Argentina is a country where paranoia could be termed a legitimate investment
strategy and recent weeks have seen a steady stream of capital outflows by
local citizens in the face of a lack of trust of the economic management of the
country. Today saw the introduction of a new requirement for both corporations
and individuals to register their identity on a government website prior to
undertaken an FX transaction. Although no restrictions on such trades have been
introduced and the policy has been changed under the guise of combating money
laundering it has caused some consternation in the local market.

Attached is a chart which shows the official Peso (ARS) spot price (red) with
that of the 3 month forward (blue) and the implied ARS rate (black) that would
be paid from the arbitrage of local shares of Tenaris (TS AR) with their
fungible US ADR (TS). The implied conversion rate has soared to 5.11% compared
to a spot rate is 4.23%, while the 3 month forward is at an elevated 4.66%.

Argentina therefore remains at the leading edge of emerging market instability.
Furthermore while local currency bonds are priced off the spot rate, it seems
clear that this overstates the underlying rate that any meaningful liquidation
of this popular asset class would receive in this skittish marketplace. -
argentinaarsrates.gif

Our regular tracking of EM monetary and credit data brings us to Hong Kong
which today published its September M2 and loan data. The former shows a stark
difference between domestic M2 growth in HK$ and that of foreign currency
(primarily mainland Chinese inflows measured in RMB). While the former has
ground to a halt (it actually shrank 0.3% over the prior 12 months) the latter
continues to grow rapidly with the result that it is on the verge of exceeding
local HK$ M2 for the first time since this data was published in 1996. This
suggests that local credit conditions for Hong Kong investors are now quite
tight, but that liquidity is now being exclusively provided by onshore Chinese
capital.

This tightening is visible in the Loan and Advance data which only grew by
0.89% in September. Although this still keeps the annual pace of growth above
20%, this is significantly lower than that seen a few months ago, and the last 3
months growth of just over 4% would represent a significant slowing of domestic
credit creation. - hongkongm2.gif - honkkongloanssep11.gif

With global markets back in a Euro-funk, our view is it is too soon to make any
bold claims about the success or failure of last week's announcement.
Thursday's euphoria looked like an overreaction at the time and it is little
surprise to see some reality imposed after the weekend. Clearly we would hope
to see some stabilizing of Euro-stress over the coming days with the Italian
treasury yield now apparently taking center stage having claimed its first
public victim in the form of MF Global this morning (whose portfolio
liquidation presumably has something to do with the particular weakness of
Italian treasuries over recent sessions). Without Euro-stress stability markets
will once more come under pressure, but we continue to believe that the US
equity market has a chance of ameliorating its losses if macro and corporate
data hold up well, while stability in Europe would allow more positive
performance to unfold.

Today's Chicago PMI data is a precursor to tomorrow's more important National
ISM data. Although the headline data at 58.4 just missed consensus of 59, this
is within the error tolerance of this series and keeps this indicator well
above the level seen before prior recessions (see pink areas on chart).
Similarly New Order (red) at 61.3 and Production (blue) data at 63.4 are both
robust readings although they are slightly lower than August's readings of 63.3
and 63.9. Inventory buildup slowed to a very healthy 54.4 (from 60.3) and
Employment (pink) grew to 62.3 (60.6). Should tomorrow's national data mirror
this report (consensus is for a fairly undemanding reading of 52) any
suggestion of an imminent US Industrial slowdown would effectively be shelved.
- chicagopmi.gif

We have spent the last 12 months predicting that Turkey's economic
management was likely to produce significant issues for investors and
there is growing evidence that events will play out in the manner we
anticipated. One of the central planks behind the easing of Turkish
interest rates over the summer was that the massive trade deficit would
"re-balance" from its record at close to 10% of GDP. For a couple of
months this appeared to take place but September's data came in at
-$10.4bln, a new record. This pulls the trailing 12 month ma down to
-$8,716 bln, or $104.6 bln over the course of the last 12 months.

To make matters worse the weekly currency reserve data was also issued
this morning and this showed a 4.15% drop in reserves to $82.32 bln, down
from their July peak of 93.9 bln. This represents approximately 8 - 10
months of the trade deficit at the current run rate, making the further
use of reserves to support the currency much more problematic (although we
expect that they will continue to be frittered away on this purpose).
Yesterday the Central Bank signaled that instead of relying on reserves it
would force banks out of the 1 week Repo market, where they could borrow at
5.75% into the far more expensive overnight market (where rates from the
Central Bank are as high as 12.5%). Clearly this caused a massive backlash
since this morning a surprise 1 week Repo auction was held while the Central
Bank also announced that bank reserves requirements would be cut for lira
deposits from 16% to 11%.

These continuous changes have been touted as a "strength" of the local Central
Bank by Governor Basci, showing its flexibility to react to monetary conditions
in real time. Unfortunately real economic decisions thrive on certainty and
that is a commodity in very short supply in Turkey. A monetary policy that was
once described as "macro-prudential" now perhaps deserves the less reverential
moniker of "hoke cokey" (or "hokey pokey" for our US readers). What is more
certain is that Turkey's numbers simply do not add up, and we notice that while
we were once alone in pointing this out to investors there is a growing chorus
of concern from the major financial houses and this is likely to encourage
investment capital to start to leave the Turkish debt and equity markets,
adding to the problems of the Central Bank. - D-TUTBEX_Index.gif -
W-TRY_Curncy.gif -

We won't pretend to have read the new European plan in detail but our sense is
that it meets our expectations for a solution that removes the European
sovereign credit market from its position as the dominant determinant of global
asset prices. In fact this change had already taken place a few weeks ago when
global markets made their lows at the start of October. Since that point a
considerable worsening of stress metrics within sovereign credit (most notably
the France/Germany spread) has largely been met with indifference by the
majority of risk assets, a distinct change from the strong linkage seen in the
first few months of this crisis.

No doubt the plan will not survive the close scrutiny of anyone with a remotely
critical mind, but this is not what was required for markets to stabilize.
Participants have had many weeks to prepare for the worst and many did so by
reallocating their portfolios away from risk. Now something "better than the
worst" has been delivered, there will be an inevitable shift back into areas
that had become de-populated. We doubt that this will allow Euro-stress
indicators to return to their "Euro era normal" but it may allow them to at
least return to the "pre-Euro normal" where wide but stable spreads were
allowed to co-exist without troubling markets.

We also believe that as the Euro crisis moves to the sidelines the coming weeks
will now start to be dominated by US economic data, which we expect to show
signs of improvement and be a positive force, alongside the growing signs that
the emerging market cycle is coming apart at the seams. This implies that markets
will remain much harder to navigate than the straightforward rally of Q4 2010,
but that there will be opportunities to make (and lose) money on both sides of
the ledger. - eurostress102711.gif

Following the improvement in the NAHB survey we had been hoping for a slight
improvement in September New Home sales and this was delivered in the form of
total Sales rising to 313K, above consensus estimates of 300K and last month's
reading of 296K. However, this still keeps activity at a very depressed level
and lowers the 36 month ma to a new all time low of 337.5K. Furthermore the
improvement in headline data is entirely due to seasonal adjustment with actual
monthly sales remaining constant from August to September at 25K (see NSA
chart), this is in line with our belief that at the current level of activity
the normal seasonality of the New Home market has broken down, with the few
buyers left much less influenced by weather conditions and other seasonal
determinants. If this proves to be correct, further progress could be expected
in the headline data over the remainder of fall and winter even if underlying
demand remains static. We also note the data reflected the regional disparity
of the NAHB with the West and South of the country producing better data than
the remainder. Again we would suggest paying particular attention to regional
markets since any recovery in the New Home market is likely to take place in
individual markets rather than suddenly taking place across the country as a
whole.

In summary this report keeps alive the hope of some better data in the coming
months while stopping well short of making this a certainty. This is still much
more palatable than suggestions of a "double dip" in housing which many had
started predicting at the height of the summer doldrums. - D-NHSLTOT_Index.gif
- D-HSMNTOT_Index.gif

Brazil's Private Sector loan data continues to show robust growth with
September's report showing total Private Sector loans increased by 1.58%
to 1106 bln BRL. The annual pace of increase moderated slightly to 18.49%,
but remains well above that of economic growth indicating that the leveraging
of the Brazilian economy continues apace. All categories of loans showed robust
growth, although Housing's increase of 2.24% was considerably lower than its
recent parabolic rate (Housing loans have increased by 47.3% over the last 12
months) and was the lowest monthly increase since November 2009. We would not
draw any conclusion from a single month's data but this will be a metric worth
watching in the coming months. Meanwhile loan delinquency and default remained
at their recently elevated level. The latter was flat at 6.8% allowing the 6
month ma (our suggested indicator) to rise up to 6.51% and we expect the level
of delinquency to continue to push higher in the coming months. -
D-BZLNPTOT_Index.gif - D-BRCDDEFT_Index.gif -

Turkey's Central Bank continues to follow its course of "hokey cokey"
monetary policy, with the abrupt collapse in the TRY causing a wholesale
reversal of their decision to lower rates in the middle of summer. This
morning saw the announcement that the Central Bank would no longer offer
funding via its one week REPO facility, which allowed local banks to
access funding at a 5.75% rate. Instead banks will now have to access the
overnight lending rate which is currently 12.5%. This move led to an
abrupt spike in overnight Turkish LIBOR, which surged to 11.16% this
morning, up from 9.29% yesterday and 6.58% a week ago (other tightening
measures were taken at the end of last week). This move has caused the TRY
to strengthen somewhat, with the spot rate falling to 1.77, its lowest
level since early September but this comes at a cost of sharply higher
local borrowing costs and the introduction of massive uncertainty into the
Turkish banking system.

To some extent the Central Bank had little choice. As we explained last
week, Turkey's reserves were somewhat less than the current trade deficit
before the bank started using them to intervene in support of the TRY. Any
prolonged use of reserves would have seen them depleted to the point of
exhaustion (a point not lost on global currency traders) and the bank has
therefore turned to interest rates to bolster its defense. Unfortunately
any prolonged spike in rates is likely to harm local economic activity and
place great pressure on the already pressured equity market as well as the
local bond market which has been a very popular destination for global
capital in 2011. This runs the risk of encouraging investor outflows from
both markets, which would in turn feed back into more pressure on the TRY.
Although today's move may work in the short term it only serves to
underline the very difficult situation that the Central Bank has created
by its mistaken policy earlier this year. - W-TRLIBON_Index.gif -

The Conference Board measure of consumer confidence collapsed to 39.80 in
October, the lowest reading since March 2009 when most fair minded readers
would agree things looked considerably worse than they do today. The "Present
Situation" indicator (blue) fell to 26 (it bottomed at 20.20 in July 2009)
while the Future Expectations index fell to 48.70, its worst reading since May
2009. Interestingly this deterioration has come against a backdrop of better US
economic data but perhaps those polled were more in tune with the emotions
being displayed in Zuccotti Park than the most recent economic reports.

From our perspective this somewhat perverse sharp drop back into extreme
negativity firms our belief that the worst is behind us for the US equity
market for 2011. Consumer confidence has an excellent track record as an
indication of retail investor sentiment (at least as good as the more widely
followed AAII survey), and as such is a good contrary indicator at extreme low
readings. What it does not do is track actual consumer spending. The Conference
Board does actually issue separate polls on intended purchases of a variety of
consumer items, including cars, homes and major appliances (although it does
not use this data in compiling the Consumer Confidence Index). It is telling
that none of these have showed a deterioration in an intention to purchase
goods over the course of the summer (although they are volatile from month to
month), despite the collapse in Confidence (see attached chart of "Intention to
buy Major Appliances". - consumerconfoct11.gif - majorappliances.gif

The RBI took the expected decision to raise the local REPO Cutoff yield to
8.50% last night but also chose to signal that no further hikes were likely for
the remainder of 2011. This news was favorably received by the market with the
local SENSEX index rallying 1.86% to the top of its recent trading range. As
welcome as the news that the RBI is on hold may be to local investors this does
not disguise the fact that last night represents another tightening for an
economy already showing sharp signs of deceleration and we note that US
corporations have started to mention Indian demand slippage this quarter (see
CMI's comments today for an example).

Furthermore it is during the period that a central bank is on hold at its
maximum rate for a cycle that the bad news typically starts to overwhelm a
market's confidence. For example the periods of May 2000 - January 2001 or the
first half of 2007 in the US both saw the FRB on hold at what was widely
assumed to be an acceptable rate for the US economy, as the US economy
deteriorated sharply and asset markets started to unravel. We expect a similar
pattern to play out in India, particularly in the more capital intensive
portions of the economy.

It is also important to note that the RBI's decision to raise rates was partly
in response to the weak Indian Rupee (INR), which briefly crossed the key 50
level this week. Emerging market central banks will be well aware of the
problems that have taken place in Turkey following an ill advised cut in local
rates, which was partially reversed at the end of last week. Interestingly the
weakness in the INR has not been caused by investor outflows from equities, but
rather a lack of inflows. New equity purchases YTD are virtually flat at
minus $314mm which compares to a level of approximately $24,000mm at the same
time last year. The Indian equity market therefore remains a very crowded trade
exacerbating the risks in the coming months. - W-INRPYLD_Index.gif -

As Europe's leaders continue to wrestle with their myriad of issues the market
has started to hone in on what we have always believed to be the crux of the
matter, namely the equivalence of France and Germany as sovereign credits. From
our perspective the entire Euro project was designed with the specific aim of
removing the traditional risk premium placed on France's sovereign debt versus
Germany and readers with long memories may recall the endless debate as to
whether the Euro would create a Franc out of the Deutsch-mark or vice-versa (no
one dared suggest it would create a Deutsch-mark out of the Drachma). This had
as much to do with the political aims of Europe's leaders (France's wish to
re-establish itself as a top tier power and Germany's understanding that it had
to burnish its European commitment as a recompense for re-unification) as from
the economic aim of lowering the level and volatility of local interest rates.

For over a decade this proved to be remarkably successful but 2011 has seen a
rupturing of the relationship. As the attached chart shows while other measures
of Euro-stress remain below their 2011 peaks the France/Germany spread has
blown out to a 19 year high of 119bp. Moreover this has been caused by a sharp
rise in the French 10 year yield suggesting that private investors are starting
to discriminate against French credits.

Although it is still possible that an acceptable deal will be crafted, the
danger is growing that this spread will start to accelerate. We note that
pre-Euro dislocations reached as far as -125 bp in August 1992, 150 bp in
September 1990 and 205 bp in January 1990. Although risk markets are currently
ignoring this issue we suspect that a continued widening would start to unnerve
markets, particularly if no agreement was seen to be imminent.

Even if markets settle in the aftermath of a deal it is going to be hard to
convince investors that the risk of investing in French or German treasuries is
equivalent. We would expect to see the relationship look much closer to the
pre-Euro period (when the average spread was just under 50 bp but varied
significantly from month to month) than the exceptional calm of 1999 - 2010.
This seems likely to be the most important economic and political legacy of the
crisis. - france-germanyspread102411.gif - eurostress102411.gif

Following yesterday's surprisingly good NAHB survey, there is a heightened
interest in this month's new housing market data. On the surface, today's
new start and permit data is an exciting report since the headline number of
658K is the highest since October 2008 and is well above last month's reading
of 572K and the consensus estimate of 590K. On closer review the data is a
little less clear cut since all of the gains are in the multi-family portion of
the survey where starts soared by 51% to 233K units (also the highest since
October 2008).

As the attached chart shows, multi-family starts essentially ground to a total
halt in 2009 reaching a low of 58K (down from their all time high of 450K in
January 2006). Having suffered a much deeper drawdown than even the single
family home industry (there was a complete dearth of construction financing
following the collapse of Lehman) this sector has been quicker to rebound as
limited financing has become available, particularly for multi-family rental
properties where end demand remains very strong in many urban markets.
Even though we suspect that September's data is an overshoot, the trailing
12 month ma of this data has risen from 88K in June 2010 to 152K this month,
which is clear evidence of a sustained recovery that puts this portion of the
construction industry roughly where it was in mid 1994 (when it was recovering
from the collapse of the S&L industry).

This does have clear positive implications for the overall US economy and
suggests that the multi-family construction industry has the potential to
be a meaningful contributor to employment and growth data going forwards.
With regards to the Single Family market, the data remains far more depressed.
Here total starts nudged up to 425K from 418K making it 36 straight months
below the 600K level. The more reliable Permit data paints a similar picture
and is almost unchanged at 417K (see chart). We would want to see readings
above 500K for single family permits in order to have a sense that something
meaningful was taking place, but we do recognize that it is Sales data that is
likely to lead this cycle, with record low inventory levels meaning that a
fairly quick response would be registered by construction metrics.

Overall we would describe today's data as more beneficial to the overall
economy than the narrow single family home building sector, although it
cannot hurt the latter to see the multi-family industry in a clear recovery. -
D-NHSPSTOT_Index.gif - D-NHSPA1_Index.gif -

An interesting article; note how much more negative commentary has become about
intervention over the last two weeks. The TRY also hardly budged in the face of
this move which represents about 1.1% of total Turkish reserves. We continue to
expect the TRY to break above the key 1.90 level.

The funny thing about sitting around watching paint dry is that it does
actually eventually dry, and something similar may finally be occurring to the
moribund US New Home market, which has been a notable absentee from the
2½ year old US recovery.

October's NAHB survey showed a surprising rise to 18 from 14 in September and
this is the best reading since May 2010 when tax credits were creating an
illusion of improvement in the US New Home market. 18 is still a very low
reading and keeps the index below the key 20 level where it has been since late
2007, but it does raise the possibility that something is finally stirring in
certain regions. The West region in particular stood out with a reading of 21
which is the highest since August 2007 (and is thus potentially the first part
of the US to break out of the slump), followed by the South which scored 19.
Future Sales were also strong at 24, but this metric would have to exceed 30 in
order to signal a meaningful change in conditions.

Together this represents the best overall NAHB report since the onset of the
financial crisis although it stops just short of representing a decisive shift
into a strong and lasting recovery. - nahboctober2011.gif

Bloomberg © story that describes the rise in Argentine Badlar rate (see
yesterday's note).

Last night saw the publication of China's quarterly GDP and monthly Industrial
Production, Retail Sales and Fixed Investment data. All have been the subject
of much scrutiny as observers look for comfort in their hope for a "soft
landing" or evidence of a deeper economic shock unfolding. For what it is worth
the data was slightly disappointing in terms of GDP (9.1% vs. 9.3%) but
slightly better than expected for Industrial Production (13.8% vs. 13.4%),
Retail Sales (17.7% vs. 17%) and Fixed Asset Investment (24.9% vs. 24.8%).

Unfortunately as comforting as this data may appear, it seems increasingly
unlikely that China's economic data will give an accurate indication of any
marked change in local conditions. As we have explained before China's economic
data has been suspiciously inert for a number of quarters in comparison to its
peers, and reflects no change in activity in the face of a very considerable
slowdown in local monetary growth (see yesterday's note).

Consider for example the key metric of Industrial Production, notoriously
volatile from month to month (it is apparently quite hard to measure as well as
being inherently volatile) in all countries bar China where it typically comes
in a few basis points away from expectations. Moreover, recent months have seen
a sharp slowdown in estimated Industrial Production in the majority of China's
emerging market peers. The attached chart compares Chinese IP (red line) with
the Average IP of India, Brazil, Indonesia, Turkey and Russia (blue). The
latter has fallen from just under 14% in March 2010 (the peak for annual growth
following the 2008/9 collapse) to a mere 3.9% in September 2011. China's IP has
fallen from 18.10% to 13.80% over the same period and shows no deterioration
over the course of 2011 while its peers have seen IP growth halve from 7.8% to
3.9%. We find the distinction of China having a uniquely stable Industrial
complex to be suspicious and suspect that facts on the ground have deteriorated
rather more than the official data would indicate. - chinaemip.gif

Europe's leaders have "never missed an opportunity to miss an opportunity" (to
borrow a phrase from Abba Eban) over the course of this long rolling crisis and
the period of calm created by the rapid expansion of the ECB's balance sheet is
in danger of ending before a credible plan is put into place.

Even prior to the weekend (and Chancellor Merkel's comments yesterday) the
Italian 10 year yield (black line) had moved back above 5.50% and this morning
have reached 5.85%. 6% would appear to be the psychological "line in the sand"
to watch. Spanish debt has been rather better behaved which is a reflection of
the manner in which attention has shifted to Italy over the course of the
summer. USD funding also remains very tight with the 3 month €/USD swap (grey
line) at -90.50 bp even after the first emergency USD auctions have been held.
At least this swap is stable and it would have to fall below -110 bp to signal
that USD tightness was becoming an urgent issue.

The clearest sign of stress this time comes in the form of the France/Germany
spread (pink) which has widened dramatically in recent days reaching a new
Euro-era low of -110 bp this morning. Note that this widening has been caused
by a RISE in the France 10 year yield (blue), whereas the summer widening was
caused by German yields falling further than French yields. This therefore is a
much more troublesome event for the Franco-German relationship (both in
political and financial terms)

We predicted several months ago that the France/Germany spread would be the
mechanism that the market used to force a solution on Europe's leaders and it
certainly appears that this assumption has proved to be correct. There is still
time for an acceptable solution to be crafted but there are also still large
gaps to be bridged between those responsible for delivering one. -
eurostressoct1811.gif

One of our more stubborn beliefs is that great popular trades fall apart
at the margins with weakness then spread to the core members of the
group. For instance, the decimation of zero income dot-com companies
took place many months before the peak in the large cap technology
sector back in 2000. We have therefore been monitoring some of the
more marginal EM countries quite closely in recent weeks for signs of
heightened distress. We have commented on emergency rate hikes in
several African countries before (not something we would usually bother
commenting on) and today we will focus on Argentina where local deposit
rates suddenly surged towards the end of last week.

Attached is a chart which shows the local Baldar rate which hit 17.375% on
Friday (the rate is published with a 2 day lag). This compares with a rate of
approximately 11% in June and 13.5% at the end of September. The current rate
is the highest seen since January 2009 although it remains well below the 2008
crisis high of 25.925% (let alone the May 2002 sovereign default peak of
130.625%). This surge in deposit rates suggests that local banks are finding it
extremely difficult to raise local deposits with the rapid depreciation of the
Argentine Peso (red line on chart) encouraging local capital to flee
the currency. We also suspect that the dramatic slowdown in foreign
inflows into local bonds has also exacerbated the problem, although this
cannot be proved. In any case whatever the cause, the Argentine banking
system is facing a funding problem of considerable magnitude at the
current time and the situation bears watching closely. - W-BADLARPP_Index.gif -

Since we were away at the end of last week we were unable to comment in real
time on China's latest batch of monetary data. Unlike China's economic
statistics which hit their targets with Madoff-like reliability, the monetary
data actually fluctuates in a credible manner and is therefore even more
important to follow in China's case than it is elsewhere as a guide to the
future.

As the attached chart shows Chinese monetary growth has slowed markedly in
recent months and with the addition of September's data can effectively be said
to have ground to a halt over the summer months. M1 actually shrank by 2.23% in
September, taking the 1 year RoC down to 8.9% (below current estimates of
Chinese GDP growth) while M2 grew by 0.83%, causing the annual growth rate to
fall to 13%. Although this may still appear to be generous (and is the headline
data which most rely upon) the attached chart shows the extent to which this
number is a back-loaded by much looser liquidity levels present in the early
part of the year. The 6 month RoC (blue line, lower chart) has slowed to 3.86%,
or just under 8% annualized. This compares to annual growth of approximately
19% a year ago and 29% in September 2009.

It strikes us as highly unlikely that a change of monetary conditions of this
magnitude has not meaningfully altered actual economic performance to a degree
greater than is shown by official statistics. It also suggests that investment
markets, especially housing which was the prime beneficiary of the 2009
monetary largess, are starting to be significantly disrupted by the tightening
measures of 2010 and 2011. Unless a rapid easing of conditions is undertaken
(which strikes us unlikely given that CPI remains above 6%) we would expect
some clear evidence of duress to emerge within a matter of months. -
chinam1m2sep2011.gif

As we had hoped a combination of better than expected US macro data and a
period of stability in the Eurozone funding markets has allowed a spirited
rally to unfold in global markets.Looking at the SPX index we can see that
the gains since last Monday's low now total 145 points or 13.5% and have
been enough to take the index right up to the top of its recent trading
range. The SPX has not managed to close above 1218.89 since breaking down
below the key 1250 level at the start of August although it did reach 1230
on an intra-day basis on August 31st. The most likely outcome going
forwards is that the index runs into resistance somewhere between the current
price and this intra-day high and then has to back-fill a portion of its gains
(two obvious targets are the small opening gaps were left this morning and on
Monday, the latter coming in at around 1155) but the likelihood of a full
re-test of the correction lows no seems significantly less probable than a
few days ago.

We say this not only because of the distance we have moved away from the 1075
low but also because we are finally seeing signs of a forcible unwind of the
"fear trade". As the attached chart shows the VXO index (middle chart) has
finally broken down below the 30 level by more than a couple of ticks. The
current reading of 28.62 is the lowest seen since the August 4th breach
of 1250 in the SPX and marks the transition outside of a "deep correction"
mind-set. If today's gains can be consolidated over the rest of the week
(which we will miss due to a religious holiday) tremendous pressure would
be placed on those holding protective put positions to unwind while at
least some premium remains intact. We saw throughout 2009 and early 2010
how powerful volatility unwinds can be at propelling markets forwards. We
would therefore not exclude the possibility of a full test of the 1250
breakdown level during the course of the current move. Our favorite two
sectors remain retail and technology which have managed to post strong
gains in recent days without the benefit of massive short covering.

Meanwhile overall US financial stress has also moderated substantially in
recent days. The BFCIUS index has retreated rapidly after briefly pushing
below the -2 "crisis" level last week. As of today the index is at -0.99,
which still indicates an abnormal level of stress but not one to be unduly
concerned about. The key level to watch for this index appears to be -0.5,
since this was the level breached during the climactic August 4th session
that signaled the acceleration downwards for global asset markets. -
D-SPX_INDEX.gif -

Attached is a link to an interview with the Brazilian radio station Agencia
Estado. Interview topics included the expansion of the ECB balance sheet and a
long discussion regarding China, Brazil and the emerging market complex. -
1.78.4.2011-10-11.1MichaelShaoul (1).asx

Indian Industrial Production for August was the latest piece of data
coming out of the EM complex to suggest a broad slowdown in activity is
underway. Production was estimated to have grown by 4.1% over the last 12
months compared to consensus estimates of 4.7%, and this was even after
the very weak July data was revised higher. As with other countries'
Industrial Production data, the monthly volatility needs to be smoothed by
a 6 month ma (red line on chart) and this reveals a clear downtrend in the
expansionary force behind IP, falling from a cycle peak of 12.16% in May
2010 to the current pace of 6.26%, the slowest pace since November 2008.
It should be noted that the peak pace of Industrial growth was far lower
in the 2009/10 recovery than was seen at the height of the 2007 boom
(17.7% in October 2007). This underlines the extent to which India's strong
post-crisis recovery was far more dominated by credit driven expansion in
banking, real estate and foreign inflows into investment markets than growth in
its local industrial sector, which again is a common thematic across the EM
spectrum.

Not only is current Industrial growth of 6.26% well below what was expected a
few months ago, this pace is now well below the local REPO cut off rate of
8.25% (which itself is much lower than the cost of capital for industrial
borrowers). Using foreign currency bonds to lower interest rates (Indian
companies were very fond of CNY denominated "dim sum" bonds) has also
become a far tougher proposition following the rapid depreciation of the
INR. We have therefore reached the point at which the cost of funds for
many Indian manufacturers is now greater than the reasonable expectation
of the return on capital that can be generated by them, which suggests
that profit margins for leveraged corporations are likely to start to come
under considerable pressure and expansion plans put on hold. -
D-INPIINDY_Index.gif -

Brazilian macro data is starting to suggest that an important downturn in
the expansionary trend took place this summer. August retail sales is the
latest piece of poor data to be released. This showed estimated sales falling
by -0.4% compared to consensus of -0.1% (the data is not seasonally adjusted)
which took the YoY% change down to 6.2% from 7.1% in July (consensus was 6.9%).
Since this is a volatile data set the retail sales need to be examined over a
longer period than one month. Our standard default of a 6 month ma is shown on
the attached chart (red line) and this has dropped to 6.80%, the slowest pace
since November 2009. This compares to a reading of 10.5% in August 2010.

Looking at the behavior of sales over the last decade we would suggest
that 5% is the demarcation point that would mark a troubled period for
Brazilian retail activity, but since this is "real" data some of the
deterioration could come from higher CPI rates in addition to a reduction
in the pace of accumulating goods and services themselves. We continue to
believe that the sharp drop in Brazilian financial assets in 2011 has been
driven by local factors as much as international ones. - D-BZRTRYOY_Index.gif -

This week's data on the ECB balance sheet continues to show no sterilization of
recent bond purchases taking place although the pace of expansion slowed
markedly from prior weeks. Excluding gold holdings the balance sheet grew by
0.39% hitting a new all time high of €1876 bln, just besting the prior peak
registered in January 2009. This took the 13 week RoC up to 20.54% and the 52
week RoC up to 22.3%. We do not expect to see any new surge in asset growth
prior to the announcement of a new policy package aimed at addressing the
multiple issues facing the Eurozone but we remain of the belief that the sudden
injection of liquidity via the ECB's balance sheet has been a crucial factor in
buying time for the politicians to thrash out an acceptable solution. This
still does not guarantee that they will take advantage of the opportunity but
at least they have the chance to do so. - W-.ECB-GOLD_Index.gif -

One of the little noticed facets of investment markets is that they tend
to be much more sensitive to a change in conditions than their actual level.
A good example of this can be seen in Europe right now where most measures
of stress remain at levels that would have been considered unacceptable at
the start of summer and yet a broad rally in local asset markets has
broken out in recent days. In our opinion the key to the newfound
stability has been the silent but sizeable expansion of the ECB's balance
sheet (see the last Weekly Speculator for a full discussion), which has
bought some much needed time for the continent's political leaders to
craft a credible response.

The effect can be seen across measures of Eurozone stress although we have
chosen to illustrate it with the Euro 3 month swap rate which briefly
transfixed global investors in the middle of September. This touched a low
of -121bp on September 12th and then shot up to -80 in response to the
announcement of a series of emergency USD funding auctions after which
time it has bounced around between -90 and -105 bp (blue line on chart).
Although this indicates that the cost of USD funding is still far from
normal within the Eurozone, it is a very different outcome from that which
occurred back in September 2008 when the rate plunged through the current
level and was at -210bp in mid October (see red line on chart). Back in
2008 matters spiraled out of control whereas this time around an uneasy
equilibrium remains in place.

With local equity markets already preparing for the worst case scenario it is
unsurprising that something of a relief rally has broken out in recent days.
The DAX index, which took the brunt of the selling pressure in late summer has
led the gains and after closing just above the 50 day ma on Friday (due to the
sudden and simultaneous deterioration across markets this summer, the 50 day ma
is an unusually useful indicator at the current time) it has managed to break
higher to the top of its recent trading range. Resistance at 6,000 now looks to
be a credible target with investors' fears being suddenly replaced with an
urgent need to reposition portfolios.

From our perspective the recent stabilizing of risk metrics suggests that
a new window of opportunity has been opened for a credible solution to be
crafted, although it is still unclear whether Europe's leaders possess the
wit, wisdom and will to put their house in order. At the same time we
would remind readers that even an obviously flawed "solution" can often
form the backdrop of a fairly long and powerful recovery rally. You only
have to look back to the original "Greece solution" last summer or the
post BSC rally in the spring of 2008 in order to see the veracity of this
comment. - D-DAX_Index.gif - euro3month101011.gif

Economic data continues to roll in supporting our contention that a broad
slowdown in domestic economic activity is taking place across a fair
proportion of the emerging market complex. This morning saw the
publication of two important metrics, Indian Domestic Car Sales and
Turkish Industrial Production.

Indian Car Sales came in at 165,925 for August, a drop of 3K (1.87%) from
the sales rate a year ago. Although this drop is itself insignificant it
should be remembered that Indian Car Sales were growing well over 25% per
annum a year ago and were expected to be growing by 18% in 2011 as
recently as April. The sharp reduction in the growth of sales is clear
evidence that the multiple rate hikes by the RBI have significantly slowed
the pace of demand. The clear danger is that the situation deteriorates
from this point on, with actual contraction in demand being experienced in
an industry which is still geared up for double digit growth. This is very
much in keeping with our "late 1980's" template for the current slowdown,
a period when credit sensitive consumer goods saw a sharp slowdown in
demand in the US and UK economies. We would expect the Indian car market
to experience surging inventories and sluggish prices, which can be
expected to weigh heavily on the cash flows and earnings of all connected
with this industry.

Meanwhile in Turkey the pace of Industrial Production looks to have slowed
markedly over the summer. Industrial Production data is particularly
volatile (apart from in China where it is suspiciously inert) but the
August data showing a mere 3.8% increase in production is the latest in a
series of poor reports. The 6 month ma (red) shows the effect of this
deterioration falling to 7.4% from a March 2011 level of 13.2%. Again this
sort of deceleration can be anticipated to have a meaningful impact on
corporate profitability and Turkey remains a country whose prospects over
the next 18 months or so are somewhat worse than the consensus view would
suppose. - M-INVSDPAS_Index.gif - D-TUIOIYOY_Index.gif -

Following the release of the September Non-Farm Payroll report the
Citigroup Economic Surprise Index (CESIUSD) has risen to -7.5 which means
that according to this rough measure the balance of US economic data released
over the last 90 days has been virtually the same as economic consensus.
Of course consensus itself has been trimmed over this 90 day period
meaning that some deterioration in data has taken place, but it is equally
true to say that the SPX index was as high as 1350 on July 7th and has
declined over 13.5% since that time.

Perhaps more importantly US economic data has typically shown a regular
cyclical nature with a number of separate "data cycles" occurring during any
single period of expansion or contraction (see the period from 2003 - 7, which
encompassed one fairly simple expansion for an example of the former or the
surge in the CESIUSD in the summer of 2008 for the latter). Over the last 8
years any negative data cycle that reached below -60 has always been followed
by a positive turn that reaches comfortably into positive territory.

We like to use a 10 week ma to smooth this data and also allow for the
reluctance of markets to change direction. As can be seen on the attached
chart, the negative data cycle climaxed roughly two months ago on this
basis and has been roughly 50% repaired. Based on the prior 8 year history
of this index, it can now be expected to push its way into positive
territory. The really interesting point will come when better data starts
to push the consensus estimates away from their current conservative
standpoint, and also when participants react by taking a more pro-cyclical
stance in their portfolios. This time around matters are complicated by
the concerns over Europe and the emerging market complex, but a sense that
the US economy is itself intact would surely go some way towards improving
the general mood of market participants. - W-CESIUSD_Index.gif -

The September 2011 Non Farm Payroll report should mark a change in sentiment
towards the US economy, since it helps establish that the US economy has not
suffered a marked decline in activity over the summer months. We had commented
after August's report that the BLS appeared to have been very heavy handed in
its adjustments and this skepticism has proved justified with August's original
report revised up from 0K to 57K for total Payroll gains and from 17K to 42K in
Private sector payrolls. July's data was also revised 42K higher, adding 99K
jobs to those two reports.

As for the September report itself, this showed estimated Total Payroll gains
at 103K, comfortably beating consensus estimates of 60K and Private Sector
gains of 137K (90K consensus). This month's figures benefited from the end of
the Verizon strike which may have added as much as 45K to Private sector gains.
Taking all this data together we can see that the 12 month ma of Private Sector
gains (thick line on chart) has flat-lined over the summer months around the
140K mark. This is similar to the rate of employment growth in mid 1993 and
2004, both of which were fretful years punctuated by fears of a "double-dip"
that never transpired. Clearly the problems for the US economy are greater this
time around, not least we are dealing with a substantially higher level of
unemployment.

However, this is more of a problem for politicians than investors. The latter
need to limit their concerns as to whether the current market level accurately
reflects the risks and opportunities present today. We would describe the 2011
employment data as disappointing since it has not signaled an acceleration of
recovery but not more troubling than that. With the prevailing mood having
shifted substantially towards a "double dip" over the summer we believe that
the potential for continued recovery by the US economy is underestimated at the
present time. - nfpprivatesept2011.gif

The September ICSC Chain Store report showed same store sales growing by
5.5%, comfortably beating consensus expectations of 4.6%. As the attached
chart shows, the 6 month ma has risen up to 5.9%, the fastest pace for
sales growth since October 1999. Quite simply this is not recessionary or
even pre-recessionary activity on behalf of US consumers and the data
actually suggests that a moderate acceleration in retail sales took place
over the summer months rather than the sort of slowdown that most
observers have been anticipating. This obviously has important
implications for the overall US economy which even without employment
growth has been able to rely on increased consumer activity to keep it
ticking over. It also helps explain the very robust performance of the
retail sector in recent months. As the attached chart of the S&P 500
Retail Index (RELX) shows, the retail sector is down less than 1% for 2011
and has far outperformed the overall SPX index during the summer sell-off.
This is quite unusual for a high beta sector that is normally one of the
first to fall during an economic downturn (see late 2007) or even a false
alarm (see 2010), and it deserves to be both noted and respected. -
D-MBRXYOYW_Index.gif - W-RELX_Index.gif -

Initial Claims rose to 401K last week, somewhat below consensus estimates
of 410K. Last week's very low number was revised 4K higher to 395K, but
the last two weeks represent the sort of improvement that we had hoped to
see once the seasonal adjustment process started to turn after the Labor
Day holiday. The 4 week ma of claims has now moved down to 414K, and can
be expected to move sharply lower next week as the artificially high
report taken during the Verizon strike is deleted from the average. This
data supports our belief that no significant deterioration in the US
economy has taken place over the summer months and helps explain why
retail sales have remained very solid in recent weeks (early indications
are that September was another solid month). Better data would still be
required to indicate that growth in the US was picking up steam, with claims
needing to fall to the 350-375K range.

Unfortunately the improvement in Initial Claims does not guarantee that
tomorrow's key (but erratic) NFP report will reflect the current state of
affairs, although the consensus bar has been set very low at 59K for total
payroll and 91K for Private Sector payroll growth. Nevertheless NFP remains the
most influential report in the monthly calendar and it would probably require a
surprisingly strong report to really shift sentiment regarding the US economy.
- D-INJCJC4_Index.gif -

The last few days have seen concerted intervention in EM FX markets as
local central banks attempt to halt the recent slide in domestic
currencies. This morning saw Turkey's central bank sell a record $750mm
for Liras (Turkey's total reserves are just under $90bln), which
has led to a rise of 0.97% in the TRY to 1.87 while a string
of currency swaps issued in Brazil led to a slightly larger move
yesterday afternoon for the BRL, which was at 1.86 at the time of writing.
In both cases continued outflows of foreign capital seem likely to
overwhelm these early moves but sustained intervention should have an
effect of slowing the depreciation of currencies, although this will come
at the cost of a significant deterioration in local liquidity levels.

Meanwhile we note considerable stress is visible at the margins of the EM
complex. This morning saw a surprisingly large rate hike by Kenya's
central bank, which increased local interest rates by 4.00% (a mere
75bp increase had been expected). This hike was an attempt to halt
the rapid slide in the Kenyan Shilling (KES) which had weakened in
response to a local CPI of 17.3% (up 4.5% at the start of the year).
Clearly no major emerging market faces the sorts of problems
visible in Kenya, and the total amount of foreign capital invested
is trivial compared to Brazil or Turkey but the dramatic deterioration
in Kenya's conditions is a useful reminder of how quickly things can
go wrong. - W-KES_Curncy.gif -

The September ADP Payroll report came in at 91K, beating consensus estimates of
75K. August's data was revised down from 91K to 89K, which kept the ADP report
significantly stronger than the August Non-Farm Payroll data. The 6 month ma
has tracked slightly lower to 107K but continues to suggest a steady grind
higher for employment rather than the sort of deterioration that many assume
has taken place. We now await the more influential Weekly Initial Claims and
Monthly Non-Farm Payroll reports that will be released over the next two days.
Consensus calls for 410K and 60K (90K for Private Sector payroll) which strike
us as undemanding targets in the current environment. - adpseptember2011.gif

We have finally found a story outlining the strong performance of the
technology sector this summer. This has very much occurred without media
comment prior to this article but if technology is to represent leadership
going forwards it needs a public recognition of its attraction.

As one of our sharper eyed clients pointed out the SPX closed last night at
1099.23, the same level as was seen exactly 3 years before on October 3rd 2008.
On that occasion the SPX went on to drop by 200 points over the next week (over
18%) as credit markets froze and global economic activity fell off a cliff. The
question therefore is how similar is the situation today to that of three years
ago.

Our answer is it depends where you are sitting. Neither period of time will be
fondly remembered in years to come but the US capital markets look to be in
somewhat better shape than 3 years ago while Europe is roughly similar and much
of the EM may actually be in worse shape today than it was 3 years ago (it
should be remembered that there were very few internal issues for EM in 2008,
unlike today).

In order to compare the state of the US in these 2 periods we have drawn up the
attached chart which shows the action of the SPX index together with the
Bloomberg Financial Conditions index (BFCIUS) and the Citigroup Economic
Surprise Index (CESIUSD). In each case, 2008 is shown in blue and 2011 in red.
Clearly there is little to choose in terms of the SPX, although back in 2008
the decline was approximately 6 months older and has started almost 200 points
higher. The real divergence takes place on the other two charts.

The BFCIUS (which measures overall financial stress in US debt and equity
markets) shows a very different picture between the periods. Back in 2008 the
index had been below the key -2 level (which indicates "crisis" level stress)
almost continuously since the start of the year. In early September the index
fell below -3 as the GSE's entered conservatorship and then plunged off a cliff
as Lehman collapsed. By October 3rd it had reached -9.68, which given that it
is based on a normal distribution should have been an impossible level to
reach. This time around the index has only just crossed the -2 level (see
yesterday's note), indicating a much more moderate level of stress, albeit one
that would still qualify as being a "true crisis".

Finally the state of the US economy needs to be considered for which we use the
Citigroup Economic Surprise Index (CESIUSD). Again a notable divergence between
the period is visible. In October 2008 data had been surprisingly robust in the
summer as the economy responded to the first wave of rate cuts, but by the
start of September a noted deceleration was in effect. The index was to plunge
to a record low in the coming weeks as the shutdown in corporate funding
markets led to a radical slowdown in global activity. In contrast the summer of
2011 saw a very disappointing string of macro data but recent weeks have seen a
marked improvement in most data. In fact the CESIUSD has risen rapidly from its
low of -117 in early June to -23.20 as of yesterday and based on historical
trends should actually become positive later this quarter. Clearly the market
is focused on other matters over the shorter term but the market is starting
to fully price in the risk of a slowdown, while the data is suggesting that the
core domestic US economy remains on track for further recovery.

September US Car Sales came in at a Seasonally Adjusted Annualized pace of
13.04mm units, significantly higher than consensus estimates of 12.60mm
units and August's 12.10mm pace. This is the highest reading since April
and very much runs against the prevailing view that the US consumer would
respond to recent market turbulence by pulling back from large ticket
purchases. In fact the weakness seen in the early summer seems to have
been much more about a shortage of supply, particularly of Japanese vehicles
whose production was disrupted by March's earthquake and tsunami, than an
indication that demand was waning. As can be seen on the attached chart
September's data brings sales back up to the recovery trend that has been in
place since mid-2009 and further progress can be expected in the months ahead.
We expect September's retail sales to look equally robust as they are announced
in the coming days. Much has been made out of the official BEA measure of
August Personal Income and Savings that was published on Friday, but this data
is far less important than the reports from actual retail and car sales (as
well as being one month behind the latter). All evidence continues to suggest
that the US consumer remains in a decent recovery trend and this is a solid
underpinning of the domestically focused economy, not that you would know this
from recent market action. - M-SAARTOTL_Index.gif -

The start of the 4th quarter has brought no respite for the beleaguered EM
currency complex with weakness visible across regions this morning. As the
attached chart shows, the ZAR (olive) remains the worst performing currency in
2011 and has given up a good portion of its "snap-back" gains. The TRY (purple)
has moved to a new all time low at 1.88 and could potentially break above the
2.00 should pressure remain in place (sentiment towards Turkey remains far too
bullish in our opinion). Brazil (light green) mimics South Africa and the
initial gains from CB intervention have now largely dissipated. With the BRL at
1.89, we would look for a re-test of the key 1.95 level in the coming sessions.
The other notably weak currency today is the HUF (orange) which is starting to
decline quite rapidly. Although YTD losses are moderate at -7.25% this is
simply a function of how strong the HUF was in the first half of the year. The
sell-off in the HUF has been quite violent and looks likely to extend itself
further. - emcurrencies10211.gif

The September ISM Manufacturing survey came in at 51.6, slightly better than
expectations of 50.5 and August's reading of 50.6. Although we would not call
this a strong report, it does push back somewhat on the growing belief that the
US recovery has already "turned turtle" and we have seen not yet seen the
typical pre-recessionary plunge below 50 that several observers have been
expecting. What is fair to say is that the very high readings of late 2010 and
early 2011 have now been replaced by a steady but unexciting trend, but this is
as likely to improve as it is to deteriorate based on other periods that this
indicator has rested above the 50 level (see chart)

In terms of the sub-indexes New Orders (red) remain just on the wrong side of
neutral at 49.6 but Production (blue) moved back into positive territory at
51.2. Inventories (olive) are now building moderately at 52 while the
Employment index is still fairly positive at 53.8. Note that this is in line
with the much better than expected Initial Claims data that was released last
Thursday.

In summary today's report supports our notion that the core US domestic economy
is still expanding and that the cause of the long correction can be found
outside these shores. - ismsep2011.gif

We continue to track the Bloomberg Financial Conditions Index (BFCIUS) as
a gauge of how close the broad sell-off is to reaching a climax. As a rule
of thumb a "crisis" requires a reading below -2 in order to bring matters
to a head (see attached chart). With the exception of the 2008-9 period
the index has never exceeded -3, as would be expected for an index made up
of a range of prices and spreads that tend to exhibit a "normal
distribution". As the attached chart shows the BFCIUS fell abruptly at the
end of last week to a new 2 year low of -1.82, perhaps reflecting some
redemption pressure at the end of the quarter. This morning the index has
continued to tick lower falling to -1.85. This suggests that we have
started to enter the climactic portion of this particular correction which
should be punctuated by an event that places a clear line under the
current episode. Hopefully this will involve supportive moves by central
banks and administrations (such as occurred in the case of the 1998, 2001,
2002 and early 2008 climaxes). A repeat of the Lehman debacle seems to be
unlikely, particularly in the case of the US capital markets. Stress
elsewhere is already running far higher than the BFCIUS indicates
(unfortunately there is not a comparable index that amalgamates Eurozone
or EM stress) and the potential for a "self feeding" unwind of positions
does exist in portions of the global markets. - W-BFCIUS_Index.gif -

Q3 2011 will go down as one of the hardest quarters on record since not only
were global equity markets universally weak but the supposed safety of
diversifying into "alternative" assets proved to be a mirage.

Attached is a chart that compares returns generated in US Treasuries 7-10 year
(light blue), EM USD debt (purple), EM local currency debt (light green), The
SPX total return (black), NDX index (red), MSCI EM Total Return (dark green)
and CRB Total return index (orange).

The only asset class to generate positive returns was the US Treasury market,
which rose almost 10% in the 7-10 year portion of the curve. Note that for
non-US investors considerable currency gains would be added to this return in
what was probably the least popular asset class going into the quarter. EM USD
bonds lost close to 2% but unfortunately most investors had chosen to seek the
higher yields available in EM local currency bonds which lost almost -8.5%, a
terrible performance for what was supposed to be a relatively safe place to
invest.

Within "risk" assets the NDX index performed the best, losing -8% which could
be termed encouraging compared to its peers. The SPX index lost -14.33% in cash
terms and -13.87% on a total return basis, but losses were far higher in
financial and commodity related sectors and far lower in defensive areas,
technology and retail. Even so this loss was much less than in other major
developed markets or the emerging market complex. The MSCI EM Total return
index was the worst performing asset on our list losing -22.56%. Commodities
were also poor performers with the CRB Total Return Index dropping -11.80% with
much of these losses coming towards the end of the quarter.

Thus the order of performance was pretty much the opposite of what investor
flows would have predicted 3 months ago. This suggests that a fair amount of
re-balancing may start to occur through the 4th quarter. US Treasuries have
already seen very positive flows in recent weeks, while the EM equity and
credit complexes are starting to see significant outflows. Although these funds
are likely to remain in cash or treasuries for some time it is now far more
likely that they will be deployed back into the US equity market in some of its
better performing sectors once this corrective phase has finally run its
course. - totalreturnq32011.gif