down as yet another month in which the New
Home market remained moribund. We would expect this to be reflected in the
upcoming Building Permit and New Sales data which should come in close to
current expectations of very soft activity (although we would allow for the
significant month-to-month volatility of this seasonally adjusted data). -
nahbaugust2011.gif

Given the sensitivity of Consumer Confidence polls to political events we are
not surprised to see a plunge in the University of Michigan Poll following the
Debt Ceiling debate and downgrade of the US AAA rating by S&P. A further group
of the population takes its emotional cues from the equity market which has
hardly made for a calming influence in recent weeks. Even so we are impressed
that sentiment fell to a level lower than any recorded in the 2008 crisis and a
level unseen since April and May 1980.

Although data of this nature is statistically shocking, it really does not mean
a great deal. Most importantly a collapse like this is not necessarily
reflected in actual consumer activity, which as we have seen was robust through
the end of July. Unless we were to hear that this had changed from a number of
key retailers, we would assume that the drop in Sentiment simply reflects an
overreaction to a series of dismal headlines and account statements. In fact
sharp lows in Sentiment typically mark turning points in economies and local
asset markets, and should this prove to be the low point in Sentiment this
cycle it would tie into our belief that this powerful global correction will be
seen to be a turning point for the absolute and relative performance of a
number of US sectors. - michiganaugust12.gif

While it may be true that flows of this magnitude may mark a short term low for
an asset class this sort of reaction is very typical of the start of a bear
market for an asset class. There has been precious little discussion about the
deterioration in macro and corporate news-flow from a number of key markets,
while the knee-jerk response has been to blame US economic weakness for the
collapse in a number of key markets and treat the sell-off as a "buying
opportunity".

Our view remains that we have commenced a difficult multi-quarter period for
the emerging market complex overall, although we would also expect this broad
decline to start to concentrate on those countries with obvious problems
(Brazil, India, Turkey, Israel are all good examples) and start to favor those
which have withstood the recent sell-off (e.g. Thailand, Malaysia, Indonesia).
It should also be remembered that even a true multi-month bear market will
include long periods of considerable appreciation. Those still over-exposed to
this area of global markets should probably wait for a sustained rally to
lighten positions.

Given the excellent earnings reports from a number of key US retailers
this week we would have maintained that US retail sales were strong no
matter what the Census Bureau came up with this morning. Nevertheless it is
always helpful when official data confirms the private sector reports since it
helps sway the mass of Wall Street opinion that erroneously relies on this
volatile source of information. July's report showed sales increasing by
0.5% in line with expectations, and Junes sales revised 0.2% higher to
0.3%. The latter is important since it further undermines the "data-myth"
of the Q2 slowdown that frankly was invisible in most earning reports. As
it is, retail sales are now estimated to be growing at 8.53% per annum, or
many multiples of GDP. This of course has important ramifications all the
way down the US supply chain since inventory levels remain significantly
constrained. We remain well disposed to the US retail sector despite its
inevitable participation in the current correction. We believe it will
come out of this episode intact and with a number of new supporters drawn
to this sector by the strong "bottom up" metrics being released. -
M-RSTATOTL_Index.gif -

In any normal month China's monetary data would dominate a morning's
headlines, particularly when they offer some firm evidence that the
multiple tightening moves undertaken in recent months are finally starting
to take effect. July's data showed both M1 and M2 shrinking on a Monthly
basis (-1.49% and -1.01% respectively). This marks only the second time
since October 2004 that M2 has shrunk in a month and given that the first
was May this year it is a sign that monetary conditions are changing
fairly rapidly. This fall has taken the 12 month RoC down to 14.70%, the
lowest reading since May 2005. The 3 month RoC is showing a far slower
growth rate with a 2.06% change representing an annualized growth of a
mere 10.8%. This moderation is reflected in loan growth which fell to 492
bln CNY, the lowest since December 2010 and well below the trailing 6
month ma of 605.45 bln CNY. As can be seen on the chart, the 500 bln level
is a key level for this metric, with loan growth staying above this level
for the vast majority of the post 2009 explosion in liquidity. Should
lending continue to moderate and the 6 month ma fall below this level we
would have clear signs that lending is truly tight in China. As it is we
have seen a number of anecdotal stories that suggests that there is an
increasingly 2 tier lending market with loans still available for large,
state connected concerns but far less easy to find for small and mid-size
private enterprises. If this is correct then the aggregate liquidity data
does not fully capture the deterioration in monetary conditions for much
of the local economy. We do not think this deterioration has been fully
captured by the official data that has shown a suspicious lack of
volatility in recent months (this is particularly true of the Industrial
Production data).

Adding to this pressure is the increasingly aggressive currency policy
being conducted, with the recent US downgrade being used as an excuse to
further lower the CNY/USD cross rate (black line on chart). As can be seen
the CNY has been considerably strengthened against the USD in recent
months, to the degree that its depreciation against the EUR (red line) and
other currencies has been minimized. The great danger for China now would
be a sudden strengthening of the USD, which would cause the pegged CNY to
appreciate markedly against other currencies. For the US this appreciation
would be coming from a historically low base and thus could be fairly
easily absorbed but for China this would risk taking the CNY from a "fair"
value into "expensive" territory. - D-CNMSM2_Index.gif - W-CNY_Curncy.gif -

One of our strongest beliefs during this correction is that concern over
the state of the US economy is dramatically overdone. While it is true that
much economic data released in June and July was very poor much of the data
released since the start of August (with the glaring exception of the ISM
Manufacturing Survey) has been significantly better than expected.

Thus at the very least we are entitled to question the thesis that the US
economy slowed dramatically in Q2 or that employment deteriorated markedly
in recent months. The last few weeks of Initial Claims data has really
underlined this point with the data finally falling below the important
400K level this week for the first time since April 1st. This print of
395K beat consensus estimates of 405K and caused the more reliable 4 week
ma to fall to 405K, the lowest number since April 15th. There is now good
reason to question whether employment ever did actually deteriorate in Q2
2011 or whether the spike in Claims and slump in Non Farm Payroll
additions was a function of the erratic Seasonal Adjustment process. If
the latter proves to be correct there is good reason to expect to see
further improvement from September onwards, since seasonal adjustments
start to become a positive influence from late August through to the end of
Winter.

Even at 400K Claims are at a level consistent with Non Farm Payroll gains well
over 100K, which may not be exciting but also can hardly be said to be
reflected in the current equity or treasury market. - D-INJCJC4_Index.gif -

Amidst the chaotic trading, regular releases of macro data continue to be
made on schedule and it is still important to consider their meaning. This
morning saw Wholesale Inventory and Sales data released for June, which we
track as an indicator of Industrial activity and the sustainability of the
production cycle. June's data showed a moderate build of Inventories at
0.6% somewhat less than the consensus of 1.0% but well within the error
tolerance of this series. Of more interest was the Wholesale Sales data
which indicated that sales grew by 0.59% to a new all time high of $395.8
bln. This is a notable landmark in the recovery of this cycle and although
it does not cover the period of July, which perhaps is more relevant for
those concerned about a sudden drop in US Industrial growth, it does cover
the last month in what is supposedly a very soft Q2 for GDP growth. What
we can say is that Wholesale Sales (as estimated by the Census Bureau)
have now recorded a new all time high while the Inventory/Sales ratio
remains extremely tight. Furthermore Sales have been growing at a very
steady 12% annual pace for a number of months (see blue line) which gives
us some confidence in the accuracy of this data. We continue to believe
that US economic activity is more robust than much recent data has
suggested, and that the current crisis has its epicenter located away from
these shores

It is hard to think of a worse day to issue a major change in the approach to
the massive overhang of foreclosed homes but the FHFA should be applauded for
taking this much needed step.

We have commented many times on the mismatch between the willingness of
house-holders to rent homes at decent yields and their unwillingness to
purchase an equivalent home, or inability to secure mortgage financing to do
so. This RFI seeks large-scale solutions to this problem and represents a key
change in direction to the management of this unfortunate legacy of prior
excess. We will follow the eventual proposals with some interest.

Most (Western Hemisphere) market participants will have gone to bed last night
feeling moderately relieved only to be faced with markets that remain turbulent
this morning. This comes as little surprise to us since the focus of the market
rally yesterday afternoon was solely on the possibility of a round of monetary
easing by the FRB which if directed at US liquidity is largely unwarranted.

We continue to believe that the primary issues facing global markets are a lack
of liquidity provision by the ECB and a deterioration of the INTERNAL
economies rates of a number of emerging market countries. In terms of the
former, the action of the ECB in recent weeks has been quite inadequate since
they are focusing solely on the symptoms and not the root cause of the problem.
For instance their decision to purchase Italian and Spanish debt has had the
effect of pulling down those specific yields (black and red line on chart) but
it has not normalized them. More importantly the relationship between France
and Germany continues to break down.

We have added the 10 Year France/Germany spread to this chart (pink, lower
panel) and as can be seen this has now widened to 87bp. Interestingly we have
started to see the financial media focus on this key relationship which we
ultimately believe will be the catalyst for a more accommodative ECB policy. We
would also not rule out the FRB from this equation. Although yesterday's FOMC
statement promised nothing in terms of future action (other than prolonged
inaction for the FDTR) it clearly opened the door to further activity of an
unspecified nature.

It should be remembered that back in 2008 Bernanke proved himself to be an
Internationalist issuing $650 bln of currency swaps to beleaguered EM central
banks (he was helped by the fact that no-one in Congress or the Senate managed
to notice this despite the figures being publicly available on the FRB website)
and the FRB could still feasibly be called into action to aid the ECB. In any
event no matter the source of funds the Euro-zone appears to need a substantial
increase in its QUANTITY of money, and not simply the shuffling of dubious
credit from private to public hands. - euroyieldsaug10.gif

Those looking for something dramatic from the FOMC statement will have been
disappointed from the text delivered this afternoon. Long on gloom and short on
solution was not a combination that bruised market participants would have
wished to see, although even getting this statement out produced dissent at a
level unseen during Bernanke's term as Chairman (3 dissenters out of 10 votes
cast)

The forecast that rates would not be raised until mid-2013 only tells the
market what it had decided for itself. The June 2013 Euro$ contracts (which
track LIBOR) fell from 84bp yesterday to 60 bp today, which is hardly a
meaningful adjustment. We already had the flattest LIBOR curve in modern
history and another 20 or 25 bp won't alter things to any meaningful degree.
The most interesting paragraph came at the end of the release:

"The Committee discussed the range of policy tools
available to promote a stronger economic recovery in a
context of price stability. It will continue to assess the
economic outlook in light of incoming information and is
prepared to employ these tools as appropriate."

We will have to await the August 30th release of this meeting's minutes to see
what the committee actually discussed in terms of policy tools available. Of
course by that time markets could have dislocated to the point that we will
know what tools were discussed because they will already been implemented, or
become moot in the event this crisis has passed us by. But today's statement
firmly passes the buck (no pun intended) back across the Atlantic to the ECB.

One of the first signs that Brazilian corporate credit markets are coming under
pressure. As we would have expected it is 2nd tier financial companies who are
the first to feel the strain. The danger is that many of these companies are
reliant on free access to debt markets as part of their day-to-day business
strategy. The closing of markets for any period of time therefore materially
raises the odds of future delinquency by one or more institutions later this
cycle.

With the FOMC due to meet this afternoon and Chairman Bernanke making it clear
in his recent testimony to Congress that "all options are on the table" it
makes sense to go back to Bernanke's (in)famous November 2002 speech on
Deflation and see what options occurred to him in this moment of almost
academic free thinking. Almost all of the options mentioned in the speech were
enacted during the Credit Easing experiment of 2008, with QE2 being much more
about targeting the quantity of liquidity. One particular policy however was
not implemented during that episode but could potentially be seen as germane in
today's fractious environment. We refer to the little known legal ability of
the FRB to purchase the debt of foreign nation states (see below):

"The Fed can inject money into the economy in still
other ways. For example, the Fed has the authority to buy
foreign government debt, as well as domestic government
debt. Potentially, this class of assets offers huge scope
for Fed operations, as the quantity of foreign assets
eligible for purchase by the Fed is several times the stock
of U.S. government debt."

During deep sell-offs such as these about the only useful exercise is to
remain vigilant for signs of relative strength. This does not simply mean
comparing daily or weekly changes in price, for we would be far more
interested in an index that respects technical support on the way down than
a simple comparison of percentage losses from the top. Looking at large global
indexes the one which still stands out in this regard is the NDX index.
Although down sharply from June's 10 year high, this decline has been
relatively orderly and the index only marked a new 2011 low on Friday
morning before rallying to close above its June low point. This morning
saw the index open down sharply and then trade lower to test obvious
support at 2100 (round number and support back in November). Thus far the
index has respected this level and moved above its opening level by almost
1%. This is far better than the vast majority of other indexes we have
observed today and we continue to be impressed by the NDX's performance
during the recent drubbing of global equities. Although it is far from
clear that we have completed the current sell-off, it is becoming
increasingly likely that it will be the NDX index that signals the all
clear when that time comes around. - D-NDX_Index.gif -

We recognize that this morning is all about the continuing deep correction in
global markets but despite this episode (which we will comment on once today's
US session has gotten underway) it is important to continue to watch key macro
data-points as they are released.

Late Friday afternoon saw one of these, in the form of a very large increase in
US consumer credit reported in the monthly data. If Monday's ISM data was one
of the worst pieces of economic news over the last 2 years than this ranked
somewhere close on the opposite end of the scale. June's data showed credit
growth of $15.5 bln, the highest reading since August 2007, on the eve of the
collapse in US housing credit markets. Although this is just one month in a
volatile series the magnitude of change suggests that something positive is
finally happening in terms of US credit formation and the steady improvement in
the 6 month ma (now $6.4mm) underlines that fact. Given that credit card
delinquency trends have been moving rapidly lower this increase in credit usage
indicates an uptick in retail activity, rather than a reliance on credit for
tapped-out households.

Other credit and monetary measures are also starting to flash "green" with M2
now rising 8% over the last year and 3.70% over the last 3 months (annualized
rate close to 15%). Even overall bank credit has finally pushed its way into
positive territory on a YoY basis (we will discuss these in more detail once
this panic has abated). The key point to bear in mind is that overall data in
Q2 and early Q3 has been much more balanced in terms of growth than most people
realize, and that the consumer related area of the economy in particular has
shown robust (if unspectacular) performance in virtually every PRIVATE SECTOR
metric that has been released in recent weeks. - consumercredit.gif

As we explained on Friday afternoon from our perspective this current panic has
been sparked off by an overly tight monetary policy being conducted by the ECB
and has little or nothing to do with the United States (we say this even after
the S&P downgrade). In the post-2008 world the provision of global liquidity
has become extremely regionalized, thanks to the huge lending facilities that
have been created by central banks that are COLLATERAL SPECIFIC to each region.
Thus while the FRB's QE2 program was of a size that was globally significant,
it did not ease monetary tightness within the ECB banking system (see Friday's
chart of the ECB balance sheet), and has therefore had little effect on the
slow-motion train wreck of Euro-sovereign debt.

Unfortunately there is only limited sign that the ECB fully grasps this
situation (which is a little sad given that it is about the only thing their
myriad of economists and analysts really need to focus on). Yesterday's
emergency announcement by Chairman Trichet

Although we were happy to see this morning's payroll report, we are not
surprised to see global markets remain under pressure this morning. This
is because to our eyes this sell off should never have been focused on
the US economy but instead on the clear macro forces at work in both
Europe and the Emerging Market complex. Just as last summer it took action by
the FRB in order to bring matters to a close, we would imagine that this
episode will require emergency easing by the ECB and one or more EM
central banks. The ECB strikes us as the most important of the two, not
merely because of its relative size but also the magnitude of problems at
the heart of its area's funding process.

In this regards it needs to be understood that in addition to raising
interest twice this year the ECB has failed to add any liquidity via its
balance sheet since the height of the crisis in 2008. In fact the balance
sheet is currently lower than it was on October 31st 2008 and actually
shrank by 10% between June 2010 and June 2011 despite the fact that the
entire 12 month period was punctuated by growing woes in European
sovereign credit. This bone-headed strategy is reminiscent of the
tightness imposed by the FRB between the collapse of BSC in March 2008 and
that of Lehman in September (not an episode that anyone at the FRB tries
to publicize). At least the FRB eventually understood its error and acted
forcibly while Chairman Trichet continues to talk piously about the demons
of inflationary pressures and the need to remain vigilant.

Given the obtuse nature of this entity and its current Chairman, the
question is what market pressures may force the ECB to change this stance
(slumping equity markets apparently being insufficient). One clear
possibility is the breakdown between the relationship between French and
German sovereign credit. We have highlighted this spread a number of times
in recent sessions since its dislocation is not receiving the attention it
deserves. At one point this morning it widened to -90bp but has now
improved to -80bp. This is still an extreme level for the EUR era
(although pre-EUR this spread has been as wide as -200 bp). It is
important to understand that this widening strikes at the heart of the
entire European project, which has been designed to tie Germany and France
together under a yoke of equivalence. Perhaps in order to force the ECB's hands
addition to the spread widening French yields may actually have to rise,
rather than fail to fall in line with German yields, although this would
risk even more dislocation in global asset markets. In any even it is the
introduction of "QE€" not "QE3" that probably holds the key to current markets.
- D-EBBSTOTA_Index.gif - W-.FRAN-GER_Index.gif -

It has not been easy keeping a steady head in recent days, particularly if
you are of the belief that the US is still experiencing a steady recovery.
Economic sentiment has never recovered from June's awful Non-Farm Payroll
report and so it is helpful that much of this data-angst has been
addressed in July's report. Total job gains were estimated at 117K with
June's number also revised 28K higher to 46K. Private Sector claims hit
154K, with June revised up to 80K (from 57K). Both numbers blew through
consensus estimates (85K and 113K respectively).

Frankly this two month switchback shows the wisdom in our approach of only
considering this data on a smoothed longer term moving average. Our
arbitrary measure (there is no point in being scientific with a survey as
error strewn as this) is to use the 12 month ma of Private Sector Payroll
change (see attached chart). This is currently at 148K, or approximately
where July's claims number randomly hit. This keeps the pattern of
employment where we assumed it was in June, namely a steady improvement
that lags our more optimistic hopes (blue dashed line) but steers well
clear of a truly "jobless" recovery (red dashed line). It should also be noted
that today's data is much more in line with other metrics (ADP report, Initial
Claims, ISM survey data) and so should be given more credence than June's
bizarre shortfall which we assume was a result of some well-meaning but
erroneous seasonal adjustments made by the BLS.

Whether this report is enough to stop the current correction dead in its
tracks remains to be seen since there are a number of powerful macro downdrafts
coming from outside the US that still need to be addressed. What this
report does do however is give participants a reason to be stubborn
regarding their views of domestic US growth and the performance of sectors
such as retail which are clearly tied to improvements in employment. -
M-NFP_PCH_Index.gif -

Text of a short telephone interview with Bloomberg © today on Brazil.

As we had expected Brazil's ugly equity market sell-off accelerated this
morning with the IBOV falling over 6% at one point this session and currently
down 5% for the day. Since we have fielded a number of questions as to what
this all means we thought it would make sense to place this decline in some
historical context.

Attached is a chart which overlays the current IBOV (blue) with the performance
of the SPX index in 2000-2. (Note we are not using the much more troubling
NASDAQ chart from this period since the IBOV showed far less excess at its
recent top than the NASDAQ back in 2000). To aid the comparison we have
rescaled the SPX by a factor of 50.

As can be seen the pattern of the decline for the IBOV is broadly similar to
the SPX of a decade ago. A long period of significant under-performance (the
IBOV was only up 1% in 2010) was then followed by a grinding decline that
overwhelmed a number of important support levels but produced little in the way
of investor angst. Eventually economic and corporate developments led to a
spike of selling that overwhelmed key support. For the IBOV this time around it
would seem that rising loan delinquency levels proved the catalyst and 58,000
the line in the sand. For the SPX 10 years ago it was the 1250 level, which
ironically is precisely the point that the recent sell-off accelerated through
this week.

The violent acceleration that we have seen over the last 3 days is typical of
what happens next (the SPX hit 1081 in March 2001 after breaking 1250). It
would also be typical for this liquidation to end fairly shortly and to be
followed by a recovery in asset prices for a period of time. However, if we are
correct this recovery will be steadily undermined by worsening corporate and
economic news until it gives way into another round of selling.

As ever we use historical guides such as this only loosely. We do not know if
the IBOV will lose 40-50% of its peak value as the SPX did between 2000 and
2002 and even if it were to do so it would probably take a number of months to
occur. We do however believe that any strong relief rally that emerges will be
an opportunity to lighten positions fairly aggressively. - ibovspx.gif

Turkey's "neo-Peronist" experiment continues to buck orthodox monetary
policy with the local central bank choosing to call an emergency meeting
and cut the local policy rate by 50 bp to 5.75%. In doing so they
signaled an intention to follow a path of "growth at all costs" that
ignores the clear pressures already being brought to bear by their prior
actions. This morning's news has not helped the local equity market and
the XU100 index is hovering above key support at 60,000. The real loser,
however, has been the TRY which has moved to 1.73 this morning and is now
down 10.54% YTD against the USD and 15.86% against the EUR. This means
that any local bond investment is now under-water in currency adjusted
terms which is going to come as something of a surprise to those who
chased the apparently attractive yields on offer earlier this year. -
D-XU100_Index.gif -

Attached is a link to this morning's BOJ statement which shows Japan is
following in Switzerland's wake and undertaking its own program of Quantitative
Easing (which we will call QE¥ for the time being):

http://www.boj.or.jp/en/announcements/release_2011/k110804a.pdf

Although the US economy continues to dominate the headlines it should be
remembered that equity market performance elsewhere is actually far worse
than within the large cap US market. This is particularly true if we were
to look at the NDX index which as recently as July 26th made a new all
time high and even after this week's drubbing is only 5.3% below that
level and up 3.97% for the year. This is not the typical market
performance that leads to a new recession although no doubt more bearish
commentators would tell us to wait and see what happens next. From our
point of view there is currently a level of concern being shown that is at
odds with actual market performance (the broader SPX index is itself
almost exactly unchanged for the year). This does not guarantee that
things will not get worse, but it does at least suggest that participants
have moved portfolios ahead of events.

If one wants to look for market performance more normally seen before an
economic decline one should look at a country such as Brazil. Here despite
almost universally positive sentiment both within (Brazil consumer
sentiment hit a new all time high this month) and outside (Brazilian
corporate high yield credit has been the favorite destination for
international flows this year) the local IBOV index has declined -19.3%
YTD (-14.2% for a USD investor). This week's sharp decline saw the index
break what many had seen to be key support at the May 2010 low, leading to
a sharp follow through this morning. Perhaps most troubling was the
catalyst for local concern, namely a sudden uptick in loan delinquency by
Brazil's major banks this earning season. This is a development which we
had anticipated but appears to have come as a surprise to most observers.
It is interesting to note that the collapse in Brazil's equity market has
gone largely unnoticed by the financial media which is understandably
sidetracked by other issues. This does not make it any less relevant as
indication of where Brazil's economic and credit cycle is heading, namely
towards more difficult times. - D-IBOV_Index.gif -

July's ISM Non-Manufacturing Index came in just below consensus (53.5) at
52.7 but at least stays comfortably above the 50 level. The Business
Activity sub-index (not shown) was fairly strong at 56.1, a rise of 2.7
points from June (and something of a surprise given other economic
reports) but New Orders (red) slipped to 51.7, the lowest reading since
August 2009. Given that July was dominated by the debt ceiling debate
which had an appreciable effect on public sector contracts this is perhaps
not a bad reading for New Orders, although we would need to see a decent
bounce in this metric in August, as temporarily withheld federal projects are
released, in order to make this claim more forcibly. As it is we would cast
this report as mediocre but not alarming, which represents something of an
improvement over the more senior Manufacturing report that was released on
Monday. - D-NAPMNMI_Index.gif -

Last summer's deep correction was ultimately centered around fears of US
economic weakness and were brought to a close by the FRB ushering in QE2. At
the time we were puzzled at the degree to which the US was singled out,
particularly versus Europe where the intractable issues surrounding sovereign
credit only kept the market's attention for about 60 days between April and
June. This year's difficulties have been much more evenly matched, with US
economic weakness and the debt ceiling debate jostling for headline space with
Europe's woes. Our belief is that the latter really is the key issue to focus
on, and that a resolution to this corrective phase will probably involve a
fairly radical change of monetary policy within the Eurozone. Thus while people
have been wondering about the likelihood of "QE3" (or a new bout of
monetization by the FRB), perhaps QEE or QE€ is the more important policy
change to look for.

This morning's surprise announcement by the Swiss National Bank (SNB) is
perhaps a precursor to such a move. As the attached link makes clear the SNB
has no wish to see its currency appreciate to the point that its industrial
base is rendered internationally un-affordable. Concerns over the currency have
clearly trumped the traditional inflation fighting zeal of the SNB, and as the
statement makes clear further moves will be considered if the CHF continues to
strengthen against major currencies. We doubt today's announcement in itself
will change a great deal, but what it does do is shift the terms of the debate
within the Euro-zone. At the very least the questionable decision to raise
local rates from 1.00% to 1.50% since April could come under review, but the
possibility of a more radical change of tack should not be ignored.

July's ADP report showed an increase in private sector payrolls of 114K,
somewhat better than the consensus estimate of 100K, June's report was
revised down to 145K (from 157K) and the 6 month ma (red line on chart)
moderated to 132K, which we would categorize as on the low end of normal.
Of course the credibility of the ADP report took a massive hammering
last month when the surprising strong June ADP report was followed 2 days
later by awful BLS Non-Farm payroll data (57K of Private Sector Payroll gains).

As we have explained many times these two reports follow very different
methodologies and both offer only a rough estimate of employment change in any
given month. It is therefore possible for them to diverge radically on any
given month but over the course of a cycle they tend to match each other
reasonably closely (see attached chart). The fact that the ADP report has
stayed above 100K is therefore an encouraging sign since it suggests that
employment conditions may not have deteriorated as far as many now
believe. Although it gives us no insight as to whether July's BLS report
will reflect this fact (consensus calls for 115K of Private Payroll
gains), or if this will be reflected in a future month's report (anything
is possible in any single month's NFP estimate) there is good reason to
believe that some of the renewed economic pessimism may be an overreaction
to recent data and market volatility. - D-ADP_CHNG_Index.gif -

Relief that the US debt ceiling impasse appears to be behind us has quickly
been replaced by angst at some of the other large issues that were briefly
displaced from participants' attention. This applies most clearly to the
sovereign debt markets of Europe which looked to have briefly calmed themselves
down two weeks ago following the re-crafted ECB rescue plan.

To our eyes this never seemed likely to lead to a sustained period of calm
since this plan did nothing to address the fact that the "myth of equivalence"
between Euro-nations credit worthiness has been shattered in recent months.
There is simply no willingness for new capital to chase the elevated yields of
bonds that are perceived to be at risk of future default or downgrade. Thus in
recent days the Spanish and Italian 10 year yield have both forced their way
back above the important 6% level, and in the case of Italian yields to a new
"Euro-era" high of 6.11%. We would expect the market to push on higher in the
coming days further testing the nerves of local politicians and central
bankers. Ironically this episode really demonstrates the benefits of the recent
debt-ceiling debate for however poorly Congress and the Senate may have behaved
they at least were responding to a mandated debt ceiling rather than waiting
for a point in the future when the marketplace was unwilling to absorb US
Treasury debt.

It should also be noted that the flight from troubled debt has largely
benefited the German Bund and bypassed the French 10 year note. Although the
latter has seen its yield moderate (thus indicating that France is not
perceived to be a problem) it has fallen far less than would generally have
been expected. Indeed the France-Germany 10 year spread has now widened to a
Euro-era record of 75 bp, which represents an additional cause for concern for
the ECB. Even though France cannot be considered to be a problem today the
clear preference of investors to hold German debt strikes at the heart of the
beliefs behind the Euro project. - euroyields8211.gif - france-germany8211.gif

The ISM report for July 2011 was a distinctly squishy set of data and is
arguably the worst set of ISM data since the economic rebound of 2009 took
hold. If there is any comfort to be taken it is that the overall index remained
above 50, indicating that no actual deterioration in activity took place in
July and the fact that a large number of survey respondents indicated that
uncertainty surrounding the debt ceiling had meaningfully impacted July's
responses. There is therefore some reason to expect better data in August but
this will be little comfort to market participants already roiled by Friday's
GDP report in the near term.

In terms of the data itself the overall index fell to 50.9, the lowest reading
since August 2009. New Orders (red) fell to just below neutral at 49.2 and we
would not want to see further deterioration from this level in future reports.
Production (blue) showed some deterioration but remained positive at 52.3 while
inventory data (olive) showed continued discipline at 49.3. Finally Employment
data (pink) fell sharply to 53.5 and although this is still a decent historical
level for this metric it is somewhat worse that the readings seen over the last
18 months. - ismjuly2011.gif

The start of the new month sees the publication of global PMI reports (it
is one of the notable factors for this cycle the PMI data is now reported
monthly for the vast majority of major countries as part of the explosion
of private sector macro data that has arisen from the 2008 crisis). In the
vast majority of cases July's data has seen reports at or close to 50,
suggesting that industrial activity continues to track the pace of prior
months (but it should be noted that a 50 in China represents a very
different pace of growth to the same report in Western Europe). In general
we tend to ignore small fluctuations in this type of data and most of what
we have seen so far strikes us as inconsequential. The two reports that did
catch our eye came from Australia and South Africa (see attached chart),
both of which showed significant deterioration in activity. In Australia
the AIG index fell to 43.4, the lowest reading since the 2009 recovery and
at a level that would suggest a meaningful slowdown in industrial activity
is taking place should this be repeated in further month's reports. South
Africa's Kasigo PMI report showed a very similar decline, reaching 44.2.

As can be seen Australia and South Africa have traditionally had very
synchronized industrial cycles which is not surprising given that both
economies are highly geared towards commodity exports and particularly
precious metals. Both have seen significant local currency strength with
the AUD being one of the strongest Western currencies and the ZAR one of
the strongest EM currencies over the last 24 months, putting pressure on
their local industrial exporters. The fact that both countries saw PMI dip
in this manner meaningfully increases the probability that an actual
deterioration in industrial activity took place (as opposed to noisy data)
and we would continue to watch for further signs of weakness in the months
ahead. - D-AIGPMI_Curncy.gif -

In depth Bloomberg © article on deteriorating credit cycle in BRIC banks. A
good summary of where we are in the current cycle.

http://www.bloomberg.com/news/2011-07-31/banks-in-brics-signaling-credit-risks-a
s-bad-loans-curb-growth.html