The World Explained

UBS Macro Sales

Friday September 17 2010
John Clemmow +1 212 713 3090

Please note that these ideas may differ from the

UBS house view
This is somewhat abridged version of a presentation that I roadshowed around Europe
recently. It summarises a number of themes I've been discussing through the Northern
Hemisphere summer.

Hi

Once again I want to return to the vexed question of asset correlations and what they mean. The
chart shown below is my old favourite, the S&P versus the 3 month copper price. It shows that at
least since the beginning of 2008, the price of copper and the value of the S&P have moved in
the same direction. The only sizable deviation from the lock-step performance of the two has
occurred quite recently when the S&P has failed to match the magnitude of the rally in copper but
even in this case, the direction of the daily performance has remarkably similar. Copper and the
S&P are just the most visible examples of the Risk On - Risk Off phenomenon which has
dominated investment strategy for the past few years. Essentially Risk On is when expectations
for the global economy are positive and equities, emerging markets (currencies, debt and
equities) and commodities all move higher whilst the USD falls. Risk Off is the inverse, the USD
rises, whilst equities, emerging markets and commodities fall. There is very little need for
sophisticated investment strategies in such an environment. All large, liquid, risk assets move in
the same direction the only difference is their beta to the risk trend. As one large macro fund said
to be earlier this year, give me the copper price and I can guarantee returns.
The reason this chart engages me so much is that theoretically it just should not be correlated
with the S&P. Even as I write there are unfortunate students being taught that commodities and
equities have a negative correlation - that equities are leading and commodities a lagging
economic indicator. Indeed part of the justification for investors pouring money into commodities
as an alternative asset class is that doing so reduced overall portfolio risk. Well it may have done
so in the past, but it certainly doesn't now. To me the puzzle is why has there been this change in
the market because it does not make obvious investment sense. Consider the market ten years
ago - I have a generally positive view about the US economy and hence the S&P, why would I
choose to express this view by selling the USD? Surely if the US is expanding that should be
good for investment flows and positive for interest rates, all of which should be supportive for the
dollar. Why should I buy copper? The US has a low marginal consumption of copper per unit of
GDP growth. High beta plays on US economic growth would be something like technology spend.
Without understanding why the illogical and theoretically wrong correlation of the S&P and copper
has occurred it is impossible to justify arguments about when and if it will break down allowing the
markets to return to "normal".

Looking back into the mists of time we can see the correlations started to move towards one as
far back as 2005 with the degree of alignment increasing over the proceeding period. Hence we
are looking for a market factor or factors that first became apparent during this period and which
has subsequently become more and more important. One of the explanations put forward is the
superficially attractive thesis of increasing risk. The argument holds that as perceptions of market
risk have increased, investors’ willingness to place value on future events diminishes. Future
earnings become less and less important leaving market performance driven my current results
which are themselves a reflection of past performance. So the fact that copper and the S&P have
become coincident is not because copper has become a lagging indicator but rather is due to the
S&P rating moving back in time. It's a wonderful argument but unfortunately its completely wrong.
If we use the VIX as a measure of market risk then we can see that apparent market risk declined
in 2005/06 and early 07 and most dramatically during 2009 whilst correlations increased. Risk is
not the cause of copper and the S&P becoming as one.

The second answer is money flow. The argument points to the increased influence of fast money
accounts on market direction and the lack of conviction that is apparently ubiquitous amongst
investors. Without long-only funds drawing a line in the sand, the market is whipped up and down
by fast money accounts that are desperately trying to catch the next trend. Now I would accept
that there is some justification to this view but it does not explain why money flows into copper
and the S&P at the same time when prior to 2005 it really didn't. It is obvious that money does
flow into Risk On and Risk Off assets en masse but just pointing to an event and observing its
outcome does not explain why it is happening. The money flow justification for correlations is just
sophistry.

My suggestion is that the rise in correlation is linked to the rise of the economic importance of
China. Prior to 2005, the US was the proxy for the health of the global economy post 2005 its
place has been taken by China. Consider your own morning meetings and compare the time you
spend discussing the US and Chinese economies and recall how the relative importance of the
two has changed over the years. If global growth is now driven by China then it makes great
sense that equity markets and commodities are linked as a booming China means a huge
increase in raw material demand as China is the most commodity intensive user of raw materials
per unit of GDP growth. A booming China was also bad news for the USD as it meant a rise in
the US trade deficit. So now it makes huge sense to equate positive global economic conditions
with a weak USD and strong commodity prices. It is my belief that China establishes the causal
link behind correlation one. But what it singularly fails to do is explain why Risk On and Risk Off
runs for what appears to be a six to nine month period before reversing. After all China apparently
managed to grow vigorously for over a decade with exhibiting the abrupt changes characteristic
of current asset class cycles. What is different about now?

Again I think that we have to turn back a few years. (Please note that I have discussed this
repeatedly in previous notes so forgive me for rapidly sketching out what is a rather complicated
story very quickly.) Any superficial glance at the Chinese economy shows that it is a very curious
beast. China does things that don not appear to make economic sense. Particularly when it
comes to heavy industry - a sector that has generated most of the country's recent growth - it
seems that China can ignore the economic realities that affect most of the rest of the world. The
huge Chinese, steel, aluminium, fertiliser (and other chemical industries), smelting and cement
industries for example use such low grade raw materials, or consume so much energy or use
such inefficient technology (in some cases all three) that would not operate in a real world pricing
environment. They have prospered and flourished inside China because it is at heart a
communist country which has not priced inputs according to the market but rather via diktat.
Communist countries can defy the market - as in the case of Russia - by pricing by decree rather
than the market, but in the end, when they lose self-sufficiency at have to start pricing - albeit at
margin to start with - using real costs; they break down. As the charts shown below make clear,
China has now lost self sufficiency in basic raw materials. The first chart shows the monthly
imports of coal and iron ore in volume terms. The second shows imports of soybeans and copper.
I could have used almost every basic raw material used in Chinese heavy industry and
construction. The pattern is the same a relentless rise in import volumes.

Let's wind the clock back to the beginning of 2009. China like the rest of the world faced a serious
economic problem. The Chinese authorities faced with the need to maintain employment and
grow the economic considered the three legs of the economy. The first, domestic consumption
was relatively small (30% of GDP) and notoriously slow to change, the second, export led
manufacturing would struggle to expand in a depressed global economy leaving the final sector,
the heavy industrial complex as the only real driver of growth. So this is the sector that the
Chinese authorities stimulated via a combination of loans and direction and the result, from March
of 2009 onwards, was a heavy industrial growth led boom that kick-started the economy.

Those of us fortunate to survive the great reckoning in developed world markets emerged from
under our desks, blinking in the sunlight and saw the sun rising in the East and made the entirely
logical investment leap that as China was expanding the prospects for the global economy were
improving so buy equities, buy emerging markets, buy commodities and sell the USD. It was Risk
On. But by expressing our view on the global economy via commodities, we set off a boom in
resource prices that meant that by the beginning of 2010 as China's economic cycle was just
picking up speed, the country was faced with rising imports of products that were already at near
all-time high prices. The rise of China which has brought a lagging economic indicator
(commodities) forward in time to be a leading economic indicator means that the economic
consequences of high commodity prices have moved from the end to the stat of the economic
cycle. This is unpleasant but not critical for developed world economies but is very bad news for
commodity intensive emerging markets - particularly those, like China, that now had to pay real
world prices for an increasing portion of its needs. So In January, a mere nine months into the
expansion it had set off, the Chinese authorities had to turn on the brakes. The ability to grow
heavy industry without regard for its real economic cost is now over.

Risk On - Risk Off is caused by the Chinese government alternatively pressing the accelerator
before slamming on the brake of the only part of the economy they can directly control. Fear of
unemployment cause the government to step on the gas - dread of cost-push inflation the need to
apply the break.
How is the cycle going to be broken? I would suggest that there are three ways. The first is that
we ban investments in commodities. Now I rather like this solution as I am increasingly of the
view that commodities are too important, they have too many real world consequences, to allow
their price to be set via investment flows. But such a ban would require leadership from the US
and an unprecedented level of global coordination, neither of which looks set to appear over the
next two years. The second break to the cycle would occur if China ceased to be the locomotive
driving global growth. If the US or India replaced China then the link between commodities, the
USD and equities would break, but once again this seems unlikely to occur within the next two
years. And finally the current conditions could end if the shape of the Chinese economy changed
- if China became a country driven by consumption rather than construction. Now clearly the
Chinese authorities would like this to occur - indeed the change in Chinese demographics from
hugely favourable to extremely poor dependency ratios almost ensures that such a move will take
place, but as I stated earlier it is unlikely to happen over the short-term. So, I would argue, that
we are stuck with the stop-start of Risk On - Risk Off for at least the two years.

This is all rather wonderful but it doesn't really help make investment decisions. The need is to try
and find a number of guides that can tell whether we are in a Risk On or Risk Off environment,
even better that can predict when the market is about to change from one phase to the other.
Through the summer I tried to come up with a number of such indicators and published my
thoughts in a series of notes. I have narrowed the field down to five. (For a detailed explanation of
why I think these tools are useful see the attached individual notes).

1) The Shanghai Composite

2) The Baltic Dry Goods Index
3) The spot price if Chinese HRC
4) The ratio of the BP closing price in New York to that in London
5) The ratio of palladium to gold

Shanghai Composite and Baltic Dry Goods Index

S&P and Chinese HRC prices

The smoothed ratio of BP US to BP UK

2.0%

1.5%

1.0%

0.5%

5 day MAVG BP
0.0%
5 day MAVG S&P

-0.5%

-1.0%

-1.5%

-2.0%
03/05/2010 21/05/2010 10/06/2010 30/06/2010 20/07/2010 09/08/2010 27/08/2010 16/09/2010
Palladium Gold and the S&P

0.65 1600

0.6
1500

0.55
1400

0.5
1300
0.45
Palladium,/Gold
1200
S&P
0.4

1100
0.35

1000
0.3

0.25 900

0.2 800
01/01/2008 09/09/2008 19/05/2009 26/01/2010

The similarity in patterns is uncanny. There is a sharp reversal around the end of June, a major
run-up in July followed by sideways to down during August and now signs of a revival in
September. I contend that the last Risk Off cycle ended at mid 2010 and that we are now in the
next up Risk On cycle. The Chinese authorities have moved from a contractual stage in their
cycle to a more expansionary position. I don't listen to what the Chinese authorities are saying I
look at what those players inside the economy are doing and they have built steel stock and
invested in the market. I don't listen to the siren call of gold rising because of an upcoming
apocalypse - sure gold is up, but other risk assets including the uber-risk on palladium are up by
a lot more. And look around you. There is almost universal gloom here in America but I can tell
you from personal experience that the feeling is not shared in Europe and Asia. And consider US
corporates. Most are bearish about the economy but are optimistic about their own prospects.
Aggregating the individual optimism makes the consensual pessimism look odd. Finally look at
the wave of M&A and corporate action hitting the tape. We are back in Risk On mode and the
market will accelerate from here.

The first Risk On cycle lasted 9 months, Risk Off around 6 months and we are now 2 months into
the next Risk On. How far can we go before the commodity brakes crimp the Chinese and global
economy? The simple answer is that I don't know but what I have assumed is that at some stage
during the first half of 2008, when commodities shot to their collective apogee, demand
destruction occurred. So what I did was to take the average price of a basket of commodities
during H1 2008 and compare it to today’s spot. When I first ran the data the general level of
potential upside was 20% - 25%. After another month of Risk On in commodities, the margin is
now much tighter. Excepting natural gas which has been distorted by shale gas discoveries, the
commodity growth gap has closed to an average of 10% -15%. Given the correlation between
commodities and the S&P, that implies maybe a further 150 points on the index before the
commodity brakes force China to shift into Risk Off mode.

H1 2008 Average Spot Spot as % of Max Price

Corn 574 507 88%
Wheat 928 733 79%
Soybeans 1355 1052 78%
Cocoa 1369 1902 139%
Cattle 92 99 108%
Copper 8034 7700 96%
Nickel 27476 23250 85%
Lead 2612 2202 80%
Aluminium 2888 2165 84%
Oil 111 75 68%
Nat Gas 10.13 4.08 40%

So what could go wrong? I can see three potential upsets to my Risk On cycle. The first is that
the US authorities, who are clearly concerned with supporting asset prices, will conclude that
asset prices have rebounded from their June lows and that there is therefore no need to consider
any further market intervention. This is possible, but given that employment and housing remains
in the mire I would suggest that they will certainly want to maintain at least current policy levels
until these indicators (both lagging) turn positive. The second is that a republican landslide in
November wrests control of the House and Senate from the Democrats ushering in a period of
deficit activism. Again this is entirely possible, although after the primary votes a republican
senate is looking less likely than it was before. But remember that Republicans are also
politicians and politicians when it comes to an apparent choice of pain for the people who voted
for you or spending other people's money tends to opt for the latter. It’s the final hurdle that
bothers me and this is the issue of food prices.

China faces two sources of cost push commodity inflation. The first is driven by its own actions
and this largely means its heavy industry policy settings. The second is not and that largely
means food prices. Whether China is expanding or contracting does not really affect global food
prices but global food prices seriously impact China. I am - as most of you know - a long-term bull
on agriculture but I have consistently warned that even if the trend of prices is up, the amplitude
of swings in basic food prices can wipe investors out. More than any other asset class, agriculture
is a trading investment. Given that, I have been pointing out that there is the potential for a rather
nasty spike in food prices during the course of the rest of this year (see my notes on corn and
wheat). The only policy weapon in China's arsenal to combat the influence of rising food prices is
to allow the Yuan to appreciate. Many would see this as positive for commodities and other risk
assets; I would not as an appreciating currency would act to even further suppress export
industries. I am therefore concerned that China might be close to a currency realignment which
would bring a premature end to Risk On. On balance I suspect that China will accept that this
year's food spike is temporary and will resist the urge for a major revaluation but I would not be
surprised if we see a combination of a mildly appreciating Yuan coupled with a more
accommodating domestic lending policy.

To conclude - correlation 1 has been driven by the rise of China; it will be with us for at least the
next two years. Risk On - Risk Off is a function of China accelerating and then braking as
commodity prices threaten to unleash cost push inflation. We are now two months into the next
Risk On cycle and have about 10%-15% further upside before policy reverses once again. Food
is a major risk and needs to be watched but at the moment is not sufficient to break the up-cycle.

John

Contacts for Investment in Commodity markets through ETFs, ETCs, structured fund, structured
products, other index linked structures;
- Asia: Katia Demekhina +852 2971 6627; katia.demekhina@ubs.com
- Europe: Zak Cherkaoui +44 20756 75317; zakariae.cherkaoui@ubs.com
- US: Jon Fraade +1 203 719 3904; jon.fraade@ubs.com

Contacts for trading Commodity Exchange Traded Derivatives;

- Asia: Terence Noe +65 649 53637; terence.noe@ubs.com
- Europe: David Cunningham +44 20756 87067; david.cunningham@ubs.com
- US: Patricia Flakus +1 312 525 6604; patricia.flakus@ubs.com

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