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Mary Anne & Pamela Aden

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Inflation-Deflation Tug

The inflation-deflation debate has been raging lately, yet no one really knows how it's going to unfold. The reason for this is because we're seeing signs of both inflation and deflation in the world, and in the markets today.

Why is this so important? It's important for a number of reasons like your lifestyle, job, savings, retirement, world politics, crime, social unrest and especially investments.

That's why we feel it's important to keep the big picture in mind at all times. So if we stand back and look at the biggest forces that are shaping, and will continue to shape our world, along with the effects these forces will have, we'd have to say it's China, terrorism and changing weather patterns. Let's start with China...

China Power

After years of slumber, the world's oldest civilization is now on its way to superpower status. In less than 20 years, China has transformed itself from a basically agricultural economy to the second largest economy in the world and the fastest growing one. It's become manufacturer to the world and by exporting these goods, China is building up huge surpluses which it's using to invest in countries worldwide. China is our second biggest lender and thanks in large part to China, the U.S. has been living beyond its means and going deeper into debt. In essence, this has amounted to a massive transfer of wealth.

Meanwhile, China's economy is growing at an annual pace of about 9% and this has been going on for many years. In contrast, the U.S. economy slowed to 3.1%, hindered by its record trade deficit, primarily with China. And there's no sign this will end soon.

With a population four times larger than the U.S., China needs to create more jobs and it'll likely keep doing this because textile restrictions were lifted last month. Since Chinese wages are so low compared to other countries, it's estimated that about 30 million jobs will be transferred to China from other countries and this mega trend is going to continue.

How will this affect us? Aside from job losses and ongoing deficits, there's much more involved. A major world economic shift is taking place and if we go back in history as Marc Faber does so well by saying that China compared to the U.S. is very similar to the position of the U.S. compared to Great Britain at the end of the 19th century.

At that time, the entry of the U.S. into the global economy badly disrupted the economies of Western Europe as the U.S. was rising and Britain was slowly loosing its superpower status. The same thing is happening today. The entrance of China into the global economy will have a negative impact on the standard of living in the West, as we're seeing with employment, as China's standard of living continues to improve.

In addition, China needs everything to continue building its infrastructure. This has been one of the big factors keeping upward pressure on the oil price, commodities and metals. And it looks like this demand will keep pushing prices higher.

Commodities Mega Trend: Has turned up

Looking at the truly big 200 year picture of commodity prices from 1804 to 2004, you can see that all commodities generally move together (see Chart 1). There have been five major upmoves since 1804 and we're just beginning the sixth. This strongly suggests commodity prices will be rising for years to come, which would coincide with China's growth and ongoing demand.

But it's not only China. There are now three billion people in the world economy who weren't there before when we consider the emergence of India and the former communist countries, in addition to China. As these people become more affluent they'll be buying more oil for their cars, metals for their industries and infrastructure, and food, which will keep upward pressure on commodity prices. So looking out to the years ahead, this is going to be inflationary.

Also interesting, these big commodity price rises have always coincided with major wars throughout history. And the current rise will probably coincide with the war on terror. In other words, wars and/or geopolitical tensions will likely increase in the years ahead.

Delicate World of Oil

This shouldn't really come as a surprise. Despite the successful election in Iraq, Bin Laden has stated many times he's out to destroy the U.S. economically. He wants the U.S. and royal family out of Saudi Arabia and he's been telling his followers, which are growing in numbers, to attack oil fields and halt supplies, which are essential to Western economies.

U.S oil imports are at record levels and the U.S. uses more oil than Germany, Russia, China, Japan and India combined. Saudi Arabia is one of our biggest oil suppliers and this alone makes the entire oil picture vulnerable. Even though it's hard to imagine because we tend to take oil for granted, it's a threat that could not only cripple our economy but intensify the war on terror if anything were to happen to disrupt our oil supplies. It would also drive the oil price up to unprecedented levels, which would tie in with this new mega rise in commodity prices. For now, we don't know what's going to happen, but somehow rising oil seems like it'll be part of the equation.

Changing Weather

At the same time, modern society and our dependence on oil has led to the worst weather disruptions in 1,000 years. This is resulting in more disasters like floods, hurricanes and droughts. Here again, as this continues in the years ahead, crops will be damaged and in more demand, which will also drive commodity prices higher.

That's the way we currently see it. This could change but until we see evidence to the contrary, we feel there's a greater likelihood inflation is in our future rather than deflation and that should prove to be good for the metals and commodities prices.

Interestingly, this commodity mega trend is coinciding with the new investment era that began in the late 1990s with a shift out of financial assets like stocks, into tangible assets like gold (see Chart 2).

Stocks Too High Versus Gold

This chart compares the Dow Industrials to gold. You can see that since 1919 there have been two major cycles and we're currently into the third. When this ratio rises, the percentage gains are better in stocks compared to gold and when it declines, gold is the winning investment.

Note, for instance, stocks were better in the 1920s, 1950s-1960s and 1980s-1990s. Gold was better in the early 1930s, 1970s and now. This mega trend is telling us gold is where our investment focus should be, not stocks at this time.

Also interesting, the lows in the ratio have occurred below 2. This also indicates stocks are still expensive and gold is cheap with the ratio now near 25. This means that somewhere ahead, and it'll likely take years, this ratio will probably again get to near 2, which will happen as gold rises and stocks fall. But either way, the ratio suggests the rises and declines are going to be dramatic.

Coming back to what's happening now, gold's intermediate decline that started in December is coming to an end. And if gold can now stay above $421, a renewed rise will be underway. This is now providing a good opportunity to buy new positions looking out to the months ahead and to the long-term.

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