One of our major concerns going into the summer was that an abrupt sell-off in
emerging market corporate credit (especially in local currency debt) would lead
to a shut-down of new issuance. Early evidence suggests that this is exactly
the path that the market is taking, with the attached story giving useful
detail to the situation.

Our belief is that emerging market growth (in both the consumer and corporate
sectors) has become very dependent on new credit issuance over the last 24
months. Should the supply of new credit remain restricted for a number of
months this can be expected to act as a significant negative force on local
economic activity.

Up until this week, one of the unique aspects of this summer's "crisis"
was that it had not been accompanied by the usual wave in refinancing
activity. Normally as risk markets undergo turmoil, the flight of capital
into the US Treasury market leads to sharply lower mortgage rates and
creates a window of opportunity to bring mortgage costs lower. Because of
the very low rates recorded last summer and early fall in the run-up to
QE2, it had not been until recent weeks that mortgage pricing had reached
the point that it created sufficient incentive to undergo refinancing.
However, as the attached chart shows, the collapse in yields surrounding
the announcement of "Operation Twist" has caused the MBA Refi index to
push back above the key 4000 level that we use to designate a "refi boom",
This also helps explains a portion of last week's move lower by treasury
yields since all anecdotal evidence suggests that very few MBS holders
were prepared for this eventuality (one of the most profitable trades in
the first half of 2011 was the use of mortgage derivatives that performed
well in the absence of refi activity) and we would expect that a fair
amount of duration re-balancing took place as the long end of the curve
collapsed lower, increasing the already strong demand in the marketplace.

Meanwhile for those able to take advantage of current rates, current yields
will take another bite out of the portion of disposable income used for
shelter, increasing income for other discretionary spending and/or
savings. This has always been the silver lining of a deep US correction in
risk assets and it is a useful positive force for the key consumer sector
going into the last quarter of 2011. - D-MBAVREFI_Index.gif -

Yesterday afternoon's report on August Brazil Loan Data showed that credit
growth remained robust in August, while loan delinquency continues to
deteriorate at a fairly rapid pace. Total Private Sector loans grew by 1.41% to
$1,089 bln. This caused a moderate slowing in the annual growth rate to 19.59%,
but still suggests that credit growth is running well above actual economic
activity. Housing Credit continues to grow much faster than overall loans,
rising 3.73% in August and maintaining its annual growth rate of just under
50%. Housing credit now accounts for 16.5% of outstanding credit up from
approximately 7.5% in 2007. Meanwhile loans due 90+ days rose to 6.7%,
their highest level since May 2008 and a full percentage point higher than
the start of the year. Note that this means that delinquency growth is now
well over 20% per annum (as measured by the change of aggregate loans in
default), and this is with employment still at a cycle high.

Since August the local central bank has chosen to cut interest rates, in
response to a collapse of local equity values and growing concerns
regarding the strength of the economy. Clearly this left the task of
reining in credit growth largely unfinished (or even "un-started"). We
would expect the central bank to keep its macro-prudential measures aimed
directly at credit growth intact until some clear signs of a slowdown are
in evidence. Of course any slowing in credit growth will lead to a surge in
the delinquency rate which even under current conditions is set to trip
over the problematic 7.00% level that would represent a significant
problem in loan defaults sometime around the turn of the year. We continue
to believe that Brazil will be a source of troubling macro data well into
2012. - D-BZLNPTOT_Index.gif - D-BRCDDEFT_Index.gif -

The ECB Balance sheet expanded by a further 2.12% last week, further
raising our suspicion that a silent enactment of quantitative easing via
"benign neglect" is taking place under the noses of those hectoring the
ECB to loosen monetary policy (we would happily include ourselves in this
number). The ECB's sterilization auctions have failed to keep pace with
sovereign bond purchases and as a result the balance sheet
has now grown by over 12% over the last 13 weeks (red line on balance sheet
chart) and grew by just over 5% in September alone.

This is a fairly significant change in the direction of Eurozone liquidity
conditions although the silence by ECB officials makes it hard to gauge the
level of intention behind it. We do not judge it to be sufficient to bring this
episode to a close but we would imagine that the provision of liquidity has
eased stress at the margins. It does also increase the probability that in the
end the ECB will capitulate and that the internal debate is now focused on the
details of a monetary easing program rather than whether it is required.

As would be expected this has led to some stabilizing of the sovereign
credit market, with Spanish bonds in particular acting somewhat better in
recent sessions, with the key 10 year yield moving back down to test the
5% level. Interestingly there has been no such improvement in Italian bond
yields, leading to a fairly sizeable positive spread between Italian and
Spanish yields. This is the first time since the EU sovereign debt crisis
commenced in April 2010 that Spain and Italy have traded in line with
their historical relationship (Italy has always been assumed to be a
somewhat worse credit). This brings up the intriguing possibility that if
it continues to make fiscal progress Spain may be able to drop off the
"acute" list of countries although there would still be a great deal of
work needed to bring yields closer to even French treasuries (still 230 bp
below Spain) let alone Germany (304 bp). - W-.ECB-GOLD_Index.gif -
D-GBTPGR10_Index.gif -

The Conference Board Survey of Consumer Confidence showed essentially no change
in September with the overall index nudging from 45.20 to 45.40. There was a
little more deterioration in the Present Situation index which fell to 32.50
while the Expectations index rose slightly to 54. Again we view these
fluctuations as irrelevant.

Given that correction in global risk assets has remained in force over the last
month (and actually broadened to include commodities and emerging market
currencies) it is unsurprising that consumer confidence remains depressed,
since it tends to be very sensitive to financial market performance over the
prior few weeks. Fortunately it is much less indicative of actual consumer
activity. Once more all the anecdotal evidence suggests that September has been
a solid month for retail sales, including that of relatively high ticket items
such as automobiles and we would expect this divergence between confidence
measures and consumer activity to remain in place until this long corrective
phase has run its course. - consumerconfidenceseptember11.gif

The August New Home Sales surprised no-one with another dismal set of data
showing sales stuck at 295K, just beating consensus estimates of 293K. July's
data was revised slightly higher to 302K but overall the report simply told us
what we already knew, which is that no recovery in new home sales took place in
2011. If there is any solace it is in the fact that sales appear to have
troughed with the data bouncing along the bottom for the last 18 months.

As can be seen on the attached chart the rolling 60 month ma has now recorded a
new low of 497.98 and will certainly trend lower for several months as the 2006
and early 2007 data falls out of the calculation. As has been the case for many
months the sole positive data came from inventories which fell to yet another
all time low at 162K. Although the seasonal adjustment process may create
some upside surprise in the data over the next few months it is next spring at
the earliest that the long awaited recovery in the US New Home market can be
expected to occur. In the meantime the industry will continue to muddle through
with the same resourcefulness that has kept many public builders solvent
through the most difficult period on record for their industry.

We warned earlier last week that copper breaking down below key support at
$8,500 was potentially a very bad sign for the commodity complex. This was
borne out by subsequent losses for copper (now trading at $7,069, well
below our own aggressive downside target of $7,500) followed by silver
which collapsed at the end of last week and has followed through this
morning to trade as low as $26.07 this morning before recovering to $28.31
(still down 9.00% for the day).

However, deep as these losses are, they pale into significance behind those
of gold which has been the primary destination for "safe haven" capital
over the last 18 months. As recently as last Wednesday evening, gold was
still above its 50 day ma at $1,782 giving the illusion of technical
strength during a troubled market. This protection was stripped away over
the next three sessions with gold plunging as low as $1,532 during the
overnight session when it would appear that margin related selling in one
or more Asian market forced prices sharply lower. The metal has staged
something of a recovery this morning and is currently trading around the
$1595 level for a loss of over 10% since Wednesday night. It is important
to note that last night's collapse in price took the metal through key
long term support at the 150 day ma, a level which has only been breached
during one intra-day session since January 2009 close to the start of
gold's parabolic run up from just over $682 to its recent high of
$1921.15, 280% its post Lehman trough. Most observers will be focused on
the 200 day ma which comes in at $1527.80 and therefore has not been
violated. Although we recognize the almost universal popularity of this
measure (and would admit it still has relevance) it has not been the key
trend indicator for gold, which bounced off its 150 day ma during several
prior brief corrections over the last 32 months (see longer term chart).
This morning's decline therefore has significant longer term implications
for gold, although we would prefer to see the measure violated during the
more densely populate US session and confirmed by a close below this level
before making any definitive conclusion.

Clearly gold's decline could not have been worse timed with regard to the
end of the quarter. It will place a great deal of additional pressure on
managers and investors who had relied on gold's strong gains to balance
awful performance elsewhere in the portfolio. This is particularly true of
investors that matched a concentrated holding in either Financials or
emerging market equity and debt instruments, both of which areas have been a
popular combination to hold with a concentrated position in gold.

We warned readers a couple of weeks ago that silver was in danger of
breaking down and pointed out the similarity of the metal's performance in
2011 to that of the NDX in 2000 (which itself was a mirror of the NKY
index in 1989/90). Recent days have borne out our concerns with the metal
collapsing abruptly to reach $32.50. This is very much "last ditch"
support for the metal, representing the level reached in the first wave of
the decline. If the metal follows the NDX index's 2000 path it could enjoy a
brief and powerful rally back as high as the $40 - $45 range (perhaps on the
back of the ECB finally starting the printing presses) but even this move would
be a last gasp recovery before a much deeper correction took hold.

It is of course possible that silver will now trace out its own path, with the
metal looking for deeper support at either $30 or $27.50 before enjoying
some respite. In the end we are not sure that the shorter term path will
matter a great deal. Silver's explosive 10 year move from $4 to $50 looks
to have decisively ended with the metal now 6 months into what should
prove to be a long and painful bear market, albeit one punctuated by brief
and powerful rallies. - D-SILV_Comdty.gif -

In recent weeks the considerable "mission creep" by the rating agencies into
political prognosticators has brought them into deserved disrepute but this
should not obscure their usefulness as a source of timely information on credit
trends since they are far better at reporting the past than predicting the
future (unfortunately they are largely paid for and relied upon for the latter).

Attached is today's report on US Credit Card Delinquency which underlines that
the 22 month improvement in delinquency remained intact in August. This is
important since we view consumer credit metrics as an important counterbalance
to official employment data since they are very sensitive to a genuine
deterioration of employment. No such deterioration was visible in August and
the report suggests that the US consumer if financially well positioned to
indulge in the traditional heavy shopping period between September and December.

Today's headlines include the news that the MSCI World Index has declined
20% from its peak triggering a mathematical definition of a "bear market"
decline. As ever the devil is in the details. Portions of the world do
appear to have entered a bear market, by which we mean the dominant force
will be towards lower prices and that the 2010 or 2011 highs will not be
re-seen for a significant period of time. This would include most emerging
markets, EM proxies (such as Australia) and Euro-zone indexes. We would
add to this US large financial companies and possibly commodity related
equities (where it is too early to be sure). However, we base this comment
not on a scan of the charts but because the decline in these portions of
the global market confirms a fundamental deterioration (most obviously in
monetary conditions) that started several months ago and which we highlighted
throughout the first half of 2011.

On the other hand large portions of the US equity market are still
experiencing what can only be termed a normal correction. Most clearly the
consumer discretionary sectors and their intersection with technology have
been extremely robust and this strong market performance has been backed
up by decent corporate earnings right up to the present day. We use the
NDX index as a proxy for this combination at even after yesterday's decline the
index was down -1.5% on the year. Although the NDX will remain vulnerable
to the global downdraft while it remains in place, its losses should remain
a fraction of those encountered elsewhere, even before currency
fluctuations are taken into account. Furthermore the index is likely to lead
the recovery in equity values that will come when some credible shift in
policy is forced upon the ECB and Europe's political establishment.

As the attached chart shows, the global financial marketplace has actually
showed discernment in its behavior, with the greatest year to date losses
(on a currency adjusted basis) now located in the emerging market complex.
As of last night's close the MSCI Emerging Market index was down over 27%
for the year and has lost further ground this morning. Germany's DAX is
down 23.5% in local terms (the EUR is essentially unchanged against the
USD for 2011). In contrast the SPX is down 10.19% (even after the 27%
collapse by the large financial sector and 20% decline in Materials) and
the NDX index 1.5%. The Consumer Discretionary portion of the SPX is down
-5.9%, while Consumer Staples have risen 0.65%. Although at the level of
global indexes it may appear to be a re-run of 2008 there is substantially
more resilience in portions of the US equity market than we saw 3 years
ago. - D-MXEF_Index.gif - spxgroup2011.gif

The sudden collapse of EM currencies has come as a rude shock to many
participants and has produced conditions in FX markets unseen since the
crisis of 2008. One measure of this is the degree to which implied
volatility for EM FX options have surged in recent days. Attached is a
chart showing the JPM G7 Currency volatility index with that of the JPM EM
Currency Index. Note that the G7 index has moved sharply higher to 15.64
but remains at the level reached in May 2010 when Greece's credit issues
first burst on the scene (it easy to forget that the EUR traded at 1.19
against the USD in June 2010, down from 1.50 at the start of the year).
The EM index on the other hand is now at 18.33, a level unseen in the 10
year history of the index apart from in late 2008 - early 2009. Note also
that the EM index made its recovery low as late as July 8th 2011, when the
index reached 8.50. At that time EM implied volatility was 2.5 points less
than the US measure, also a post 2008 extreme. We suspect that the steady
downward move in EM currency volatility together with the appreciation of
currency values had encouraged a significant amount of short put trading as a
way to augment income. This in part explains the rapidity of the recent move
higher in vol (and lower for currencies). However, the size of the losses
means that redemption pressure has now been generated in the emerging
market bond complex, which for months has struck us as a dangerously
overcrowded portion of global asset markets and this has the potential to pile
on the misery. Although we doubt the extremes of 2008 will be revisited across
the board weaker currencies may come close to this level (indeed the TRY has
recorded an all time low today) we do expect losses to continue. In most cases
the levels recorded against the USD in the summer of 2011 are likely to be long
term peaks unseen again for a considerable period of time. -
D-JPMVXYG7_Index.gif -

Despite the rapidly building stresses in the Euro-zone funding system there has
been no stated change of policy regarding the maintenance of the ECB balance
sheet. However, our tracking of the weekly data shows that there has been a
fairly notable increase in the size of the balance sheet since the introduction
of an expanded facility to purchase Italian and Spanish debt.

As can be seen on the attached chart the official ECB balance sheet grew
by 2.32% last week and is now at its largest level since June 2010. The
balance sheet excluding gold (which is revalued periodically but
fluctuations in gold's price has no influence on liquidity levels) grew to
€1,771 Bln, an increase of 13.28% over the last 13 weeks.

It is unclear whether this surge is simply a reflection of the delay that
it takes the ECB to drain the effect of debt purchases by holding repo
auctions with European banks (in which case the balance sheet will shrink
back over the next week or two) or if there has in fact been an unspoken
shift in ECB policy regarding the size of its balance sheet. The latter
would suggest that we are close to the ECB reaching its breaking point
over a resistance to Quantitative Easing, but it is too early to draw this
conclusion with any certainty. Even so the ECB's provision of liquidity is
easing at the margins, although at a pace which is unsufficient to reverse the
deterioration in Euro-zone funding markets. - W-.ECB-GOLD_Index.gif -

This time last week the ECB announced a series of USD auctions aimed at
relieving an acute shortage of USD funding for Euro-zone institutions. This
caused a sharp reduction in stress measures and allowed a snap-back in European
asset markets to take place. We viewed this as a short window of opportunity
for more concrete steps to be introduced and unfortunately this period seems to
have ended without any progress being made. As the attached chart shows our
measures of Euro stress have moved back to where they were a week ago with
Italian 10 year yields (black) at 5.75%, the France Germany spread (pink) at
88.5 bp and the 3 month Euro swap (grey) -103 bp.

If the FRB's new policy of "Operation Twist" has been greeted by disappointment
by the market this is still far preferable to the continued ECB policy of
"Operation Twist in the Wind". Markets respond well to decisive leadership in
times of crisis and this remains sadly lacking on the far side of the Atlantic.
Meanwhile the spreading of dislocation into the emerging market complex greatly
raises the stakes for global investors, with the US asset markets and currency
increasingly looking like a safe haven. - eurostress92211.gif

As most people had expected the FOMC elected to extend the maturity of its
Treasury holdings by shifting $400mm of short dated paper (3 years or less)
into treasuries with maturities of between 6 to 30 years. In addition they have
elected to use proceeds from maturing or redeemed MBS holdings to purchase
additional MBS securities rather than Treasuries (a policy originally enacted
in August 2010). One more the FOMC was split with three dissenting votes
opposing this additional policy. It also should not be ignored that the
language used by the FOMC to describe economic conditions was substantially
more bearish, which from our jaundiced viewpoint is a positive sign for the US
economy.

As we explained earlier today the effect of this move on underlying monetary
conditions is likely to be moderate since they were already about as loose as
can be accomplished prior to the statement. The major move post-announcement
has been in the ultra-long 30 year portion of the curve, which is the only
maturity to trade well above its 2008 low (3.04% compared to 2.51% in December
2008). Given that the 10 year to 30 year spread is still very wide at 118bp
(down 8 bp today) there is still some room for yield compression in this
portion of the curve. Nevertheless, as proved the case with QE2, we suspect that
the major portion of the move downwards has already taken place and the
treasury curve will now be vulnerable to any sense of renewed economic growth
in the US and/or a solution to Europe's funding issues.

As we await this afternoon's FRB statement and the possibility that some
additional policy easing is being considered, it is worth considering both
the state of current monetary conditions within the US and the actual
effect of QE2 on the US treasury market.

Looking at monetary conditions, these are currently extremely loose and
stimulative. One can argue about their effectiveness in stimulating actual
economic activity but there is little doubt about their level. At the
short end of the curve interest rates are at or below the 25bp FDTR all
the way out to 3 years (currently 28 bp), and are now anchored by the
promise made at the last FOMC meeting not to raise rates for an explicit
time frame. Clearly little additional change can occur even if the FRB was
to stop paying the tiny interest rate on excess reserves parked at the FRB
(although this would depress bank earnings in the meantime).

The longer end of the curve has been getting most of the attention, with
the possible decision to extend the average maturity of debt held. But
here again current yields are already extraordinarily stimulative. Perhaps more
importantly not only are rates low, but actual money supply growth has suddenly
started to accelerate with M2 growth now over 10% YoY.

One relationship worth considering is that between M2 annual growth and the 10
year treasury yield, since this shows the extent to which monetary growth
exceeds or lags the cost of longer term capital. With annual M2 growth close to
its 2008 peak (and exceeding this pace on a 13 week basis) and the 10 year
yield at an all time low, this spread has never been wider than it is today
(838 bp). Again having already achieved this remarkable combination of
ultra-low long term yields and rampant money supply growth it is hard to see
what more monetary policy can deliver. In fact we believe that the very
resilient performance by US equity and fixed income markets this summer are a
direct consequence of very loose monetary policy, in contrast with both
conditions and performance in most of the rest of the world.

The final point to remember is that even if the FOMC was to announce a
large scale intervention in the long end of the curve, it is unclear what
the ultimate response of the bond market would be. This time last year in
the run-up to QE2 the smart trade was to buy the middle of the US Treasury
curve ahead of the anticipated intervention by the FRB. The 5 year note
yield made its low on the day that QE2 was announced at 1.01% and went on
to back up all the way to 2.42% over the next 3 months as US macro data
and corporate earnings surprised to the upside (see chart). It was only towards
the end of QE2 that concerns over the US economy and then Europe led to the
massive flows back in to US Treasuries, with the low yield of 78 bp being
recorded almost 3 months after QE2 was completed.

Our opinion is that the US treasury yield is going to be far more influenced by
news out of Europe and emerging markets together with US macro data going
forwards than actual FRB activity. Today's statement may prove to be
influential for a few hours or a couple of sessions for global markets but US
monetary policy is not the main issue facing global investors today. Despite
the disappointment it would cause, we would be happy to see the FOMC keep to its
current track although we would not be surprised to see them bow to pressure
and be seen to be "doing something". - D-FARBTRSY_Index.gif -
D-M2%_YOY_Index.gif -

August US existing home sales came in somewhat above expectations as
5.03mm compared to 4.75mm consensus and 4.67mm in July. We do not consider
the positive deviance to be statistically significant and it still keeps
the existing home market mired at a level of activity equivalent to the
late 1990's. However, what this data does do is push back on the concept
of a double dip in the US housing market. In fact looking at the Single
Family home data what is surprising is how static the data has been over
the last 9 months with very little deviance in monthly reports since
November 2010. the 6 month ma (red) shows this and at 4.32mm is
indistinguishable from August's single month print of 4.47mm units. Perhaps
this steady pace of sales has something to do with supply as well as
demand, since we note that total inventory has stabilized around the 3mm
level. It may well be that the speed of processing foreclosure units is
starting to have an effect on the pace of existing home sales, accounting
for the steadiness seen on the chart.

In any case whatever the cause August's data is consistent with our belief
that the US housing market remains in the middle of a multi-year process
of working off the excess of the early 2000's. Clearly a faster pace of
sales would help, but this is not a requirement. Other than a benefit from
the swing in seasonal adjustment we do not expect to see much change
between now and the start of next spring, but at least a deterioration in
housing can be taken off the list of worry items for the weeks ahead. -
D-EHSLSL_Index.gif -

The silent meltdown of EM currencies continues apace with further sharp losses
being recorded over the last couple of sessions. We have updated our chart to
include the RUB (dark blue) which has fallen very sharply in recent days.

As can be seen the ZAR has now overtaken the TRY and is down 19.4% on a YTD
basis (but unlike the TRY nowhere close to its 2008 low). Perhaps the most
important line to follow though is the BRL (green) since Brazil was very much
the favored destination for fixed income flows during the first half of the
year. The BRL is now down over 9.3% for the year after appreciating strongly
during the first 6 months when investor flows were rampant. Since the start of
Q3, even allowing for the large positive carry on interest rates, the BRL is down
12.41% against the USD (see table attached), a loss that will come as a
complete surprise to many who rushed into this trade a few weeks ago. The sharp
losses in currencies have also depressed equity returns for USD investors. In
Brazil's case almost the entire recovery of a 19.1% rally in the IBOV from 47,793 to
56,945 has been extinguished by the currency depreciation. In USD terms the
index has bounced a mere 5.1% and is still down almost 25% for the year. -
emcurrenciesytd92111.gif - carryqtd.gif

We have spent much of 2011 outlining the clear stresses in the Turkish economy
and are unsurprised to have witnessed a sharp correction in the local equity
market and the TRY come within touching distance of an all-time low against the
USD.

These are not normally the conditions that one would imagine lead to a debt
upgrade to investment grade from a major credit agency but we have become used
to some very "bold" decisions from S&P in recent weeks, who are dominating the
headlines this morning after downgrading Italy from A+ to A last night.

In the case of Turkey, today's decision is a classic example of taking a clear
existing trend and extrapolating it forwards despite the fact that the
underlying favorable conditions have significantly altered for the worse. The
announcement may create a brief window of respite (the XU100 index is up 4.4%
and the TRY 1.36% at the time of writing) but it will not change the
significant problems facing the administrators of this economy at the current
time. Nor will it make Turkey's markets immune to what appears to be a
significant divestment of emerging market exposure by global investors should
this gather pace in the coming sessions.

We apologize if we sound like a broken record but the outperformance of the NDX
index, and the silence with which this has been greeted, is one of the more
mystifying aspects to the current marketplace. Perhaps this is because it is so
inconvenient to the dominant narrative which places a slowdown in the US
economy at the heart of the current problems, with the consumer anticipated to
be a key source of weakness. Meanwhile despite relentless outflows from US
equity mutual funds a number of large consumer sensitive technology and retail
companies have managed to record new highs in recent weeks, with AAPL becoming
the largest global corporation with a cushion of over $20bln to XOM.

However, it is important to realize that the outperformance of the index does
not derive from one stock alone (although after its recent gains AAPL is now
just over 15% of the NDX index). During yesterday's session for instance a
total of 8 stocks reached a new 52 week high, the largest number since July 8th
just prior to the run up to the 10 year high (see chart). That this should
occur at a time that most global indexes are bouncing off their 52 week lows,
and during a session in which many popular currencies lost 2 to 3% and a number
of commodity markets broke down, demonstrates that the NDX index has been the
most reluctant of participants in the wave of global "de-risking" that is still
ongoing. Indeed it would appear that the funds remaining in US equities are
starting to crowd into some of the more obvious names with clear signs that
they are being accumulated on weakness. This has created a "safety net" effect
during weaker sessions and caused the index to suffer significantly less damage
than all other major global markets, while participating fully during stronger
sessions in global markets. - ndxhilo92011.gif

We have argued for several weeks that copper is the key commodity to
follow in order to get a sense of the "average" strength of the entire
complex, since its range-bound performance placed copper between very
strong gold and quite weak crude amongst the three major commodities. This
morning's breach of key support at $8,500 is therefore a significant move
that may suggest some liquidation is occurring across the complex at the
current time. Given the strong correlation of flows between emerging
markets and commodities it is not surprising that both should come under
sustained pressure, and that key support levels should give way in multiple
markets simultaneously. With less than two weeks left in the third quarter we
suspect that fund redemptions may have a large influence on the current market
weakness, with the need to sell to meet the month end deadline making for some
ugly downside moves. - D-LMCADS03_Comdty.gif -

With most eyes firmly fixed upon Europe it is worth noting that a sharp
deterioration in the performance of emerging market currencies in recent days.
This suggests that investor flows may finally be starting to reverse out of
both emerging market equity and fixed income markets, and threatens to make the
3rd quarter a very expensive one for investors who rushed into these popular
markets a few weeks ago.

Attached is a chart showing seven popular EM currencies all of which have been
rebased against the USD at 100 for their 12/31/10 values. As can be seen all 10
currencies are now down for the year with the losses ranging as high as 16% for
the TRY (purple), which today broke above the key 1.80 level and has led EM
weakness. Closely behind comes South Africa's ZAR (olive) now down 15.2% on the
year. This had been one of the strongest EM currencies over the last 24 months,
becoming significantly over-valued in the process. Perhaps most surprising is
the performance of the BRL (green) which is now down 5.6% for the year.
Although this is not yet a sizable loss YTD it comes in the face of massive
investor flows into local credit markets and magnifies the losses of the local
equity market (17.45% as of Friday) for foreign investors, while totally
extinguishing the positive carry from higher local interest rates.

Our sense is that this process has further to go and that the RBI's move to
defend the INR last week looks likely to be followed by a number of other
hurried currency interventions. It is important to understand that this would
change monetary conditions within emerging markets fairly sharply, since
interventions to prop up local currencies involve the selling off of reserves
and serve to deplete local money supply. Thus the positive twin forces of
investor flows and intervention to depress local currencies that did so much to
boost emerging market performance (both in terms of actual activity and market
performance) have suddenly reversed in recent weeks, with some troubling
implications for investors still heavily exposed to this asset class. -
emcurrencies9192011.gif

September's University of Michigan poll came in at 57.8 just above consensus of
57, but this does not change the fact that this is a remarkably low number
given current economic conditions. At 2.8 points higher than last month's
multi-decade low this reading remains in a territory only previously recorded
during the deep recessions of 2008/9 and 1980. The same can be said about the 6
month rate of deterioration which hit -21.80 in August and bounced to -9.70 in
September. These sorts of readings have previously only been seen as a reaction
to a sharp deterioration in economic conditions and not during a period in
which the economy's direction hangs in the balance. The polled population has
clearly become much more cautious about future risk in recent years, which is
understandable, but does not change the future outcome.

Fortunately there is little historic evidence that consumer sentiment affects
actual retail activity in a straightforward manner. Where it does tend to
matter is in investment flows since this data tends to follow substantial moves
in equity markets. Again this collapse is an exaggerated response to losses in
the overall US equity market, but perhaps this is because retail activity has
been concentrated in "cheap" financial stocks and non-US equities both of which
have fared far worse than the overall equity market (the SPX is down -3.26% YTD
at the time of writing). - univodmichigansep11.gif

In recent weeks, the vast majority of emerging market central banks have
either placed policy hikes on hold (Chile was the latest example yesterday
afternoon) or actually reversed course and started implementing cuts
(Brazil and Turkey). The Reserve Bank of India (RBI) chose to break ranks
last night and raise the 3 month REPO cut off yield by 25bp to 8.25%. This
brings the cumulative rate rise since March 2010 up to 3.50% and the rise
over the last 12 months back up to 2.25%. The rate cut may not have been a
surprise (the majority of forecasters had anticipated it) but this does
not make it any less constrictive for an Indian financial system that is
already showing clear signs of stress.

However, as can be seen on the attached chart, the RBI has previously ignored
signs of weakness in the local asset market and in fact chose to push rates
sharply higher in 2008 despite an already weak local equity market. It was not
until after the collapse of the SENSEX by approximately 50% from its January
2008 high that the RBI made its first rate cut in October 2008 and there is no
reason to suspect that this institution has become more market friendly over
the last 3 years.

One issue further complicating policy is the sudden weakness of the Rupee
(INR). The INR spot rate moved sharply higher this week prompting direct
intervention by the RBI once it crossed the 48 level. In response to the
intervention and increase in rates, the INR has moved back to 47.26 this
morning, but this still leaves it under significant pressure. The weaker
currency is a double negative since it encourages higher local rates by
the RBI while increasing the risk of losses for foreign investors who remain.
As we have explained before, the INR and a host of other key EM currencies were
boosted by powerful investor flows into both fixed income and equities
over the last 30 months. This process has ceased in recent weeks and even
started to reverse at the margins turning a positive force into a headwind
right at the point that local asset markets and economies could use some
extra help. India remains one of the clearest example of this phenomenon
and we continue to regard it with extreme caution. - W-SENSEX_Index.gif -
W-INR_Curncy.gif -

The market has now had 24 hours to absorb the implication of yesterday's news
regarding the ECB's attempt to stabilize access to USD liquidity within the
Eurozone and its response has been a positive but hardly overwhelming
endorsement of this new policy.

In order to track this in real time we have added the 3 month Euro swap premium
(grey line lower chart) to our existing chart showing key Euro sovereign
yields. Conveniently its range is very close to that of the France/Germany 10
year spread and given that it is large French banks that have been the main
victims of the USD drought (caused by a refusal of US money market funds to
roll over large commercial paper positions) there is more than a numerical
coincidence between these two measures.

As can be seen this key funding rate improved sharply yesterday from -98 to -77
bp, before closing at -81bp. Today has seen a slight slippage down to -85bp
which still indicates a high degree of funding stress but at least not a USD
shortage that is feeding upon itself (which was the case prior to yesterday).
Note that the first USD auction will not take place for approximately 3 weeks
leaving the market to fend for itself in the interim.

The sovereign credit market shows a similar moderate improvement. The Italian
10 year yield (black) has moved down to 5.45% and the Spanish yield (red)
nudged lower to 5.30%, while the France/Germany spread (pink lower) has crept
up to -74 bp. Our sense is that this week's move has done no more than buy some
time for further steps to be taken. This in itself is an achievement for there
was a growing risk of an imminent rapid drain of liquidity from one or more
major European institutions. This has moderated over the last 48 hours but the
market will have limited patience with the authorities if further changes to
policy are not forthcoming. - eurostress91611.gif

Last month's Philly Fed data proved to be a very poor report that decisively
broke confidence amongst many market participants even though its weakness was
not really reflected in the more important national ISM data that was released
2 weeks later.

September's Philly Fed report shows some improvement (suggesting that August's
data was an abberation) but still remains in negative territory at -17.5,
slightly worse than consensus estimates of 15.0 (black line). The key New Order
metric rose to -11.30 but stays in negative territory which is the worst news
contained in the report. Inventories (blue) show a fairly fast rebuild at 10.20
and Employment (green) turned slightly positive at 5.80. Somewhat confusingly
shipments (not shown) fell quite dramatically to -22.8, which is hard to
reconcile with other data.

Interestingly this month's survey contained a special question regarding actual
activity over the 3rd quarter:

"How will your firm’s total production for the third quarter compare with that
of the second quarter?

Lower 41.1
No Change 17.8
Higher 41.1
Average increase: 0.3%*

Again this does not really tally with the sense the overall data has given of a
sharp slowdown in regional activity. A further question regarding the 4th
quarter did come out on the negative side on balance but not to the degree that
may have been expected:

"For the upcoming fourth quarter, what growth do you expect for production at
your plant compared with third quarter?"

% subtotals
Significant deceleration 8.1
Some deceleration 21.6
Slight deceleration 18.9 48.7

No change 10.8 10.8

Slight acceleration 16.2
Some acceleration 17.6
Significant acceleration 4.1 37.8
NR 2.7 2.7

Total 100.0 100.0

As with so much of the recent US data we would describe today's Philly Fed
report as disappointing without offering decisive evidence of the degree of
slowdown that is rapidly becoming baked into consensus belief. -
phillyfedsep2011.gif

Earlier this morning the ECB announced the first major change to its
liquidity management since the acute funding pressures within the
Euro-zone became apparent. This involves the creation of 3 separate
auctions of 90 day USD paper to be held on October 12th, November 9th and
December 7th and is designed to address the particular shortage of USD
liquidity that we highlighted yesterday on the chart showing the 3 month
Euro swap rate. Although we do not believe that this represents the sort
of decisive shift in policy that would place a line under this traumatic
episode, it is an important shift in both rhetoric and policy that
indicates that the ECB and other central banks are at least watching the
deterioration of liquidity and starting to design specific policies to
address it. The initial response of the funding market has been impressive
with the swap rate improving to by 18 bp to -80.25 (see chart), although this
still represents a very abnormal level for this metric.

We would also note that the FRB has been pulled into this new action,
echoing its key role in the collapse of Euro-liquidity 3 years ago. In the
weeks after the crisis the FRB injected a total of $650 bln into global
central banks, a large portion of which went to the ECB (with substantial
funds also being sent to a number of key emerging markets).

This can be tracked on the weekly report of the FRB's balance sheet that comes
out each Thursday afternoon (FARBCBLS index for Bloomberg (c) users).
Interestingly having been at zero for many months this facility briefly spiked
to $200 mln on August 17th and $500mln on August 24th before falling back to
zero one week later (we had not noticed this activity prior to today). Although
these sums are trivial, the sudden reactivation of this facility prior to
today's announcement is surprising and is possibly a sign that the FRB wished
to test the operation of this facility in case it needed to be reactivated
(note this is pure conjecture on our part).

We have speculated before that the FRB could ultimately be pulled into a
coordinated rescue of the Eurozone debt market and today's announcement takes
the FRB one small step further towards a fuller involvement (although we would
still describe this as an "outlier event").

Meanwhile the reaction of other European asset markets to today's news is
instructive. Equity markets have rallied hard, aided by the fact that this
announcement was made on the eve of tomorrow's option expiration which causes
the maximum disruption to those holding large put positions (this is an old
trick of central banks, initially used by Alan Greenspan at the height of the
LTCM crisis in October 1998). Whether these gains can be sustained into next
week is therefore questionable in the absence of improvement in other key
markets such as sovereign credit. This has been largely unmoved by
today's announcement, with yields remaining highly extended for Italian
(5.58%) and Spanish (5.40%) 10 year paper while the France/Germany spread
has ticked higher to -78bp (see chart). This indicates that at best, today's
news represents the "beginning of the end" for this episode. While the change
in rhetoric and stance by the ECB and other central banks is helpful, it
does not constitute the sort of resolution to this long and troubling
episode that in our opinion is still required. - D-EUBSC_Curncy.gif -
euroyileds91511.gif

Another poor Initial Claims report has dampened the enthusiasm that had
built after the recent recovery in the US equity market. This week's
headline report rose to 428K from last week's 417K (revised higher from
414K). This is somewhat higher than the consensus reading of 411K and
takes the 4 week ma back up to 419K, roughly where it was in late July
prior to the sharp improvement in August's data. However, this week's
report covers the Labor Day holiday which means that the headline report
is calculated off 4 days of claims with the number then adjusted by an
assumption of how many additional claimants would have turned up on the absent
Monday. This together with other seasonal factors means that this week marks
the widest negative deviance between Non-Seasonally Adjusted and Seasonally
Adjusted claims in the annual calendar (see chart) making it significantly less
reliable than a normal week.

What we would say is that recent reports make the next 3 or 4 week's reports
somewhat more important than usual since they should indicate whether or not
recent data is an early signal that employment has started to deteriorate
within the US economy or simply one of the regular deviances from trend during
an economic cycle. - D-.INITSEAS_Index.gif - D-INJCJC4_Index.gif

We continue to be impressed at the robust performance of the NDX index,
which has resisted the temptation to collapse on a number of weak global
sessions and taken advantage of the periods of respite to regain ground lost
last month.

Today is an example of the latter and the gain of 36.4 points (1.66%) has
taken the index just above its falling 50 day ma for the first time since
the abrupt collapse at the start of August. The index is also back in
positive territory for 2011 making it unique amongst major global indexes.
The index still has plenty of resistance with the early September high (2268)
and the flat 200 day ma (2288)in its immediate path and would not be immune
to any further shock-waves emanating from Europe. Nevertheless it has
established itself as something of a safe haven in recent weeks despite is
makeup of economically sensitive equities and we expect it to hold up
relatively well for the duration of the corrective phase as well as lead
any recovery that follows. - D-NDX_Index.gif -

As rumors swirl regarding the stability of large European institutions it is
worth remembering that today marks the third anniversary of the day authorities
failed to find a workable solution for Lehman Brothers, sparking off the crisis
that led to gridlock in global funding markets and wholesale liquidation of
financial assets.

With this in mind we have attached two charts that compare the build up of
financial stress in the US and European funding markets in recent weeks to that
in the run up to Lehman's failure. For the US we are using the LIBOR/OIS
spread, which became the focus of rabid attention back in 2008 and for Europe
the 3 month Euro-swap rate.

In terms of the US, although there has clearly been a deterioration of most
measures of credit and funding markets to well below "normal" levels, these
remain well within acceptable limits for a deep corrective phase. They are
indicative of limited liquidation of financial assets and a pull back from
funding commitments but not the free-fall that was already in evidence in the
weeks leading to Lehman's failure. The LIBOR/OIS spread is typical in this
regard, widening to an abnormal 27 bp but well below the 85 bp reached on the
Friday prior to the "Lehman weekend". This measure was to soar to 350bp by
early October prior to the FRB's massive intervention in credit markets.

In Europe on the other hand measures of financial stress indicate that a much
higher risk of a "credit event" currently exists. The 3 month Euro swap
rate measures the premium that lenders will pay to access USD funding. In
normal markets this has ranged from 0 to -30 but in recent days has collapsed
as low as -112 (note that the opposite was true in 2008 when this rate was
still at a normal -14 on the even of Lehman's collapse). This highly abnormal
rate indicates a breakdown of the market mechanism within this important
funding market and suggests that Europe is experiencing levels of stress which
have historically preceded financial failure. Although funding markets can
dislocate and then repair themselves very rapidly it normally requires an event
to bring "closure" (no pun intended) to an episode that has reached the current
level of stress.

This does not guarantee that this will occur. There is still time for a much
needed shift in monetary policy and/or direct injections of capital into the
European banking system. But waiting for the results of well meaning conference
calls which are not followed up by concrete action or scanning the Chinese
Internet for evidence that large scale bond purchases may be forthcoming,
remind us of the tension that mounted as the limousines drove up to the NY
Federal Reserve on that sunny Sunday morning three years ago. -
euroswaprate20082011.gif - liborois.gif

India becomes the first significant emerging market to intervene to defend its
currency from depreciating against the USD. Note that despite the comments in
the story capital withdrawal is still quite moderate, but simply removing the
powerful inflows into Indian financial assets (over $30bln into equities alone
in 2011) has uncovered the latent currency weakness in a deficit economy.
Although an intervention such as this may work in the short term any sustained
speculative run on the currency is likely to force the rate well above the 48
level that has been chosen as the "line in the sand".

On the basis that it is more important to watch what a central bank does
rather than what it says it is doing we have started to monitor the ECB's
balance sheet quite closely. Weekly data is published on Tuesday morning
(US time) and breaks down the balance sheet into a myriad of categories.
One of these is the ECB's gold holdings, which are re-valued once a
quarter. Thus when interpreting the level of liquidity supported by the
ECB's actions it is necessary to back out the effect of gold price changes
since these really have nothing to do with the availability of credit in
the Eurozone system (the FRB in contrast holds its gold at a fixed value
well below the current market price).

The attached chart therefore shows the total ECB balance sheet ex gold holdings
(which currently total €363 bln) and this reveals that the ECB was even tighter
in early 2011 than the total balance sheet suggests. While the latter rises
steadily (if slowly) from late 2009 the balance sheet ex-gold shrank by
approximately €300 bln (16%) from June 2010 to April 2011, taking the balance
sheet's size back to approximately €1,550 bln where it was in late September
2008.

Recent action has ameliorated things to a degree and the balance sheet (ex
gold) has risen back to €1,723 bln, with the bulk of the increase taking
place at the introduction of the new expanded bond purchase program. This
week's data showed a further increase of €13bln (0.77%). This suggests
that the ECB has either chosen or has been unable to entirely sterilize
its bond purchases, but is not a sufficient pace of increase to suggest a
stealthy change of policy. Even after this recent increase monetary
conditions in the Eurozone remain inappropriately tight, reminding us of
the FRB's mistaken policy during the 6 months between the fall of Bear
Stearns and Lehman in 2008. - W-.ECB-GOLD_Index.gif -

We have been patiently monitoring silver since it made a climactic surge to
just under $50 since this move struck us as a textbook case of speculative
excess causing an important long term top to be put in place. Since that time
silver, unlike gold, has been unable to benefit from the deterioration in
financial stability and growing pressure on global central banks to move
towards looser (or in the case of the FRB even looser) monetary policy. Thus
while gold was able to surge from roughly $1,500 to a new all time high of
$1,900 at the start of July, silver's strong performance in percentage terms
(gaining roughly 26% from $34.70 to $43.70) only represented a partial
retracement of the steep decline suffered in May.

Thus far September has not been a kind month for silver, despite the continued
ructions in Europe. Losses of 4.12% last week have been followed by a further
loss of 4.07% today taking the metal just below the 50 day ma at the time of
writing. We would not yet consider this support to have been decisively broken
but it is certainly under pressure, and a breach would sent the metal down to
test what should be strong support in a band between the 200 day ma ($35.85)
and the May low ($32.12). Interestingly, a comparison of silver's 2011
performance to that of the NDX index in 2000 still holds up nicely and this
guide suggests that silver could be expected to decline to around $35 around
the current time,then enjoy one last bounce of support before commencing a much
more serious (terminal) decline a few weeks later (see chart).

Since we are dealing with two very different asset classes separated by a
decade in time there is no guarantee that history will repeat itself in this
manner. On the other hand there are reasons to pay heed to history's guide, not
least of which the inability, thus far, of silver to take advantage of what
theoretically are ideal circumstances to advance. - D-SILV_Comdty.gif -
silverndx2000.gif

Over the weekend China issued its monthly monetary statistics which
continue to show a steady tightening of conditions within the economy.
Total M2 grew by 1.01% in August but since this was a significantly lower
growth rate than August 2010 the annual rate of change slowed to 13.56%,
the lowest pace since 2001. The more volatile 3 month RoC ticked higher to
2.27% but this still projects an annual growth of less than 10% going
forwards.

Interestingly this reduction in M2 growth is occurring against a backdrop
of steady loan issuance which has been close to 600 bln CNY for the last
18 months. August New Loans totaled 548.5 bln CNY, which were a little
higher than consensus estimates of 500 bln. Back in August 2010 loan
growth of virtually the same scale (600.92 bln CNY) translated into annual M2
growth of 19.21%. This shows the effect of accelerating asset prices and
the total volume of assets available for purchase (primarily housing
related), causing the same amount of nominal lending to result in quite
different monetary growth.

At 13.5% M2 is now at or below the reported growth rate of Industrial
Production (13.5%), Retail Sales (16.9%), Urban Fixed Assets (25%) and Imports
(30.7%). We may not yet have reached the point at which monetary policy has
disrupted economic activity (although as we explained on Friday we doubt that
the official data will make this apparent in real time) but we are certainly
headed in that direction. The prevailing view of either no slowdown or a
moderate "soft landing" still strikes us as somewhat optimistic. -
D-CNMSM2_Index.gif -

The attached short statement from the ECB this morning shows that strains over
the Euro-sovereign crisis are reaching their breaking point in both asset
markets and board-rooms. Nowhere have these ructions been more painful than
within Germany, which is in the unfortunate position of playing unwilling "ant"
to the surrounding "grasshopper" nations. We have commented extensively in
recent weeks on the performance of the DAX and it is unsurprising that it is
Germany's prominent ECB member Juergen Stark which has chosen to resign in
protest as to whatever "solution" is being proposed within that body.

In terms of the market reaction we note that the Euro is finally starting to
come under pressure and that it fell sharply in response to this announcement.
We had been quite surprised at the resilience of the key €/$ cross in recent
months but key support at 1.40 seems to have finally been broken and the
process of "catching up with reality" is typically fairly brutal. There is no
obvious support before 1.35 and even that level may prove to be a resting place
before this currency resumes a deeper decline.

+------------------------------------------------------------------------------+

ECB: 9 September 2011 - Jürgen Stark resigns from his position
2011-09-09 13:45:40.211 GMT

http://www.ecb.int/press/pr/date/2011/html/pr110909.en.html

PageExcerpt:
Today, Jürgen Stark, Member of the Executive Board and Governing Council of the
European Central Bank (ECB), informed President Jean-Claude Trichet that, for
personal reasons, he will resign from his position prior to the end of his term
of office ... - eurusd9911.gif

In general we caution that most economic statistics are simply too
volatile to be followed on a month to month basis, and that they should be
used as a guide for general trend (which they are fairly good at
monitoring) or direction rather than as an indication as to where exactly the
economy is at any point in time.

In China's case the problem with the data over the last couple of years is that
it is simply not volatile enough. Even if we were deluded enough to believe
that China's "command economy" results in a superior control over the the
outcome of economic policy we would still be left trying to understand how
China's statisticians are so much better at measuring this activity than every
other major economy. Absent in China's data are the large monthly swings either
side of a mean that can amount to several percentage points in faster growing
economies (see for instance Brazil, India and Turkey in comparison). Instead
the three major measures of activity (Retail Sales, Urban Fixed Assets &
Industrial Production) have remained remarkably static, despite a historic
tendency to fluctuate fairly wildly prior to 2009 (see attached chart).

August's data followed the familiar pattern with Industrial Production
(13.5% vs. 13.7% consensus), Retail Sales (17% vs. 17%) and Fixed Assets
Investment (25% vs. 25.2%) all being reported in line with expectations.
This is even after a fairly radical change in monetary conditions over
recent months, which in theory should have seen somewhat more of an
acceleration 12-18 months ago and a deceleration in recent months. Our
growing belief is that China's official economic data should not be relied
upon to make any substantial investment decision and that the few private
sources of data (such as sales reported by public companies) will prove to
be a much better guide to any change in conditions. Note this does not
mean that China is already decelerating, simply that one cannot conclude
that all is well by taking official data at face value. - D-CNRSACMY_Index.gif
-

A very good summary of what to expect tonight from the President. Needless to
say we do not see this speech as marking a turning point in the correction. If
anything it risks reminding the market of the woeful shortcomings of leadership
on both sides of Washington's aisle.

US Initial Claims remained slightly higher than expectations of 405K
coming in at 414K. Last week's claims were revised 3K higher to 412K but
deviances of this magnitude are well within the error tolerance of this
series. This data takes the 4 week ma up to 414K, where it was in mid-July
prior to August's improvement but still well below the level seen in early
May. Claims therefore remain somewhat better than the non-farm payroll
data released for August and show not significant deterioration in
employment over the last 6 months (but no improvement either). There were
no special factors in today's data but it does mark the last report before
the Labor Day holiday and the consequent change in seasonal adjustment. -
D-INJCJC4_Index.gif -

Given that the SPX index stopped making straightforward positive progress
in mid February (shortly after doubling its March 2009 trough value) it is
interesting that it is only in the last couple of weeks that strategists
have started to change their 2011 year end targets. Bloomberg helpfully
keep track of the consensus in a single index (although it should be noted
that this is based on the larger Wall Street houses rather than a totality
of the entire range of opinion).

As can be seen on the attached chart, the normal practice has been to issue a
bullish year end target in January (hence the staircase like effect on the
chart) and then wait for the market to catch up. On 5 occasions since the data
starts in 1999 the market has beaten the consensus (2009 marking the peak
outperformance), with the other years seeing some significant misses.
Unsurprisingly strategists tend to be reactive rather than predictive. There is
no example of the mass of opinion predicting a sustained transition from bull
to bear markets or vice versa. No doubt individual strategists have had their
successes, but these are balanced by the simultaneous failures of their
peers.

The current situation is intriguing since the last few weeks of August saw
a fairly sizeable cut in the year end consensus from just over 1400 to
1359, the latter being the lowest consensus target for 2011. Note that no
update to this index has been issued since the release of last week's
employment number which caused much hand wringing, and we suspect that a
further trimming of estimates will take place in the near term. Even so
the SPX index still lies approximately -175 points below the year end
target and was -233 points below in mid August. The only time this gap has
been wider was during the rapid bear market declines of 2000-2 and 2008-9.
On the other hand, 2010 witnessed a very similar gap open up in the summer
months (-227 points in early July) but still saw the SPX beat its year end
target, embarrassing those who were pressured into cutting estimates
during the correction

2011 is therefore poised between a bullish repeat of last year and the
more troublesome examples of prior bear markets. Perhaps the answer to
this conundrum is that we may be witnessing both phenomena across
different sectors. We have no problem defining the financial sector as
being in the middle of a deep bear market, with little likelihood of the
2010 recovery peak being matched for a significant period of time.
Similarly many non-US markets have exhibited behavior much more typical of
the early months on long bear markets than brief "bull market corrections".
Within the US on the other hand, there are a significant number of sectors and
individual issues that have suffered only moderate damage to their 2009
recovery trend lines, and we remain fairly optimistic that new recovery highs
can be established within these areas once the current corrective phase is
behind us. - W-.SPXSTRAT_Index.gif -

An interesting article that highlights a very important change in sentiment
amongst retail chains. New-store openings have been a notably absent factor in
the 2 year old economic recovery and while retail sales overall have remained
much more robust than most expected there has been a steady stream of new
supply from shuttered bank branches and companies that have lost out to
electronic sales (particularly in books, video and music). A change in this
dynamic would have broadly positive ramifications that would spread well beyond
the income statements of retail mall operators, and would also confirm our
positive stance on the US retail sector as a whole.

As we had expected, the long weekend took place against a backdrop of
sharply deteriorating conditions in the Euro-zone credit market with
Italian 10 year yields back at 5.50% and the France/Germany spread at -85
bp (see chart). This together with weak employment data on Friday has led
to not just equity weakness in today's US market but a substantial up-tick
in financial stress as well. Attached is a chart of the Bloomberg US
Financial Conditions Index (BFCIUS index) which some of our longer time
readers will recall was a constant reference point for us in 2008 & 2009.
This index takes an array of risk metrics (including the VIX, credit
spreads and swap spreads) and shows their collective standard deviation
from mean conditions. As can be seen, with the exception of the "generational
fat tail" of 2008/9, prior deep corrective phases have culminated with the
BFCIUS breaking through the -2 level. Last summer was an exception, but in
retrospect this was really simply a "profit scare" caused by an unusually
violent US data cycle, after the initial scare surrounding Greek sovereign
credit there was never any distress within non-equity markets, with most of
this concentrated on the US from July onwards.

2011 has been a much more damaging affair, at least outside of the US.
Equity losses in many countries are now well over 20% and clearly 2011 has
been the year in which Euro-zone credit has ceased to clear in the private
market without heavy central bank intervention. It is therefore
unsurprising that somewhat more stress has been visible in the BFCIUS index
which fell below -1.40 this morning (see attached chart). Our assumption
is that from this point on any deterioration in conditions outside the US
(both in the Euro-zone and emerging markets) will start to be transmitted
more forcefully to US asset markets (particularly credit markets) and that
the BFCIUS will end up much closer to the -2 level than it is today. As
troubling as this might seem, this would probably mark the beginning of
the terminal phase of this long corrective phase and create a good buying
opportunity for both US equities and HY credit (we do not see a repeat of
2008 taking place in the US).

We believe that global central banks are close to capitulating under the stress
of capital markets and note that the last week has seen surprising moves by
both Brazil and Switzerland, both of which are important but perhaps not first
tier central banks. The ECB remains the key to the current crisis we continue
to wonder how much more damage will need to be incurred within that region
before this institution changes its rigid stance on monetary policy. We are far
less interested in the actions of the FRB since the US already has very high
levels of liquidity (M2 growing over 10.2%) and extremely low rates across
the entire yield curve. There is little else that the FRB could establish
from any further monetary action at the current time. - W-BFCIUS_Index.gif -
euroyieildsep62011.gif

The ISM Non-Manufacturing Survey for August climbed to 53.3 from 52.7 in July,
allowing it to beat consensus estimates of 51.0. Underlying data was reasonably
robust with New Orders (52.8) and Business Activity (55.6) both staying in
positive territory. Backlogs remain slightly negative at 47.5 (up from 44.0)
and Employment just stayed in positive territory at 51.6 (52.5).

None of the above gives any hint of recession for the US service industry. On
the other hand the comfort to be drawn from this data is limited by the fact
that it has been quite late to indicate a deterioration of conditions over the
14 years of its existence. By itself, the release of this data is unlikely to
change the rapidly hardening consensus that the US has experienced a sharp
slowdown in growth but it still belongs in the positive side of the data ledger
where it has somewhat more company than many observers realize. -
ismnonmanaug2011.gif

August's Non-Farm report would appear to confirm the worst fears regarding the
US economy but we would resist the urge to read too much into data that has a
history of massive fluctuation. Not that this will stop the marketplace
reaching its own conclusions, and we would expect a fairly violent reaction to
this data given that Europe was already showing signs of unraveling prior to
its release.

In terms of the report itself Total Payroll Change was estimated at 0K compared
to a consensus of 68K. Last month's data was also revised sharply lower to 68K,
with all revisions at the expense of Public Sector jobs. The Private Sector
payroll change fell to 17K vs. 95K consensus but this data was dragged lower by
45K because of the effect of the Verizon strike. Even so 62K would have been a
very weak month compared to last months 156K of Private Sector additions. This
month's data takes the 12 month ma of Private Sector payroll gains to 142.2K,
which remains at the low end of expansionary conditions. Note that it is not
uncommon for single month data (black dotted line) to approach zero during
periods of economic growth.

Interestingly the sector breakdown of job creation/losses shows a slowdown
across virtually all categories. Most will see this as confirmation that all
employers simply refused to hire in the face of uncertainty over economic and
political issues. There may be some truth in the notion that uncertainty
creates inertia but in our experience when a blanket change in data takes place
it is normally some heavy handed adjustment within the BLS that is causing the
data to shift dramatically. The business decisions that drive economic activity
simply do not operated in this simplistic manner, nor do economies act as a
single body across industry classifications. Furthermore a slowdown of this
magnitude would have shown up in some of the other employment metrics such as
Claims data or private sector surveys. Our assumption is that not for the first
time the Non-Farm Payroll report has taken a trend and exaggerated it out of
proportion.

+------------------------------------------------------------------------------+

U.S. Employment Change By Industry for August (Table)
2011-09-02 12:39:10.663 GMT


By Chris Middleton
Sept. 2 (Bloomberg) -- The following table shows the change
in employment by industry and the year-to-date figures for 2011.
*T
============================================================================
------------Growth in Payrolls------------
Aug. Year Chg 2 Yrs Ago 3 Yrs Ago
============================================================================
Total Nonfarm 0 1,259 1,170 -5,615
Goods Producing -3 294 -60 -3,168
Construction -5 4 -322 -1,591
Manufacturing -3 206 129 -1,601
Durable Goods -3 220 200 -1,118
Computer & Electronics 1 27 18 -115
Motor Vehicles and parts -3 12 55 -148
Private Service Providing 20 1,415 1,796 -1,832
Trade, transport -8 337 172 -1,297
Retail Trade -8 157 91 -665
Transportation & Warehousing -2 86 78 -244
Information -48 -80 -138 -345
============================================================================
------------Growth in Payrolls------------
Aug. Year Chg 2 Yrs Ago 3 Yrs Ago
============================================================================
Financial 3 -11 -110 -535
Business Services 28 500 822 -488
Computer Systems 8 72 102 71
Legal 0 0 -6 -45
Temp Help 5 150 495 -89
Leisure 2 165 161 -205
Education & Health Services 34 412 788 1,090
Educational Services -2 55 118 125
Health Care & Social Srvcs 36 358 671 966
Government -17 -450 -566 -615
Federal ex postal service 3 -75 74 178
State ex education 6 -63 -116 -141
Local ex education -6 -98 -231 -248
============================================================================
NOTE: All figures seasonally adjusted. Employment figures in thousands.
*T
SOURCE: U.S. Department of Labor {BLSW <GO>}

For Related News and Information:
For Non Farm Payrolls: NFP TCH <Index> HP<Go>
News on the U.S. labor market: TNI US LABOR <GO>
Stories on the U.S. economy: TNI US ECO <GO>
Stories on consumers: TNI US CONS <GO>

--Editor: Alex Tanzi

To contact the reporter on this story:
Chris Middleton in Washington at +1-202-624-1993 or [email protected]

To contact the editor responsible for this story:
Marco Babic at +41 44-224-4112 or [email protected]
- nfppchaug11.gif

As capital markets start to wind down ahead of the Labor Day weekend (although
tomorrow's NFP report will keep some activity going at least through the start
of trading) it is worth noting that Euro-zone yields have started to indicate a
moderate build up of stress once more.

As the attached chart shows, the Italian 10 year yield (black) has nudged higher
to 5.15%, its highest level since August 9th, while Spain's yield has stopped
improving at the 5.00% level. Any continued push higher by either countries'
debt yield will start to ring alarm bells. Meanwhile the spread between French
(blue) and German (green) yields has started to widen once more (see pink
line). This had recovered from almost -90 to -60 bp in mid August but has
started to move lower in recent days, reaching -72.7 bp today. This shows that
Euro-zone debt markets remains quite dislocated and the fact that Europe's
markets will be open on Monday creates some additional uncertainty for those
positioning themselves for the weekend. Our belief remains that this corrective
phase will not be behind us until the ECB has taken credible action to address
Euro-zone liquidity, although we would now treat any further downdraft in US
equities (particularly for the NDX index and retail stocks) as a buying
opportunity. - euroyieldssep12011.gif

The August 2011 Manufacturing report came in at 50.6 compared to a consensus
expectation of 48.5. We had felt that this consensus expectation was
unrealistically low and are not surprised to see the data beat this and stay
above the key 50 level. Even so we would have hoped to have seen a somewhat
better number given the fact that the impact of the debt ceiling debate on this
data (primarily from federal contracts not being issued) should have
diminished. Even so this data is much better than the scary (and we believe
erroneous) data that emerged from some of the Regional Fed reports.

New Orders (red) remained just below 50 at 49.6 (49.2 last month). The current
level is not a concern but a further deterioration would be. Production (blue)
actually fell a little more to 48.6 (52.3) while Inventory (green) grew to 52.3
(49.3). Employment (pink) fell to 51.8 from 53.5. Interestingly the largest
drop came in Export Orders (see separate chart) which fell from 54 to 50.5, in
line with our belief that any softness being felt in the US originates from a
slowdown in activity outside this country.

What this month's report demonstrates is the continued importance of domestic
US retail sales (including car sales) for the US industrial sector. Fortunately
the early signs are that August has been another decent month for retailers,
even with the total loss of East Coast sales for the key last Saturday of the
month. Our view remains that betting on global growth makes much less sense
than concentrating a portfolio within the limits of the internal US economy.
- ismaugust2011.gif - ismexport.gif

As we explained last week the US Initial Claims data had been effected by
the labor dispute at Verizon and the removal of this issue has led to a
fall back in Initial Claims to 409K from last week's revised figure of
422K. This moves the 4 week ma of claims up to 410.3K, but since 3 of
these weeks were boosted by the strike the true underlying number is close
to 400K. In any case we are far more interested in the behavior of this
index post Labor Day, when we suspect some financial sector layoffs will
hit, but be ameliorated by a much kinder seasonal adjustment process. We
still think it likely that Claims will push decisively below 400K by the
middle of Q4. Regardless of what tomorrow's NFP report comes up with, the more
reliable Initial claims data shows no significant deterioration in labor
markets has taken place in recent weeks. - D-INJCJC4_Index.gif -

Brazil's central bank sprung a major surprise cutting the SELIC rate by 50
bp to 12.00% on Wednesday night. All 62 economists surveyed on Bloomberg had
predicted no change to the rate, while interest rate markets had anticipated a
fall of perhaps 25 bp by the turn of the year. It would seem that the central
bank has responded to the clear political pressure exerted earlier this week
and to the weakness of recent economic data and the plunge in the local IBOV
index.

This sudden action is very reminiscent of the Greenspan FRB which suddenly
cut rates in early January 2001 outside of the meeting schedule. The
reaction of asset markets to that earlier move is instructive, the SPX
index gained 5.01% on January 3rd following the announcement and the NDX
index a remarkable 18.77%. Forward motion then stopped fairly rapidly and
by late February these gains had been erased. A new corrective phase
ensued by late March saw both indexes sharply lower than their level
prior to the rate cut. Our view is that something similar will occur in
Brazil. Once a mature economic cycle is disrupted by monetary pressure
simply easing rates does not fix the problem. A full inventory and
distress cycle needs to be completed first. Lower interest rates may make
the adjustment process less painful and create the conditions for eventual
recovery but it takes a considerable period of time for this process to be
completed. We have used the SPX index from 2000 - 2002 as a reasonable
template for Brazil's current market for a number of weeks (see attached
chart). The unexpected cut in the SELIC certainly plays into this
comparison and we would be aggressive sellers into the inevitable sharp rally
which will follow this move. We had used the 60,000 level as a potential bear
market rally target for the IBOV index and this still seems like a reasonable
level to look for.

The other market to consider is that of currency. Although Brazil's
interest rates remain high after this cut, their direction is clearly lower
on a much more rapid trajectory than the market had anticipated. The BRL
had stopped making progress against the USD for most of the last 4 months
and may now actually start to show signs of weakness going forwards. -
D-BZSTSETA_Index.gif - ibovspx2000aug312011.gif