Finance Digest for Week of December 5, 2005

HEDGING FOR CHEAPSKATES

With $1 trillion of assets and counting, hedge funds are all the rage, not least among people who think the market is in for several rough years and want a way to hedge their bets. They are fans of the long/short hedge fund style, in which the money manager buys some stocks long and sells others short. Pick the right stocks and you can make money in a sideways or even a down market with this approach. The main thing wrong with hedge funds, apart from limited liquidity and murky disclosures, is their fees. Solution: Find a mutual fund that follows the hedge strategy you want. For some flavors of hedge fund investing that is not possible. For long/short it most definitely is. At least 20 long/short mutual funds have cropped up in recent years. The table below lists six.

MUTUAL FUNDS TRACKING COMMODITIES AS INFLATION HEDGES

With inflation perking up, you would not be called crazy to want a modest hedge in the form of commodities. To be sure, someone getting into oil, soybeans and gold just now has missed a good run-up, but that does not lessen the argument for using hard assets to balance out a portfolio of financial assets like stocks and bonds. If you believe that the Chinese and Indian economies will stay hot, commodity prices have a lot more to grow. There are a lot of ways to play the commodities game. You could buy hard assets, futures or options on those assets, shares of commodity producers (like oil companies) … or a mutual fund that holds a mix of commodity investments.

WINTER COMES LATE AND HARD

As 2005 prepares to slip into the past, a hard cold winter is blowing in. The upper mid-west and highfliers are being hit hard. The consensus strains to see troubling high pressure systems as isolated local conditions. The goings-on in the airline, auto and auto-parts arenas are not local and fleeting. This is the leading front of a shift in season. Finance and retail areas will be raked by these winds in the near future. The income and benefit patterns of American workers are in transitions. Many years in the making, changes are now unfolding so quickly that many will fail to see them – as they did when the pace was glacial.

The Fordist model and economy that came to define middle class life looks terminally ill. This is emblematic of profound change. Conversation on this subject tends to be dominated by political pontificating and is avoided by many economists. The business species best suited to the new weather will prosper and those ill-suited will struggle and perish. Real wages have been under pressure for a very long time – real median income has gone nowhere in four going on five years. Inflation – artfully recalculated toward understatement – drifts up, still lagging soaring debt, and both dangerously outrun wage and benefit growth. We have learned to live by asset inflation, falling tax rates and debt, debt and more debt. Housing values – now about to stagnate, then fall – have risen over 50% in the past decade. IRS data suggest that after tax incomes for the bottom three quarters of earners declined since 2002. Robust growth in the top 10% has occurred across the same period. This has kept the aggregate measures looking good.

These words should not be seen as an attempt to deny many areas of real strength, innovation and growth. However, wages and the structural underpinnings of the classic American middle class experience are in horrendous shape. So too are auto makers, retailers, airlines, areas and institutions that depend on them for health. It is high time to factor this emerging definitional fact of 21st century American economic life. Financial, retail and housing related areas have grown fat on assisting this transition. They must now learn to grow in a changed environment.

When the canaries start dying in the mines, look beyond the birds’ frailty. The GM story needs to be re understood as a tale about the changing marketplace as well as Toyota efficiencies and a GM legacy of poor management decision. Those dependent on robust income-based spending by America’s traditional middle class beware. Sears, GM, United Airlines, Ford and many other retailers and producers must find new niches and sources as their traditional customer base vanishes up into luxury goods or specialized products, or down toward discounters. Wal-Mart and Coach describe the new landscape better than Sears and JC Penney. Jet Blue and Toyota fit better this new world than Oldsmobile. Regardless of your feelings about the winter blowing in, ignoring it is akin to dressing for summer all year because it is your favorite season.

DOLLAR’S RISE AIDED BY OPEC HOLDINGS

Middle Eastern oil exporters have rediscovered their love of the U.S. dollar in the past year, helping fuel the currency’s rally to two-year highs against the euro, yen and sterling. The position marks a sharp turnround from the third quarter of 2004, when the proportion of bank deposits held in dollars by members of the OPEC slumped to a record low. By the middle of this year, the proportion of OPEC deposits held in dollars had rebounded from 61.5% to 69.5%, with the share held in euros falling from a high of 24% to 16%.

The data will reinforce the view that the dollar’s surprise strength this year has been partly caused by OPEC’s recycling of petrodollars. The currency has risen 13.5% to $1.17 against the euro when most commentators had forecast a 4th straight year of losses. Oil exporters have become financial kingmakers as real oil prices have leapt 170% in real terms since 2001 to 25-year highs. The U.S. Department of Energy estimates Opec oil revenues will total $430 billion this year, up 27% from 2004.

The Bank for International Settlements attributes the sharp rise in the proportion of dollar deposits to the stabilization of the dollar and the 300-basis point rise in U.S. interest rates since June 2003, which has lifted the return on U.S. deposits. In contrast, the European Central Bank only initiated its first rate rise of the cycle last week. While this may seem an obvious factor, BIS found that the currency composition of OPEC deposits had become much more sensitive to changes in interest rate differentials than before. BIS found that many oil-producing nations had been net sellers of U.S. Treasuries since 1997, instead buying corporate and agency bonds and equities with higher risks and rewards.

CHINA SLOWDOWN – EARLY NOT WRONG

About six weeks ago, I threw in the towel on the ever-elusive China slowdown call. In doing so, however, I cautioned that we simply may have been too early in looking for a downshift in Chinese economic activity. Based on intelligence gathered during a recent visit to Beijing, I am increasingly convinced that is, indeed, the case. In my view, the die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle, driven by an important and surprising contraction in bank lending.

China’s booming investment cycle is on an unsustainable path. For 2005, we estimate that fixed asset investment is likely to exceed 46% of Chinese GDP – astonishing by historical standards for China or any other economy. Even in the heydays of their own development booms, the investment shares of the Japanese and Korean economies never got much above the low-40% range. I very much agree with Andy Xie who recently argued that China is now at a point where its ever-rising investment share is a recipe for excess capacity and deflation. The consensus view in the markets is that China will sustain its investment boom through the 2008 Beijing Olympics – that it will simply not accept the potential embarrassment of a growth slowdown until after that momentous event is over. But if China stays the course of its investment-led boom, then the fixed asset investment share of its GDP could well be in the 55-60% range by 2008 – a recipe for a monstrous overhang of excess capacity. In short, China’s investment-led growth boom is now in the danger zone.

So what stops it? Reforms. Up until now, China’s investment binge has been funded largely by its “policy banks” – huge organizations that were originally integral parts of the country’s central planning apparatus. Bank lending in China has not been a market-based, risk-adjusted credit allocation process but, rather, the open-ended state-directed funding of a state-owned economy. Given the precarious conditions of a largely unprofitable state-owned enterprise sector, policy lending was also a recipe for a huge build-up of non-performing bank loans (NPLs). Chinese reforms are bringing this vicious circle to an end – changing the funding mechanism by converting policy banks into commercial banks. This could well be the tipping point for China’s runaway investment boom.

In my conversations with Chinese banking officials and regulators two weeks ago in Beijing, I got the distinct impression that the change in credit culture from policy lending to commercially viable lending is now being put in place. There are signs that this dramatic shift in the Chinese bank lending culture is already working. A turn in the bank lending cycle may now be at hand. As newly listed Chinese banks, along with those that are about to become listed, move to put their lending practices on a commercially sound basis, I suspect that the days of open-ended Chinese bank lending will quickly draw to a close. At that point, the excesses of a bank-financed investment boom will then come under increasingly intense pressure. All this points to a prompt and significant deceleration of runaway Chinese investment growth. A big investment slowdown is coming – sooner rather than later. I worry about Chinese growth in 2006.

The cynics dispute this claim, arguing that the State will not allow it. But in the end, the State cannot have it both ways – drawing on international capital willing to bet on banking reform and holding on to uneconomic, state-directed policy lending practices. China does not need 9%-plus GDP growth to keep the magic alive – 7-8% will do just fine. A more rational, market-based system of credit allocation could go a long way in restoring sanity to an overheated Chinese investment cycle. The sooner the better. The alternatives of excess capacity and deflation – and the hard landing that would then occur – are unacceptable to Chinese reformers. We were wrong on the China slowdown call in 2005, but my guess is we were only early. In light of what I just learned about the rapidly changing bank lending culture in China, I am quite comfortable with the out-of-consensus possibility that Chinese GDP growth is about to slow into the 7-8% range.

IF FULL PENSION DEBTS DISCLOSED S&P 500 SHAREHOLDER’S EQUITY WOULD DROP 7%

Let us assume that the U.S. Congress cuts through a political briar patch and passes a law that forces full disclosure of pension debts. The consequences might be stunning. Companies with poorly funded pension plans might have to contribute billions of dollars more to their retirement plans and touch off worker demands that employers pony up even more money for their retirement security. Just as surely, investors would punish companies with the highest retirement debt, according to a study by David Zion and Bill Carcache, analysts for New York-based investment bank Credit Suisse First Boston. They examined the effect of fully disclosing and accounting for the pension liabilities of the 374 companies in the S&P 500 Index with defined-benefit plans. “We estimate that would cause the total shareholder’s equity for the companies in the S&P 500 to drop by $255 billion, or 7 percent,” they wrote in their Nov. 10 report. The 18 most underfunded companies would fare worse, suffering a 25% reduction in shareholder’s equity.

Zion and Carcache figure that shareholder equity – a company’s total assets minus total liabilities (which should include what it owes its pension program) – would be wiped out at the seven S&P 500 companies with the biggest funding gaps in their pension plans. The analysts said that pension assets and liabilities are treated as “off-balance sheet” items, which distort how much a company really earns and holds in corporate assets. They estimate that only 21% of the $1.3 trillion in S&P 500 pension fund assets are currently reported on balance sheets. There is no way that employees or investors now can discern total pension debts since companies do not have to report their so-called 4010 liabilities to the public. That is the amount owed if a company terminates its defined-benefit plan and has to buy annuities for workers.

Only Congress, the Pension Benefit Guaranty Corp. (PBGC) – the quasi-government pension insurer – and employers know the 4010 numbers. They are prohibited by current law from releasing them, although several proposed laws call for making this information public. “If you’re a real weak company, the market would be very interested in that (termination liability number),” said Ron Gebhardtsbauer, senior fellow at the American Academy of Actuaries, a professional association in Washington.

Employers have opposed disclosure of their funds’ termination liabilities, arguing that it is not an accurate picture of their pension debts. What is indisputable is that struggling companies have often grossly underreported their pension liabilities and shirked their pension funding obligations. Earlier this year, when the pension agency took over the plan for 36,000 ground employees of United Airlines parent UAL Corp., it was discovered that only $1.2 billion in assets were set aside to cover $4.1 billion in pension promises. A separate UAL plan for the pilots had $2.8 billion to cover $5.7 billion in obligations.

HOUSING BUBBLE BURSTS IN THE MARKET FOR U.S. MORTGAGE BONDS

In the U.S. bond market, the housing bubble has burst. Bonds backed by home loans to the riskiest borrowers, the fastest growing part of the $7.6 trillion mortgage market, have lost about 2.5% since September on concern an 18-month rise in interest rates may force more than 150,000 consumers to default. “We’ve been hearing about risks of a house price bubble, easy credit and loans to borrowers that really don’t qualify, and now in the last couple of months we’re starting to see things turn for the worse,” said Joseph Auth, a bond fund manager who helps oversee $135 billion at Standish Mellon Asset Management in Boston. “We don’t know if it’s going to be a hard or soft landing.”

Mortgage securities with low ratings and loans from Ameriquest Mortgage Co. and New Century Financial Corp., two Irvine, California-based companies that specialize in lending to the 50 million people with histories of late payments and bankruptcies, yield the most in two years. The rise in yields reduced the value of loans made by lenders, resulting in lower profit margins and higher rates for consumers with bad credit. The slump in the bonds is one of the first signs the housing boom is ending after the Federal Reserve’s 12 interest rate increases. Real estate has accounted for about half the economy’s growth since 2001, according to Merrill Lynch.

About 13.4% of all mortgages at the end of June were to borrowers considered most likely to default, such as those with high credit card balances, up from 2.4% in 1998, according to the Mortgage Bankers Association. The Washington-based trade group’s members represent 70% of the home-loan business. The amount of bonds backed by these high-risk loans has more than doubled since 2001, to a record $476 billion. The market “will deteriorate as housing slows down,” said Christopher Flanagan, who runs asset-backed debt research at JPMorgan Chase & Co., the 4th-largest mortgage lender in the U.S. The amount of loans made next year may fall by as much as 25%, he said.

The last time delinquency rates on lower-rated mortgages jumped was in 2000 as economic growth slumped following the Fed’s six rate increases. The central bank has lifted rates 12 times since June 2004, to 4% from 1%. Losses on mortgage bonds backed by subprime loans that will be made next year may rise to 7%, contrasting with 2% for bonds issued the past two years, should home prices hold steady, said Kenneth Posner, a New York-based finance analyst at Morgan Stanley.

Lenders that rushed to provide mortgages amid rising home prices are now stuck with loans worth less than they expected because bond investors are demanding more protection. They are raising mortgage rates help to make up the difference. “In a rapidly changing environment, you can find yourself ahead or behind the yield curve,” Robert Cole, chief executive officer of New Century, the No. 2 lender to people with the lowest credit scores, said in a November 15 interview. “With rates going up, it’s more likely behind.” Profit margins for New Century may narrow to 15 to 25 basis points this quarter from 61 basis points in the third quarter, and 175 basis points in 2004, Chief Financial Officer Patti Dodge said in an interview. “Originators don’t charge enough for the risk” and will lose money as investors demand higher yields, said Alex Wei, who co-manages $3 billion in bonds at Philadelphia-based Delaware Management.

Beware Interest-Only

For years, it was a perk for the rich, but 2005 saw an explosion of sales to ordinary folks of a product known as interest-only mortgage loans. And now, the lenders themselves are starting to get worried while mortgage brokers continue to push these products for all they are worth. And with the pressures building on all sides in the mortgage industry, they could wind up being the next great regulatory crusade for 2006.

Through the first half of the year, the share of I-O mortgages as a percentage of all mortgage originations rose to 23% from 17% in the last six months of 2004, the vast majority of it in adjustable rate paper, according to the Mortgage Bankers Association. Meanwhile the share of more traditional adjustable rate products was falling, to 36% from 46%. Lenders piled into I-O product, eager to keep underwriting volume alive. These products require that the borrower cough up only a monthly interest payment for a set period of time. After that initial phase, the rate adjusts and the principal kicks in. The arrangement can make a lot of sense for borrowers who want to preserve cash flow for investment purposes or for those who have low salaries but large annual bonuses that can be budgeted to account for adjustments in the loan payments over time.

But increasingly, that is not how these loans are being used. Low interest rates have driven people to the home-buying market, pushing housing prices to eye-popping heights. Interest-only loans are helping families stretch for homes they otherwise could not afford, or to finance vacation homes. In effect, the borrowers are taking a product designed to preserve cash flow for other investment purposes and turning it into debt leverage to get the deal done. More leverage, more risk. But now it is becoming evident that no one knows exactly how much risk there is, even the lenders.

A huge quantity of mortgage paper is packaged and sold to investors every year, a lot of it by the two federal entities set up for this very purpose, Fannie Mae and Freddie Mac. In 2004, some 18% of the $1.8 trillion mortgages securitized were interest-only mortgages, according to Bear Stearns, and that likely increased dramatically this year. Hedge funds and other institutions hungry for higher-yielding investments have been snapping up the lower-rated pieces of securitized mortgages. That does not mean the risks are completely covered. “Apparently, there is not sufficient data for any institutions to know how much they have,” said Charles McMillon, of MBG Information Services, an economic analysis group in Washington, D.C.

The real risks may end up falling even harder on individual borrowers than the lenders and investors in such debt. As HSH Associates, a mortgage research firm, notes that for consumers, “the benefits are way overblown.” Not paying any principal now means that much more paid in interest later. Ruth Hayden, a financial planner in St. Paul, Minnesota, calls the phenomenon “Yuppie Money”, and warns against the temptation. “It’s pretending you have more than you have,” she says. “It’s over-leveraging.” But who wants to be the ant when the grasshopper lifestyle looks more appealing?

More and more Americans are moving to get away from overheated housing markets.

Many residents of high-priced housing markets around the country are cashing out and moving to more affordable areas. In Massachusetts, a quarter of the people in the state said they would leave if they had the opportunity, according to a poll by MassINC, a non-profit public policy think tank. They would join some 170,000 Bay Staters who left for other parts of the U.S. between 2000 and 2004. The No. 1 reason cited by those who want to leave: The high cost of living. And the No. 1 area needing major improvement: Housing affordability.

On the other side of America, Hawaii faces a similar mindset – two out of every five residents say they have considered leaving the islands because of the cost of housing, according to a poll co-sponsored by the Hawaii Business Roundtable and Pacific Resource Partnership. California suffers a net loss of about 100,000 residents a year to other states, according to Economy.com. In recent years, many have cashed out their rapidly appreciated homes and moved to Arizona, Washington, and Oregon. But now that prices have climbed in those states as well, the latest trend is that Californians are turning to the Midwest, where spacious houses are available for half of the cost of similar space in Los Angeles.

On Long Island, the once bucolic suburb but now heavily developed region next to New York City, about 70% of residents are at least somewhat concerned that high housing costs will drive their families from the region. And this is not a far-off issue – 45% said it was at least somewhat likely that they would move out during the next five years. There are two factors at work, according to Carrie Meek Gallagher, project director of the Long Island Index, which published the findings. The first is that younger Long Islanders aged 18 to 34 are unable to afford decent homes. The second is that older residents who already own increasingly valuable property find they can sell their present homes, buy in less expensive locales, and have big nest eggs left over. Younger Long Islanders, says Ms. Gallagher, often find that they may have to take a slight pay cut when they move to the Sun Belt, “but they more than make up for it by being able to buy a brand new house for half the price it would cost on Long Island.” The trend has already taken root and seems to be accelerating. “There was a big jump, from 62% to 70%, in one year of the 18-to-34 age group who think they are likely to leave within the next five years,” according to Gallagher.

Study: More housing markets called overvalued.

Even though the number of cities where home prices are “extremely overvalued” dipped slightly in the third quarter, the percentage of the U.S. housing market considered frothy and at risk for a price correction nudged higher, a study scheduled to be released Friday shows. “The data suggest that the incidence of overvalued markets is becoming more concentrated,” says Richard DeKaser, chief economist at National City. The study, by National City, a Cleveland-based bank, and financial information provider Global Insight, examined 299 metro areas that account for 80% of the single-family home market. DeKaser defines “extremely overvalued” as 30% higher than he estimates prices should be based on historical price data, incomes, mortgage rates and population density.

The number of significantly overvalued cities fell to 65 last quarter vs. 67 in the second quarter, but the percentage of the market with out-of-whack home prices rose to 38%, up from 35% at the end of June. The findings come amid reports of slowing sales and moderating prices around the country. For the second straight quarter, Naples, Florida, topped the list, with homes 84% overvalued. The rest of the top five: Merced, California, 76.7%; Salinas, California, 74.8%; Port St. Lucie, Florida, 72.2%; and Stockton, California, 72.0%. A surprising 41 of the 65 significantly overvalued markets were in California and Florida. DeKaser stresses that does not imply homes there will suffer a 70% or 80%-plus collapse. He notes that price corrections are generally about “half” the magnitude of the total overvaluation. Even declines of that size are unlikely unless an economic shock occurs. Newcomers to the “at-risk” list include Phoenix, 34.8% overvalued; Pensacola, Florida, 33.2%; Orlando, Florida 32.7%; and Honolulu, 31.3%.

Also noteworthy: A few cities previously deemed very frothy dropped off the list. Worcester and Essex County, Massachusetts, are no longer 30% overvalued, a sign that cooling is underway in many previously red-hot markets. Also dropping off the overvalued list: Jackson, Mississippi; Bay City, Michigan; Portland, Maine; and Charlottesville, Virginia. “We’re beginning to see more diversity among metro areas,” says DeKaser, noting that not all markets are getting more pricey as they were in 2003 and 2004. “We are seeing places like Massachusetts reverting back to normal, and places like Arizona and Florida doing precisely the opposite.” What remains to be seen, DeKaser says, is whether the most overvalued markets will have an orderly price correction to more normal, historic price levels – or more painful declines.

California home affordability holds near record low.

California’s high home prices, paired with rising mortgage interest rates, shut out 85% of households in the state from the housing market. Only 15% of California households could afford to buy a median-priced home there in October, the same level as in September and down from 19% a year earlier, according to a report from the California Association of Realtors. The group’s measure of home affordability is hovering above a record low 14% posted in August. Home prices in California have doubled over the last four years, with prices soaring in coastal urban areas, now among the priciest local home markets in the nation. Association economist Robert Kleinhenz said the measure will stay at 15% or slip to 14% through February because home prices will hold steady while mortgage interest rates edge higher.

The median home price in California is off its peak of $568,700 in August, but home buyers now face higher monthly housing costs because mortgages have become expensive to finance, Kleinhenz said.

Massachusetts sellers chop asking prices as housing market slows.

Boston-area homeowners trying to sell their houses are sharply reducing asking prices – in some cases, by $100,000 or more – in response to the sudden slowdown in the real estate market. The median price of a single-family home in Massachusetts has dropped 7% in the past two months, to $349,000 for sales that closed in October. But reductions in asking prices of 10% or 20% are now common in both high and moderately priced neighborhoods, according to real estate agents and listings of homes for sale.

“The evidence – both early data and the anecdotes – are pointing more toward a hard rather than a soft landing” in the housing market, said Nicholas Perna, an economic consultant in Ridgefield, Connecticut. “Prices could come down. Could it be 10 to 15 percent? There’s no way of knowing, but what we’re getting is more clues that you’ve got a decline in prices underway.”

Homeowners in no rush still have the option of letting their listing expire, unsold, and putting the house back on the market in the spring when brokers hope conditions will improve. But those who need to sell quickly – couples in the midst of a divorce, employees who are relocating to another region, or owners who are purchasing another home, for example – may have no choice but to entertain offers they would have scoffed at months or even weeks ago.

Housing slowdown may claim 800,000 jobs in 2006.

A sustained decline will hit the U.S. housing market next year, costing the nation as many as 800,000 jobs, according to a new economic repor. The slowdown is likely to last several years, with as many as 500,000 construction jobs and 300,000 financial sector positions lost, the quarterly Anderson Forecast predicted. “We expect housing to start slowing the economy this quarter or the next,” said Edward Leamer, director of the study done at the University of California, Los Angeles. “Some jobs in manufacturing might well disappear as a result of weakness in housing, but this may be offset by jobs brought home or not lost to foreign competition,” he wrote.

The forecast said eight of the last 10 economic recessions were started by housing market slowdowns. Though the coming cooldown will cause a drag on the nation’s economy, it will fall short of triggering a recession, the forecast said. The report cited several signs that the decline could be under way. “On all these grounds, we believe housing is due for a sustained decline,” economist Michael Bazdarich wrote in the forecast. “The remaining questions are how hard the fall will be and when it will begin.”

FIVE RISKS

The annual year-end forecasting ritual has begun. For us, it is always sparked by the extension of our forecast horizon to another year – in this case, our first official glimpse at 2007. We also take an in-depth look at our calls for the year nearly completed (2005) as well as for the 12 months lurking just ahead (2006). It is as close to soul searching as the heartless macro prognosticator ever gets.

Time and experience – there is a difference – has taught me not to take the point estimates of our global forecast-extension exercise too seriously. We do our best as a tightly knit group of seasoned forecasters to capture the rhythm of the global business cycle. We agonize over policy assumptions – monetary and fiscal – currencies, oil prices, inflation, yield curves, and, yes, even global imbalances as we put the pieces of the global macro outlook together. But in the end, the outcome of this exercise typically suffers from the classic drawbacks of groupthink. The offsetting inputs from our far-flung network of economists around the world often tend to produce a rather boring outcome – something close to a trendline forecast for the world economy.

Our latest year-end global forecast exercise is no exception. Our first cut at 2007 calls for a 3.8% increase in world GDP growth – down slightly from an upwardly revised 4.1% increase for 2006 (versus our previous estimate of 3.8%). On the surface, these are pretty impressive numbers for the world economy – slightly above trend (an average of 3.7% world GDP growth since 1970) and well above the global recession threshold (2.5%). If this forecast comes to pass, it would mark five consecutive years of above-trend growth for the world economy – the longest stretch of global vigor since the late 1980s. With global inflation expected to remain well contained over this time horizon – we are forecasting industrial world CPI increases averaging just 2.0% over 2006-07 – our global baseline is starting to take on the ever-seductive characteristics of Rosy Scenario, that voluptuous handmaiden of yesteryear. In looking at the major regions of the world, our baseline forecast conveys the impression of “steady as she goes” through 2007.

The pitfalls of groupthink have long taught me to focus on the risks to our baseline view of the world. That is especially the case when we peer into our scratched and cracked crystal balls and stretch the forecast horizon out for another year. Baselines are an important aspect of any macro debate – be it for an individual economy, a region, or the world as a whole. But, in my view, the baseline should only be viewed as a starting point. Over the course of any year, the unexpected always happens – namely, oil shocks, natural disasters, wars, or financial market disturbances. Our baseline is the benchmark by which we then measure the impacts of these all-too-frequent “exogenous” disturbances. This is where the rubber meets the road for the macro analyst – not in discerning the precision of a baseline but in trying to capture the risk factors that are most likely to jar economies off this trend-like path. In that spirit, I present the five risks that I believe will be especially critical in shaping the global macro climate in the year ahead: 1.) Global rebalancing, 2.) China slowdown, 3.) the American consumer, 4.) The dollar, and 5.) Central bank credibility.

In the end, good macro is not about honing the precision of the baseline forecast. It is more about a risk assessment of unexpected developments on the tails of the probability distribution. As I look to 2006-07, I see the downside risks outweighing those on the upside by a factor of two to one. Specifically, I think there is a much greater chance that world GDP growth could slip back into the 2.5% to 3.0% danger zone rather than cruise at or above our nearly 4% projection. As 2005 draws to a close, ever frothy financial markets are in the process of discounting an increasingly sweet macro scenario that bears a striking resemblance to our baseline view of the world. If my risk assessment is correct, financial markets could be in for a rude awakening.

TO SPOT NEXT BUBBLE, WATCH INTERNATIONAL FUNDS

By any measure, it has been a blowout year for international stock mutual funds. Strong performance. Torrents of new money. In both respects, a showing that has left domestic U.S. stock funds in their wake. International investing has grown so trendy as to make a dedicated contrarian suspicious. In an age of financial extremes, is this going to be the next locus of excess – a new bubble a-building?

Maybe I jump the gun in raising such concerns. Here are some facts and figures to help you judge for yourself: The almost 300 U.S.-based international equity funds that specialize in stocks from other countries averaged a 14.7% return for the 12 months ended Nov. 30. That handily beat the 10.2% return for domestic growth and value funds. This international category comprises only broadly diversified funds, and does not include the single-country and regional funds that produced every one of the top 18 gainers among all equity funds. These worthies ranged across the globe from the Profunds UltraJapan fund, up 83.2%, and the T. Rowe Price Latin America Fund, up 70.6%, to the Turkish Investment Fund, up 60.5%, and the ING Russia Fund, up 56.2%.

A surge of new money from investors brought international stock fund inflows to a projected $150 billion this year, pushing assets past the $1 trillion mark, according to the New York consulting and research firm Strategic Insight. The inflow represent about a 41 percent increase from the record set last year of $106 billion, says Avi Nachmany, Strategic Insight's director of research. Back in the early to mid-1990s, a previous boom period for international investing, net inflows topped out at much lower heights of $60 billion in 1993 and $66 billion in 1994, Strategic Insight reports. “Despite recent gains, only 18 percent of all equity fund assets are invested in international equity funds,” Nachmany says, suggesting that investors have not gone overboard yet on their allocations to international stocks – they are just catching up after a long period of lagging interest. In the vast global economy of the future, all other nations beyond U.S. borders are surely going to account for more than 18% of the action, are they not?

And yet, it is hard to overlook some worrisome portents in the recent flows. Fund investors, prone to the all-too-human propensity for buying what has looked best lately, have a disturbing history of flooding fund groups with money just as those sectors hit market peaks and began to fade. The biggest month ever for stock-fund inflows – a staggering $55.6 billion – came in February 2000, just as the great bull market of the 1990s was giving way to a severe 2½-year bear market. By July 2002, the mad rush was running the other way, with $52.6 billion of outflows from stock funds less than three months before the decline hit bottom. There is no evidence, by the way, that this behavior pattern is confined to the “unsophisticated” small-investor populace. Witness how hedge-fund returns have dwindled this year amid a stampede of buying interest in that once-rarefied realm.

If you ask me, the fundamental case for investing internationally looks as solid as ever. Still, there was also a compelling rationale behind the U.S. stock boom in the late 1990s – an upsurge of productivity brought about by the Internet and other technological wonders. That story, valid then and still unfolding today, was not enough to prevent stock prices from suffering a nasty comedown in 2000-02.

SAME AS IT EVER WAS

For the past few weeks we have looked at the argument for the case “This time it’s different”, made eloquently in a 130-page book called Our Brave New World by the very bright minds behind GaveKal Research. The trade deficit of the U.S. does not matter, they aver. For the next few weeks we turn to look at the opposite view, made by Bill Bonner and Addison Wiggin in their new 370-page book, Empire of Debt. Not only do they tell us that things are not different, but that the end result will be the same as it has always been. And for the curious, the end result is not a pleasant thing.

Where GaveKal sees a rising dollar, Bonner and Wiggin see The Demise of the Dollar (the title of a separate book by Wiggin). Where GaveKal sees promise and positive benefit in a negative balance of trade, Bonner and Wiggin see hubris and peril. Is it an Empire of Debt about to go the way of all empires, or into a Brave New World? Let us make no mistake, these are polar opposite views. And where you come down makes a large difference in how you manage your investment portfolio, not to mention how you order your future. This will make for an interesting, if not altogether fun, letter. Warning: you are about to enter a major doom and gloom zone.

There are two stories in Empire of Debt. The first is the traditional argument of the Austrian economic school. You cannot forever run trade deficits. Eventually your currency will collapse, as people will not want any more of it. You cannot borrow and consume your way to riches. Yet our national debt – private, corporate and public – just keeps soaring. However you want to measure it, in absolute terms or as a percentage of GDP or income, debt is up and continues to climb. So, one of the main themes in the book details how the increase in debt in America, combined with both trade and government deficits, must end in tears. One cannot spend oneself into riches, whether as an individual or as a country.

The second, and far more troubling, theme in the book pricks at our national conceits, at the very value and beliefs that we as Americans hold about ourselves. We (or most of us) see ourselves as the good guys. Bonner sees the United States as an empire. That in and of itself is not exactly a new thought. Many hold that line of thinking, and do so proudly. Pax Americana makes the world a better place. Niall Ferguson contends that it is all that holds the world back from another Dark Ages. Someone has to order the world and make people and countries play nice. For Bonner, being an empire is not a good thing, even though he readily admits that America is not the traditional empire of old. All empires must come to an end. So how will the American Empire end? For Bonner, it is in debt.

America is not an empire in the traditional sense. The Mongols or Romans conquered and demanded taxes, (a rapacious 10% or so). The British and French took commodities and cheap goods. Americans send an army and then pay hundreds of billions to the conquered. In the same way that investors thought that tech stocks would only go up in 1999, or gold in 1979, Bonner and Wiggin see a country that thinks that its stock can only rise. Since that has been the case for 225 years, why should it be different now? Yet, “The U.S. suffers from … structural deficits that will limit the effectiveness and duration of its crypto-imperial role in the world,” explains Niall Ferguson.

And thus we come to it. To Bonner and Wiggin, America is on a course to a soft depression brought on by debt precisely because we have become an empire. We have spent the income of future generations in order to consume today, amassing a staggering debt that grows ever larger. We have obligated our children to pay a Social Security and Medicare burden that they simply will not have the means to pay as things currently stand. The generational contract will be broken because it cannot be paid. This is not your ordinary run of the mill doom and gloom. It captures a whole new level, for it is an inevitable doom. We are slouching toward an evening in America, unaware of our own fate. Thus have all empires ended, either with a whimper or a bang. They make a good case. The question is, can we ignore it? Are they wrong, or will somehow things be different?

NEW THINKING ON OLD AGE

Nothing, said Benjamin Franklin, is sure in this world except death and taxes. These days, however, many in the rich world are faced with another certainty: old age. This has left politicians struggling to work out how society should take care of this rapid surge in geriatrics. Britain is the latest country to search for an answer. On November 30th, the Turner Commission, which was charged with finding ways to make the pension system more robust, released its report. This urged the government to make sweeping changes that would force people to save more, and to remove the perverse incentives not to do so.

Under the Turner plan, everyone would feel the pinch of putting Britain’s faltering retirement system right. The commission recommended slowly raising the state pension age, preferably to 68, by 2050. This would not be popular with pensioners. It would also be hard for the government to defend, given that it recently cut a deal to let those already working in the public sector retire at 60.

The report also endorses a new voluntary savings scheme, into which workers would put at least 4% of their wages, with employers contributing 3% more and a further 1% coming from the government in the form of tax relief. While the system would be voluntary, the commission suggests making it “opt out” rather than “opt in”, meaning that workers would be automatically enrolled, but could choose not to contribute if they wished. Recent research indicates that “opt out” systems substantially raise the rate at which workers contribute. This does not exactly please companies, which are complaining that the new plan would put thousands of small firms out of business. The pla’qs defenders argue that Britain’s current system is unsustainable; workers are not saving enough, meaning that the government will have to bail them out somehow.

Britain is not the only country trying to figure out how to support the elderly in an era of ever-lengthening lifespans. Continental Europe’s lavish government benefits guard the old against poverty, but are threatening to bankrupt the states that offer them; the French finance minister told parliament this week that the government was looking at an unfunded pensions liability of €900 billion ($1.1 trillion) on top of already record levels of public debt. Forced savings schemes have become more popular, but the amounts are often too small to substitute for a traditional pension.

The problem, in a nutshell, is that governments have simply promised pensioners more than a shrinking workforce can realistically deliver, and even now few of them are facing it square-on. Fixing the problem means big bills – to deliver on promises to current retirees in the PAYG systems, and to put new workers into schemes that are more actuarially sound because they rely more on growth-enhancing investments. This would enable the economy to support more retirees per worker. But it remains to be seen whether politicians are any more willing than their voters to delay gratification.

FLAWS, FACT CHECKING, AND THE INTERNET

If you spend a lot of time online you have probably visited Wikipedia, the Internet encyclopedia. I have used it countless times and found it to be highly reliable – its references and external links are often as useful as the topic entries. Anyone can contribute to Wikipedia and anyone can improve the contributions of others. I believe this tool is the Internet at its best. But somehow it is not surprising that Wikipedia’s most visible exposure to date came in the form of a black eye last week: A retired newspaper editor came across his biography on Wikipedia, only to read a defamatory (and perhaps libelous) comment that linked him to the assassinations of John and Robert Kennedy. In turn, he wrote an op-ed piece in USA Today that said Wikipedia is “a flawed and irresponsible research tool.”

Now, maybe I would say the same thing (or worse) about a source that publicly associated me with two notorious murders. Yet I hope I could have risen above my own (justified) personal outrage, especially if I had been a career newspaperman. We all know how often the “best” sources and the “brightest” minds have published “facts” that later proved to be egregious errors. Most days I can find stories about what “moved” the stock market and read comments that are too stupid to ridicule. Common sense says that when it comes to information sources, a reader or researcher should treat them ALL the same way – with an attitude of healthy skepticism. Veracity must be proven, never assumed.

It is true that the Internet has dramatically increased the volume and velocity of rumors and urban legends. Yet it is also true that you can find several excellent web sites dedicated to exposing false information for what it is. But if I am looking for, say, a list of “cognitive biases” – or distortions in the way we perceive reality – I know of only one reliable online source, which is also sure to include a robust number of references and external links: Wikipedia. Flawed? Yes. Irresponsible? No way, certainly less so than most newspapers on most days. That list of cognitive biases is one that every investor should read and consider, by the way. If you do not see yourself in there at least several times, read it again more slowly.

CAPITALISM AND COW WORSHIP

It was 4 a.m. I was asleep in the Fairmont Vancouver Hotel when the phone rang. “Thangachi!! (Sister!!)” yelled an enthusiastic voice from the other end. It was Perumal, our old cook from India. As youngsters growing up in India, my mother always warned, “Perumal won’t be here forever, you girls have to learn to cook.” She worried that hiring help around the house was getting increasingly difficult. No one wanted those jobs anymore. What would we do if Perumal left? And leave he did. “I’m in Malaysia now!” he yelled into the phone. “I work in a Malaysian restaurant in Ipoh. I like it here. They pay me well.” He said. Perumal worked for my family in India for 26 years. We paid him 5,000 rupees (about $114) a month. He worked six days a week, often seven. Today, he sends money home to his family, and his daughter is going to college next year. “I want her to study computers,” he told me proudly. “Maybe I’ll come back to India someday and start a restaurant. It’s not like before, you know. Everyone wants to eat out these days. I’ll start a nice vegetarian restaurant.”

Perumal is right about it not being like before. The Indian middle class has grown so affluent that they can easily afford to eat out more often compared to a decade ago. In fact, according to a McKinsey report, the Indian food industry grew faster than the information technology industry over the last 10 years. The fast food industry in India is even bigger business. India’s fast-food industry is growing by 40% a year and is expected to generate over a billion dollars in sales this year.

Consumerism is big business in India. There will be 628 million middle-class Indians by 2015. And already, their net income has doubled over the last 10 years. Obviously, every multinational company now wants to sell in India. Some companies have failed and others succeeded. The ones that failed did so because they were not sensitive to the cultural factors that affect consumer behavior in India. Kellogg’s introduced corn flakes in India in 1995. But the product failed miserably. It achieved less than 20% of its initial sales target. How could Kellogg’s have gone wrong? Corn flakes are cheap, more and more Indian women are working and do not cook breakfast anymore and people want a nutritious yet quick meal, right? The answer lies in the quirks of Indian consumption patterns. Something my uneducated cook understood, but the suits at Kellogg’s did not. Indians consume differently. In this case, Indians like hot milk in their cereal. Kellogg’s cereal is made for cold milk and did not hold up to hot milk. It became soggy. Nobody wanted to eat it. For years, Kellogg’s struggled in India. It was only after revamping its product and making a cereal suitable for hot milk that Kellogg’s became profitable in India.

So here are some cultural quirks multinationals should keep in mind when marketing in India: 1.) Indians like hot cereal. 2.) Most Indians worship cows; part of the country is vegetarian. 3.) Indians do not kiss (at least not in the movies). It was point number two that my cook Perumal drove home. You see, not only are many of us vegetarian, we are a cow-worshipping, non-beef-eating lot. About 20% of India’s population is completely vegetarian, and about 82% does not eat beef.

Yet McDonald’s revenue in India has grown a whopping 50% annually since 1997. How does McDonald’s thrive and flourish in cow-revering, vegetarian India? Enter the Maharaja Mac – a 100% ground lamb burger served with tomatoes, special sauce, lettuce, cheese, pickles, and onion on a sesame seed bun. Other items include the Chicken Maharaja Mac, the McVeggie and the McAloo Tikki (with potatoes). The vegetarian items are advertised with a “100% pure veg” stamp on them. 75% of the McDonald’s menu in India is Indianized. In 2001, McDonald’s also introduced the Veg Surprise burger, a veggie burger with Indian spices. Not surprisingly, sales volume shot up 40%. As for the flagship Maharaja Mac and the McVeggie, not only are they profitable, they are also politically correct burgers. Indian political activists are always eager to protest again so-called “cultural imperialism”. And foreign-based fast food chains are easy targets.

Take KFC, for example. After an ambitious start in the late 1990s, KFC scaled back its expansion plans after major protests. KFC was also accused of using illegally high amounts of MSG and frying its chicken in pork fat (India’s 150 million Muslims do not eat pork). Activist groups protested outside the restaurant in Bangalore, holding placards reading “Quit India” and “Stop Playing Foul”. KFC now has just one restaurant in India. McDonald’s has 58 restaurants in India. And it seems all set to “beef up” more profits in the country.

As Managing Director of McDonalds India, Vikram Bakshi says “When you go into any country, very clearly, you have to understand the culture; you have to understand how you intend to be relevant to the consumer in that country. I don’t think any brand, no matter how big it is, can take the market lightly. And I think the biggest mistake is when you think you have a big brand and that everyone is overwhelmed by it. Because whatever the brand, it has to be relevant to the consumer of that country.”

P.S. McDonalds only has franchises in India now. But very soon, an important law will be passed that will allow McDonald’s to enter India directly. Already, Wal-Mart, Nike and Microsoft are getting ready to set up shop in India in anticipation of this law. And once it is passed, these four stocks will skyrocket. This law is going to be the turning point for the Indian economy – and for smart investors who have their money in the right places.

GO EAST, YOUNG COAL MINER

In February 2005, I wrote an article for the International Speculator called “Too Late for Coal?” The takeaway was that valuations on junior coal companies had run well ahead of the fundamentals for these firms. Indeed, as Dave Forest, managing editor of the Casey Energy Speculator, points out in the following article, there has been a severe retrenchment this year in the share prices for many of the junior coals. But the fact remains that the market for coal as a commodity is still booming, fed by the astonishing growth taking place in China. So how do we profit? Dave has a few ideas …

When metallurgical coal reached $125 per ton in late 2004, the market assumed the party was just getting started. And how better to gain leverage than with the handful of small-market-cap companies eyeing rich new coal deposits in British Columbia? The press reported an unprecedented bull market for coal stocks, and analysts conjectured the birth of a coal trust sector. But in every case, the story ended up the same: skyrocketing costs. With most resource prices rising, mining and petroleum companies face increasing competition for equipment, raw materials and employees. The last has been a major problem in western Canada, as many laborers have headed to the booming oil sands of Alberta, where employers are paying top dollar.

Given these problems, a new trend is emerging: a preference for international coal projects. After all, if cost control is the key to coal mining profits, what better solution than to head overseas, where labor is plentiful and cheap? It remains to be seen how cost-effective overseas companies’ operations will be. But given the low labor costs they enjoy, it is a good bet that they will outperform the coal miners in high-cost British Columbia. If so, the future of coal investing may well be international.

A TALE OF TWO COUNTRIES

On that side of the Atlantic “pond”, on a little island that calls itself Great Britain, it was the best of times. In contrast to its neighbors on the Continent, Britain had rung up an extraordinary period of growth and prosperity over the last dozen years. On this side of the pond, a big island known as the cradle of liberty and democracy, the USA, also basked in the glow of prosperity and global dominance. The world’s only remaining superpower, it was also the engine of global economic progress … especially as the world’s 2nd and 3rd largest economies, Japan and Germany, remained mired in slow/no growth. Indeed, for the entire English-speaking world it was the best of times. In the Far East, incomes and wealth were rising rapidly in Australia and New Zealand. Ireland’s spectacular growth had earned it the title of “Celtic Tiger”. And here, in North America, things were bubbling along nicely north of the border in Canada.

And yet, the skeptics and the contrarians were not convinced. They pointed to dark clouds on the horizon. They claimed that these “best of times” were not sustainable. They predicted that soon we would arrive at the worst of times. What were they worried about? Were they just perpetual worrywarts, perma-bears who always went around like Chicken Little saying the sky was falling? Were the facts they cited significant? Was their reasoning sound?

And so we wait with bated breath to see what lessons that great teacher, History, has in store for us. If the past is any guide, the combination of interest rate hikes and oil price shocks is sure to lead to recessions. And the central banks on both sides of the pond are sure to respond with the only trick in their playbooks – interest rate cuts. The critical question is how deep and prolonged the recessions are going to be. On both sides of the Atlantic, the consumer holds the key. Will they maintain spending levels long enough for the central banks to come to the rescue with sharply lower interest rates and reduced debt service burdens? Or will they cave in as the recession brings higher unemployment and lower incomes? Most importantly, will credit defaults on mortgages and other consumer debt deal a serious blow to the safety and soundness of the financial systems? If the latter happens concomitantly with a steep stock market decline and housing bust, we face a serious global recession or even a depression.

Yes, it is indeed the best of times on both sides of the Atlantic. That is the good news. The bad news is that it could be the precursor to the worst of times. As Charles Dickens wrote in A Tale of Two Cities about France in 1775, both the U.S. and the UK have “rolled with exceeding smoothness down hill, making paper money and spending it.” And yet, the trials to come will provide plenty of opportunity to rebuild the character that made these nations great … foregoing immediate gratification, living within one’s means, saving rather than borrowing, and investing to increase real productivity and ultimately incomes. At least we have that consolation

FAMILIARITY IS OVERPRICED

Familiarity breeds contempt … but not right away. In the beginning, familiarity breeds desire, when then becomes mere comfort, then only tolerance, then resignation … and THEN contempt. Most U.S. bond investors appear to have entered the comfort/tolerance phase. We predict they will arrive at the contempt phase, eventually. But for now, most bond investors prefer familiar, high-risk bonds to unfamiliar, lower-risk bonds. As recently as last February, for example, bond buyers readily accepted a 5.6% yield on the 3-year paper of General Motors. We were amazed. In the February 11 edition of the Rude Awakening we observed, “Net-net, GM seems fully deserving of its ‘near junk’ rating and seems likely to trend from bad to worse.”

In other words, GM’s tenuous financial health was no secret last February. And yet, investors continued to bid for GM bonds, even after the company fell into the ranks of junk credits. (To be sure, the buyers of GM bonds have been demanding ever higher rates of interest over the last several months. But they still buy, nonetheless). Meanwhile, the Brazilian government’s 3-year notes have gone begging. Unfamiliarity, tinged with suspicion, is to blame. “Brazil is not GM,” some might protest. To which we would reply, “Thank goodness.” Brazil, despite its considerable foibles, runs a trade surplus and only a very slight government deficit. It also boasts the world’s strongest currency over the last three years. GM, for its part, is merely familiar. The teetering auto giant has managed to attract buyers to its bonds, based on what it has been – NOT on what it threatens to become.

Throughout the last year, the Rude Awakening has continuously spurned GM’s stock and bonds, while simultaneously extolling the virtues of certain Brazilian investments. We have not been blind to either GM’s storied past, nor to Brazil’s checked economic history. But we simply believed that the relative pricing of GM and Brazilian bonds was way out of whack. We still do, though less out of whack than 10 months ago. On March 25, for example, Brazilian 3-year notes paid an 18.1% rate of interest, while GM 3-years paid only 6.5%. Today, Brazilian 3-years yield a still-hefty 16.5%, while GM 3-years yield a nearly identical 16.2%. Which one is the better credit, the fatally-indebted auto giant or the resurgent South American economy? The question answers itself. GM is skidding toward bankruptcy, while Brazil is lurching toward financial respectability.

Until recently, however, GM’s lengthy history of success protected it from exacting credit analysis. On the flip-side, bond investors have shunned Brazilian debt. The country’s considerable recent successes have not yet erased its legacy of serial currency and debt crises. But we suspect that the world is changing, and that we may no longer trust assumptions from the past to guide investments in the future. Indeed, generally speaking, we would spurn all U.S. high-yield debt in favor of foreign sovereign debt. Both are risky; but we would prefer the risk of holding bonds from unfamiliar, but increasingly credit-worthy, foreign governments to the risk of holding familiar U.S. junk bonds.

“When the Banana Republic countries can borrow at single- digit interest rates, it means investors have no fear,” Steve Sjuggerud recently observed. “Right now, the lack of fear in emerging markets (based on emerging market interest rates compared to U.S. interest rates) is literally off the charts. As a group right now, emerging market countries can borrow for the long term at an average interest rate of 6.8%. This is ludicrous, and a record low level. 2.4 percentage points above U.S. Treasury interest rates is the record, and it’s where we are now.” We would not quarrel with Dr. Sjuggerud’s observation, but we would add two qualifications. 1) The narrowing of spreads between Treasurys and emerging market debt may be saying as much about the deteriorating credit-quality of the U.S. government as it does about the improving credit-quality of emerging markets. But that is a topic for another day; 2) If emerging market bonds are a sell, U.S. junk bonds are a “double sell”.

To frame the comparison, consider two NYSE-traded closed end funds: the Salomon Brothers Emerging Market Income Fund II (NYSE: EDF) and the RMK High Income Fund (NYSE: RMH). RMH holds BB-rated (junk) bonds from U.S. issuers while EDF holds BB+-rated government bonds from emerging markets. RMK pays 10% per annum; EDF pays 8% (most of the difference in yields results from the fact that RMH applies more leverage to its portfolio than EDF). Both investments seem roughly comparable, but if we dig a little deeper, key fundamental differences emerge. RMH’s top ten holdings include the junk-rated bonds of airline-leasing companies, mortgage-lenders and manufactured-home financers. By contrast, Brazilian government bonds represent 22% of EDF’s portfolio, while Mexican bonds represent 21%. No doubt, RMH and EDF both hold risky bonds. But we would rather buy into the unfamiliar risk of growing foreign economies than the familiar risk of troubled U.S. industries.

In short, familiarity is overpriced.

HEDGE FUND WORRY GROWS

High-flying investors are pouring tens of billions of dollars into hedge funds in the expectation of large returns, but financial experts worry that, in the event of a market-rattling surprise, these funds could spread havoc through financial markets. While hedge funds cater to institutions and the wealthy, experts say they have grown so large that, in a worst-case scenario, the failure of a few hedge funds could disrupt the banking system and hurt ordinary people too.

Hedge funds are lightly regulated investment pools that, unlike mutual funds, can bet on everything from real estate to energy futures. To achieve the eye-popping returns that investors have come to expect, they can engage in risky strategies, such as loading up on debt and engaging in unlimited short-selling. The risk of hedge funds was illustrated in 1998 with the blowup of Long-Term Capital Management. Despite having two Nobel-Prize-winning economists and some of the brainiest Wall Street traders, the hedge fund made enormous bet on bonds that went sour, and a coalition of Wall Street banks, corralled by the New York Fed, had to bail out the fund in order to avert a financial meltdown.

The implosion of Long-Term Capital Management injected a dose of humility into the swashbuckling hedge-fund industry – but not for long. The number of funds has more than doubled worldwide since then, and assets have grown to more than a trillion dollars from little more than $200 billion, according to the Hennessee Group, a hedge fund adviser. Money has flooded into hedge funds as a sagging stock market and stubbornly low interest rates have spurred investors to search elsewhere for higher returns.

“Because of their size and because of the nature of what they do and how they do it, they could end up magnifying the impact of any significant event,” said Andrew Lo, an MIT economist who, despite heading up his own hedge fund, has become one of the industry’s chief doomsayers. In a recent paper, he predicted that a reckoning for hedge funds is just around the corner. The surprise could come in the form of a terrorist attack, the default of a large borrower, or even a sudden shift in interest-rate policy by the Fed.

Lo said if the surprise hit a market with a heavy concentration of hedge funds, the value of hedge fund assets would start to plummet as investors ran for the exits. The Wall Street banks that lend to the hedge funds would immediately call in their loans. But to pay them back, hedge funds would need to sell their assets at the worst possible moment, causing yet more losses and prompting the banks to rein in even more credit. A “death spiral” would set in, Lo explained, that could bring down several large hedge funds, along with their bank lenders.

THE GOLD STANDARD GETS NO RESPECT

There is a lot of dumb stuff written about the gold standard and the Great Depression these days. I open the paper yesterday and I read a column by Robert Samuelson in The Washington Post, “Gold’s Enduring Mystery”. Samuelson goes on to say some things about gold’s role as money for much of recorded history. Then he gets to the Great Depression and he enters the realm of the absurd. He writes, “But the gold standard’s very rigidity led to its collapse in the Great Depression. Too little gold fostered banking and currency crises.” Tsk, tsk. Poor gold! Now the blame for the Great Depression lies at your feet. Truly, the victors write history. For here is history from the view of a paper money enthusiast.

Such a view is not uncommon. Our own newly appointed Fed chief, Ben Bernanke, also holds such views. Bernanke is a Great Depression buff, just as people are Civil War buffs. It fascinates him. He studies it as a man might pick over the remains of some archeological dig. He even began a book about it. Greg Ip’s piece in the Wall Street Journal summarizes some of Bernanke’s views on the Great Depression. On the top of the list: “Beware of outdated orthodoxies such as the gold standard.” To the world-improver set, confident they can push the right buttons and pull the right levers, the gold standard is nothing more than a straitjacket. To those who see gold’s charms, that is precisely its chief merit. You see, the gold standard checks the creation of new money.

If every dollar must be backed by a certain amount of gold, then you cannot create money out of thin air. The gold standard says you must have the gold first. Governments find it harder to wage war, dole out entitlements and build public works with a gold standard tying them down. Banks cannot lend as much money; hence they cannot make as much money. This is why the banking interests of this country backed the creation of the Federal Reserve. They appreciated the value of a good cartel.

The problem, Mr. Sameulson, is not that there was not enough gold. The problem was too many dollars. When Roosevelt ordered Americans to surrender their gold coins in the spring of ‘33, he was not saving capitalism. He was burying it. Bernanke may have studied the Great Depression, but he has read the wrong books. He should give a look at Murray Rothbard’s America’s Great Depression. Rothbard’s examination is clear and logical, without the trappings of mathematics that otherwise pollute economic texts today.

The gold standard is not to blame for the crises of the past. They were caused by our inability to keep the promise to redeem in gold. And, secondly, that far from causing crises, the gold standard kept in check the growth in money. As a result, the gold standard served to stem unsustainable booms and avoid the necessary busts that follow.

Why gold can go higher and higher.

The number of zeros on formal statistics sometimes disguises their real meaning. The U.S. government currently borrows $5,000 a year on behalf of each U.S. family, which it dares not tax for electoral reasons. This is the source of the budget deficit. That uncollected money remains in the hands of the family, which currently prefers buying foreign goods and spends $5,000 on them, producing the trade deficit. The foreign supplier sends the $5,000 back to the U.S. by buying government bonds and American businesses. This money from abroad is the source of the fine-sounding U.S. capital inflow. Give or take $1,000 this same $5,000 deficit triangle is completed for each of about 100 million U.S. households every year, and that is why there is a $500 billion budget deficit, and similar trade deficit and U.S. capital inflow. It is tempting to assume that this is the way it has always been and that somehow it must be stable, but that is wrong. This is a wholly new way of arranging things.

The last four-year administration ended having increased the average U.S. family’s gross future tax debt by about $19,000. The family’s total accumulated uncollected tax, i.e., its share of the country’s public debt, grew by that $19,000 to about $74,000, three quarters of which has been built up since 1985. The demand which has sustained growth for 20 years has arisen from this money being spent twice, and this duplicated spending is the only explanation that is needed to understand the remarkable strength of the USA’s economy. But the legacy of it is this $74,000 tax debt for each of just over 100 million families.

How serious is a $74,000 tax debt? We do not know because it has never happened before, but we do know that in Argentina in 2001 their sovereign public debt was about $12,000 per family, and at that level it triggered the capital flight which was the direct cause of their debt default and subsequent economic crunch. It is both extraordinary confidence in underlying USA economic robustness and an apparent lack of alternate options which appears to be preventing a similar U.S. setback. But the confidence rests on the demand strength, which itself arises from the scale of the deficit triangle.

To resolve the U.S. public debt problem safely is very difficult. Raising taxes to the required level is unthinkable. Trade protectionism was tried before and it triggered tit-for-tat trade restrictions and global depression. Meanwhile formal debt default is unnecessarily dramatic, but it seems it can be effected without the same national loss of face by a policy which allows the dollar to bleed value: so serious inflation seems much the most likely result. Assessing how severe the coming inflation might be is also difficult, but it is possible to get an idea by looking at the bond market. For 25 years the bond market has been growing fast, to about 40 times what it was in the early ‘80s. U.S. dollar bond markets have grown to contain 50 times all the dollars in current circulation. This frozen money is up for redemption over the coming years so it will turn back into cash, and little of it can sensibly be re-invested in bonds with inflation threatening and rates turning up from long cycle lows. In any event much of it must be returned as consumable cash to the retiring boomer generation. This suggests a possible cash glut in the medium term, and that indicates inflation too.

Fear of this should have already caused a downwards dollar correction, but this has not happened because the alternate currencies have similar problems. Commodities on the other hand have been rising in price – and gold particularly so. Gold is famously useless in almost everything except that it cannot be made, and is reliably difficult to find. The value of anything reflects its utility at the margin, which means it only needs a slight shortage to create price surges and a slight surplus to create price slumps. The utility of gold is simply that it is rare, and for 5,000 years people have used reliably rare stuff to store value for the future. Paradoxically rarity is in surplus wherever artificial money is being reasonably well managed, and this makes gold’s natural rarity less valued in those times. But what savers are now realizing is that official money is not being well managed and cannot in future be relied upon for rarity, and they believe their governments will soon be forced to create money in large quantities.

Arising from the scale of public debt the forced monetary issue which is being anticipated by savers is causing them to value the unimpeachable rarity of gold higher. More and more people no longer believe that the artificial rarity of bonds, or bank-notes, shares, or even houses are offering that same assurance of future scarcity, and until responsible fiscal and monetary management returns to government the outlook for gold is likely to remain resolutely positive.

A Golden Tan

“The bull market in gold is still young,” declared Michael Martin late last week. “I would be buying every dip on the way up … just like tech stock investors did throughout the 1990s.” On most work days, Martin, a 26-year veteran of gold-stock investing at R.F. Lafferty in New York, would prefer to see the yellow metal go up, rather than down. A rising gold price makes his clients happier, after all. But since he has seen so many down days throughout his career, he has learned to sell short gold stocks on occasion, or at least to ignore them from time to time. “So what are you doing now, Mike?” we inquired yesterday. “Gold hasn’t provided the convenient correction that many gold bulls have been waiting for. Are you buying gold stocks anyway?”

“Selectively, yes. Even though gold keeps chugging higher, the curious thing is that many gold stocks are not chugging higher. If you take a look at bellwethers like Newmont and Goldcorp, you’ll see that they have been drifting lower, even as gold has soared to new 23-year highs. [Monday’s] market action is a perfect example. … Gold is up almost $6.00 an ounce, yet most of the major gold stocks have barely budged. Newmont is up a few pennies; so is Anglo (NYSE: AU) … while Goldfields is actually down on the day. We’ve been seeing this kind of action for the last few days.”

“[A]ctually, gold stocks have been lagging for about two year,” we said What do you think these divergences mean? Are the shares pointing to a lower gold price? Or is gold pointing to higher gold stock prices?”

“Obviously,” Martin replied, “on a short-term basis, you can never know what these divergences are indicating until after the fact. But on a long-term view, I think the gold share market is providing a nice little entry point. Not a great entry point, perhaps, but a nice one. If you try to get too cute in the midst of a strong bull market, you spend all your time ruing your indecision. Better to take a position with a three-year view and not worry so much about the next three weeks. That’s why I’m focusing on stock-picking more than market-timing. … I’m concentrating mostly on the mid-tier names … the prospective takeover targets. … Just today, Goldcorp (NYSE: GG) snapped up Virginia Gold (Toronto: VIA), while Yamana Gold (AMEX: AUY) bought a little company called RNC Gold. … [I]t is still easier and cheaper to ‘find’ gold on the stock market than to find it through exploration.”

How about some names? “I’ll start by mentioning that a good friend of mine, a resource investors in Canada, mentioned four takeover candidates to me a few months back. They were Alamos Gold (Toronto: AGI), Viceroy Exploration (Toronto: VYE), Bolivar Gold (Toronto: BGC) and Greystar Resources (Toronto: GSL). So since my buddy guessed correctly once (Goldfields make a recent bid for Bolivar), I’m wondering of he might also be right about one of the other three. Out of this group, I’m partial to Alamos Gold, which has some very interesting gold/silver properties in Mexico.”

“I’m noticing that most of the stocks you’ve mentioned are in the $200 million to $300 million range.”

“Yeah, that seems to be the sweet spot,” said Martin, “which leads directly to my personal favorite: Tan Range (Toronto: TNX). The stock has a $250 million market cap, a fascinating business plan and an impressive pedigree. The company’s chairman and CEO is James Sinclair, who’s a well-known name in the gold market. Sinclair’s made millions in the gold market, even in bad times.”

“Tan Range is a small Tanzanian version of the old Franco-Nevada. It does not conduct any mining operations of its own. Instead, it buys prospective gold properties, then options out exploration and development rights under royalty agreements to major mining companies. The company owns about 120 mineral resource properties in Tanzania’s Lake Victoria region, and has multiple exploration agreements with Barrick Gold, AngloGold Ashanti and Northern Mining Explorations. … [G]reat properties and a great business strategy, run by a guy with great track record.”

Gold shines as alternative to leading currencies.

U.S. and European equities lacked a clear direction on Thursday, although there was no stopping the seemingly relentless rise in the price of gold. The precious metal hit a fresh 24½-year high, confounding widespread expectations that its advance would come to a halt after it broke through the $500 an ounce barrier just over a week ago. Analysts said gold had benefited from recent concerns about inflation, borne out of the prolonged rally in the oil market. “Investors increasingly sought an alternative to the major currencies, which themselves are representatives of economies suffering from varying mixes of ill-conceived policies,” said Seven Days Ahead, a London independent consultancy. “That alternative was gold.”

DECEPTIVE WARNINGS: NEARING ECONOMIC DISRUPTION, THE FED DISTORTS PERCEPTION

As Federal Reserve Chairman Alan Greenspan sails toward his port of retirement, he and his associates are now given to issuing warnings, on numerous topics and with increasing frequency. Most recently, the Fed Chairman has warned of fiscal policy causing a “pernicious drift toward fiscal instability” and of a “protectionist reversal of globalization”. He also warns that he fears “that we may have already committed more physical resources to the baby-boom generation in its retirement years than our economy has the capacity to deliver” so Congress needs to review how best to review its limited resources (this is not new news).

Nominally, Chairman Greenspan is giving warnings. However, the cadence and varied topics of successive warnings by Chairman Greenspan over the past few months have created a cacophony so as to give them little effect – and the warnings are issued on important but secondary issues that mislead the public as they divert citizens’ attention from the root cause and scope of approaching economic correction. Notable in recent warnings from Greenspan, Federal Reserve Governors, and their allies, is the focus on fiscal matters for which the President and Congress have responsibility, while the nation faces two primary threats that arise directly as a consequence of decades of Federal Reserve monetary policy failure: 1.) The U.S. and World economy face a potential inflation and interest rate spike with a disrupting effect on financial markets and existent investment bubbles; especially if they were to occur suddenly. 2.) The economy is distorted and is declining in sustainable economic terms due to an historically high debt level that has grown strongly during the past 20 years.

The U.S. energy complex has been damaged from Hurricanes Katrina and Rita in a way that may lead a sudden spike in energy costs (esp. natural gas) this winter – with an associated impact on inflation and interest rates. In much the same way as America, in an inflationary environment as a consequence of Central Bank monetary policy, was made vulnerable to the OPEC oil embargo in 1973, the U.S. (and Canada) similarly stand vulnerable today because of similar monetary policy failures. To be clear: we face the possibility of an epic economic correction.

Neither our elected representatives, nor politicians or government officials, the mainstream financial community, or the media, who all have a duty to inform citizens, have provided fidelity of information to properly inform the public. In advance of crisis, concerted and direct action is now required by allied Governments to begin the arduous task of reforming our monetary and financial system.

We are entering an economic phase very similar to the early 1970s where, after the money supply had been increased at double digit rates for a decade, commodity and consumer goods inflation appears in the economy. And we hear no coherently delineated Fed policy or exit strategy from the current economic environment where extreme pressure will be applied by inflation in consumer staples and commodities. Upward commodity price pressures, belatedly signaling past inflation of the money stock, will continue to force up interest rates to much higher levels which will have a profound impact on our economic and social structures. The Fed and other Central Banks’ challenge is to try to maintain low interest rates and contain the $100 trillion residing in the bloated financial instrument investment “silos” to prevent an economic dislocation while inflation in commodities and consumer staples accelerate. Intervention in the markets to try to contain pools of capital to financial instruments is an interesting academic discussion however it will invariably fail. There are too many observant investors and, given the rapid transmission of information and capital, market turmoil is likely.

With regard to maintaining the façade of low inflation, Central Bankers know that the economy has enormous momentum and that the economy can take years to respond to monetary policy adjustment. After a decade of egregious Fed inflation of the money stock and the onset of an inflationary wave, this makes somewhat absurd the theater of CNBC commentators every 6 weeks waiting with baited breath for minor word changes in the Federal Reserve’s interest setting FOMC statement. The real conundrum to uninformed observers is if inflation is as low as the Fed claims, why continue to increase interest rates? In reality, a true consumer price inflation rate north of 7% and galloping commodity price inflation will take little heed of a 4% Fed Rate and additional ¼ point hikes. Raising rates high enough to pop the housing bubble will start a strong economic decline and a rapid transference of investments into safe haven classes. Bonds do not fit this description. In this way the “inflation targeting” policy as promoted by Bernanke is farce. The current onset of a strong price inflation wave after more than a decade of especially strong monetary inflation which has also induced distortions in, and malstructuring of, the economy will not and cannot be stopped by twiddling interest rates as the Fed has been doing.

The economy was made vulnerable in 1973 by the previous decade of Fed inflation of the moneys stock – CPI inflation was then running at 8% and commodity prices raging – before the OPEC Oil embargo struck the economy with crippling energy cost rises that further spiraled inflation into the teens. One differentiation from the 1970s is that, after Greenspan’s tenure, the economy has been left grossly mal-structured with numerous investment bubbles and unproductive enterprise from the prolonged credit cycle expansion, and we have far higher debt relative levels than in the 1970s.

While much has been written about the serial bubbles that were spawned starting in 1995 by the Fed’s and Treasury Secretary Rubin’s “strong dollar policy” dilution of the money stock, the Fed’s January 2001 initiation of ultra-cheap money with what was to drop U.S. interest rates from 6.5% down to the ultimate Fed Funds “emergency rate” of 1% in 2003 and 2004 compounded speculation in a housing bubble that was already visible. It also inflated bubbles in the bond market, financial derivatives markets and reinflated the stock market bubble. Canada and other nations’ Central Banks followed suit. Greenspan has followed a repeated pattern of embarking on destabilizing policies, issuing muted warnings, then continuing these destabilizing policies.

In 2004, total U.S. debt increased $2.8 trillion or at a rate of 24% of the nation’s annual GDP. However, the GDP grew only 7% or $763 billion to $11.7 trillion in nominal terms. With a true inflation rate in the range of 6% for 2004, we now see that increasing the debt level by 24% produced only 1% of net growth – and Greenspan himself notes that $700 billion of economic activity in 2004 originated from capital gains on home sales and real estate equity extraction. In other words, the economy has become so malstructured that without unsustainable housing bubble activity, the economy contracted by $600 billion in 2004. Subtract the temporary speculative activity by financial services companies boosting apparent economic activity, and GDP declines even further. With rising interest rates, the increase in debt required to continue the economy can no longer be maintained.

In an environment of declining real economic net growth coupled with increasing inflation forcing interest rates higher in the economy, we see a economic landscape of investment bubbles and an economy laden with record debt and so malstructured that it barely responds to stimuli relied-upon by the Fed in years past. “Stagflation” is little more than a distorted and under-performing economy containing unproductive enterprise as a consequence of excessive debt, along with rising prices and rising interest rates following bouts of mismanagement of the economy’s money stock.

As background noise to the current situation, Alan Greenspan, former and current Fed Governors, and Robert Rubin – architects of the mid-1990s U.S. monetary juggernaut – now give frequent warnings about budget deficits and “fiscal imbalances” being an economic threat. Greenspan makes statements that “stability in the past fanned excess” [i.e., as if the current rampant speculation was caused by stability – not the Fed policy of repeated monetary liquidity injections and market intervention when crises occurred from the October 1987 stock market crash and on] and they all warn that the large current account deficit places the economy at risk. High budget (fiscal) deficits do result in unmanageable government debt and ultimately cause higher interest rates. And the large current account deficit combined with a low savings rate which they and successor Treasury Secretaries Summers, O’Neill, and now Secretary Snow promoted with their strong dollar/low interest rate monetary policies do place the world’s leading economy in a position of dependence upon foreign finance.

Warning us now about fiscal matters and the large current account deficit borders on disingenuous. The elephant in the middle of the room that gets no mention is the destabilized economy that has been so addled and distorted by debt and excess monetary liquidity that the continued over-consumption, over-indebtedness, excess speculation, goods inflation, and creation of the economic bubbles on which the economy relies can no longer be sustained – nor is it advisable to do so.

Attempted steering of an economy through Central Bank modulation of the money stock and interest rates has long been warned to be a hapless and eventually tragic pursuit by Austrian School economists such as its most famous adherent Ludwig von Mises. Throughout history, Austrian School economists have been repeatedly shown to be correct in their warnings of the repercussions of Central Bank intervention into the money supply and interest rates. By allowing the market to set interest rates, as advocated by the Austrian School and as occurs under the gold standard monetary system, the interest rate is constantly adjusted by the trillions of consumer and industry decisions made each day thereby tailoring the cost of money according to the economy’s evolving needs. As a consequence, the cost of money and economic growth maintain a steadier equilibrium – both continually adapting to the influences of the other.

Instead, by intervening into the process of determining the cost of money and thus the debt level in the economy, and using other additional tools such as “unconventional measures” alluded-to by Bernanke, Central Banks artificially prolong credit cycles and lower interest rates setting into-play distortions and reverberations throughout the economy resulting in the surpluses, shortages, economic excesses, and volatility associated with all central planning systems. In extending the current credit cycle – better named a debt cycle – as Greenspan and other Central Banks have repeatedly effected throughout history, Fed policy has induced malstructuring of the economy which is littered with unproductive enterprises which are reliant upon the availability of capital at low interest rates that will now again shake-out as capital becomes less affordable in the increasingly inflationary environment, whether or not the Fed would like this to happen.

Two major arguments dictate that the era of monetary and economic intervention effected by central banks must now come to an end: 1.) For the reasons outlined by the Austrian School and proved repeatedly through experience, Central Banks are not able to effectively emulate the constant adjustments of market forces in determining the supply and cost of money. Such Central Bank monetary intervention invariably fails with disruptive corrections when distortions have increased to the point of stepwise correction as well as leading to unsustainable asset bubbles, unproductive enterprise and speculation, wasteful natural resource consumption, and mal-structuring of our communities and society. 2.) Concentrating the power of controlling the economy in the hands of a few (or one) central banker and those who can influence them represents a national security threat to the economy. Countries that spend $trillions in the pursuit of national defense and anti-terrorism war campaigns should consider that at the core of the nation with a Central Banking system are a handful of individuals whose decisions can completely destabilize the economy.

“The onset of a corrective economic adjustment down to sustainable levels is underway and we advise individuals to moderate their consumption and speculation and ensure adequate safe haven positions in their investments.” After the dot.com stock bubble popped in March 2000, we did not – and we still do not – hear these words from those with a fiduciary duty to warn us. Instead, in a paradoxical turn, Central Banks, Governments, mainstream financial services companies, politicians of all stripes and the media promote and cheerlead the unsustainable thus further compounding speculative excesses and increasing the damage from the ultimate and inevitable correction.

Because the $100 trillion invested worldwide in financial instruments represent a bet on a distorted and declining foundational economic structure, a correction in the inflated value of these instruments and the low interest rate dependent housing bubble will inevitably occur to bring their value into balance with the productive demand and capacity of our weakened economic structures. When the excessive debt, unproductive activity, and economic distortion are removed from the economy by a decline in availability of artificially cheap capital (debt), the economy will be restructured for future productive growth. The real economy is in decline and the ultimate correction will be magnified by delaying ameliorative action.

The World’s economy is at risk of an economic upset dictating that it is time to put political opportunism aside. Our governments, either in unison or independently, must intervene to restructure our monetary systems now. Such a suggestion may seem radical especially to those who are benefiting from the current speculative and volatile financial markets in which vast fortunes are being made and financial services industry profits attain record levels. However, the consequences of not taking action at this time when the markets are relatively placid and attempting instead to impose such a restructuring in times of crisis risks social and economic upheaval that is unacceptable. One government has to have the courage to move first. It is time.