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The Outlook is "Just Sandy" -- Shifting Supply-side Dunes

"Only three things are needed to generate active sand dunes: a source of sand, winds strong enough to move that material, and a lack of stabilizing vegetation." Sid Perkins, Science News

Depending on whether the US housing slump devolves into a deeper, longer-running downturn, we could very well be witnessing the trigger to some significant global structural adjustments. All the ingredients exist for some significant shifts -- lots of sand, some coming heady winds, and lack of stability. But, as always, shifting dunes are caused by blowing sand. That pretty much sums up our forecast -- a lot of blowing sand, meaning a swirl of competing cross-interests. Out of this "poor visibility" a major new investment environment will likely unfold.

You may remember the last time that phrase "poor visibility" was popular. As then, we can expect that corporate executives will again resurrect this term over the foreseeable future as a way of explaining a disagreeable profit outlook. But, at present, that is not what we mean by poor visibility. Rather, we expect quite a few competing crosswinds ahead, as US reflation interests clash with Japan, China and European agendas.

Despite these expected blowing and confusing sand storms, a few developments can be seen quite clearly -- at least two strong certainties and a number of high probabilities:

  1. Without any monetary or fiscal reflation responses, we consider the probability of a US economic recession within the next 2 to 6 quarters (if not begun already) at near 100%.

  2. Another prediction that we feel sure about, is that there is a 100% probability that there will be official responses to this threat in the US. Regulators and policymakers will not stand idle in face of an economic downturn. But, this is where things start looking sandy. In a world of global money, other countries around the world -- namely Japan, China, and in Europe -- will have competing interests ... as does the large speculative investment community.

  3. As things stands now, we think there is at least a 50% to 75% probability that a North American housing downturn will devolve into a grinding bottom of 2 years or more. It's true that the onset of a real estate slump has been quite rapid to date. That all the more argues for heavy responses soon.

  4. Given the above, we believe that there is a high likelihood that a "Stagflationary Supply-side Boomlet" will emerge over the next several years. We think it will be a tradable investment theme, yet awaiting a favorable entry point, which has yet to arrive.

    How profitable this idea will be depends upon the state of he global economy, but more on this later. The greatest significance of this new shift -- one of those shifting sand dunes referred to earlier -- is that inflationary pressures will move back into wages (and, the Consumer Price Index by inference) as opposed to asset prices and massive external deficits.

  5. Furthermore, it seems it will be North America's turn to struggle through its version of a large structural adjustment as occurred in the "Asian crisis" of the 1990s. The parallels are surprisingly apt although quite inverse in several respects.

    A main difference is that the US central bank may necessarily prove to be much more interventionist than were many Asian countries a decade ago. It is one thing to suffer through the "fall-out" and complications of an "over-investment" boom as did many Asian countries; quite another to go through the "flare-out" of an over-indebted "overconsumption" boom.

All the above signify that some major adjustments are likely to befall North America in the next several years, signifying monumental changes for investors and households. As the 1960s were as different to the 1970s, in the same way a new secular era with a new set of distinctive features is being born. Some indicative developments have already begun.

Significant Event Watch

Earlier in the year, we mentioned that we had called the advent of a Significant Event -- the top of the housing bubble -- and that this development would be one of the key factors impacting our investment policies. Now, only months later, this view is widely gaining credence as housing statistics have definitely and obviously turned down. We continue to believe that it is one of the major framers of the investment outlook over the next several years.

There are two important questions that fall out of this perspective: Is the downturn seen to date, just the beginning of a longer-run asset deflation or just part of a "soft landing" adjustment that will slowly equilibrate with rising income levels over the next half-decade or so?

The answer leads to a very important second question ... one that very likely will trigger another Significant Event that we have been evaluating for some time. At what point will the housing downturn factor sharply in the decisions of the US Federal Reserve Board? To date, the consensus view is quite sanguine on this consideration. Some see continuing high inflation pressures requiring further rate hikes. Others, anticipate that moderating inflation trends will allow the Fed to stand pat, then gently beginning to lower interest rates over the next 6 to 12 months thus again bolstering real estate activity.

As low real interest rates and a wave of ample and innovative credit have pushed real estate prices up, in this view it is crucial to re-stimulate the mortgage engine to generate more housing demand and wealthdriven consumer spending.

Let's address the first question: Are we witnessing the first innings of a classical housing bust or not? We believe the answer is "yes." However, that said, this downturn will not go uncontested. Yet, all the same the excesses are simply monumental. It will not be easy to re-ignite the housing mania.

Consider some of these statistics:

  • 32.6% of new mortgages and home-equity loans in 2005 were interest only, up from 0.6% in 2000.

  • 43% of first-time home buyers in 2005 put no money down.

  • 15.2% of 2005 buyers owe at least 10% more than their home is worth.

  • 10% of all home owners with mortgages have no equity in their homes.

  • $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007. (The above statistics drawn from Barons article by Lon Witter, assuredly the most quoted over the past 10 days.)

  • Housing related industries -- for example, builders, mortgage lenders and real estate agencies -- have generated 44% of the jobs created since 2000 and today employs 1 in 10 workers. (Source: Moody's Economic.com) Already, these industries have stopped adding to payrolls. Actually, in some regions builders are already reporting lay-offs.

Already this early in the housing downturn, various mortgage lenders are sounding the alarms. Assuredly, these problems have been building for some time. For example consider the trend reported by Washington Mutual (WaMu) in its annual report. At the end of 2003, 1% of WaMu's option ARMS were in negative amortization (payments were not covering interest charges, so the shortfall was added to the principal). At the end of 2004, the percentage jumped to 21%. At the end of 2005, the percentage jumped again to 47%. By value of the loans, the percentage was 55%.

We could cite several pages of pertinent statistics and classical theory that argues that a debt-induced bubble (in this case, real estate related) is invariably followed by a maniacal down-phase. The swings of human mass psychology alone requires it, but also the laws of mathematics and momentum. The mortgage bubble today is simply an up-sized version of the junk bond bubble of the 1980s. Then, a rising default rate on earlier loans was hidden by the boom of fresh new junk issues. Finally, when the new issuance collapsed (and also, due to a tougher economic climate), default rates soared.

In retrospect, people wondered how such poor paper, much of it based on unsustainable business plans, could have been considered such a trendy and brilliant investment. The same thing applies to many of today's new mortgages. They simply are not based on sustainable finance ... rather suspension of logic and the "greater fool theory."

Yet, human behavior, being what it is, will want to defer reality and continue to pander after the "easy times" of seemingly limitless home equity withdrawals and easy credit. We see it even now. Even though real estate markets have markedly softened this year, home equity withdrawals have not yet abated ... if anything they have accelerated. According to various estimates, home equity withdrawals throughout the first two quarters of 2006 have heightened to between $700 and $800 billion (per annum), equivalent to an astonishing 9% of Disposable Personal Income!

However, in the last week of August, for the first time in a long time, mortgage applications actually declined. This may signal an important fulcrum point, also leading to declining equity withdrawals and a sharp continuation in declining consumer sentiment.

As these factors now come to the fore, as mentioned, they will not be uncontested. Crucially, these realities are bound to impact the policies of the Federal Reserve Board. They cannot stand aside and ignore a high probability of an uncontrolled housing slump. Therefore, we expect it may not require many more months of a housing downturn for the Federal Reserve to begin slashing interest rates. That will lead to a slumping US dollar ... and another serious pincher movement for the "carry trade." None of these expectations seem to be factored into current market sentiment.

Whatever the case, we can be sure that the Fed will take precautionary action. And, not to forget, the Fed remains the friend of Wall Street. While it may not lament a modest slowdown in the housing markets, it cannot tolerate a full bust that cascades into the equity and bond markets. It will do everything it can to fight this outcome ... even sacrificing the dollar and its inflation targets.

For now, optimism reigns that inflation may be coming under pressure as commodity prices seem to have peaked and the expected impact of higher interest rates and a slowing economy will do their deflationary work. The only problem with this view is that it does not recognize the other manifestations of inflation ... a looming, jagged trade deficit and generally over-valued asset values. That is certainly the case with respect to real estate, but is also true for equities and bonds, though overvaluations are somewhat milder in these cases.

Near-term Market Reactions

For now, financial markets remain sanguine despite the various warnings shots over the bow so far this year -- both the tremors in the "carry trade" and the precipitous decline in housing sentiment. Market participants have a deeply ingrained but false sense of confidence in the powers of the nation's central bank. However, the type of credit-driven downturn that is beginning to occur in the real estate sector is not of a type that can be easily averted by slashing interest rates. Why? Because collateral values are falling faster and many financial institutions will therefore be tightening their loose and ill-advised lending policies even more quickly.

This is exactly what happened in Japan in the early 1990s. This will be even more the case in this current environment as it cannot really be said that high interest rates are the cause of any downturn in the first case. Longer-term interest rates, though they may have risen some more than100 to 170 basis points year-over-year at various points since 2004, cannot be called "high." In fact, real interest rates, relative to true inflation levels, remain remarkably low.

Shades of this phenomenon seem to be already revealed in this recent comment from Toll Brothers: "It appears that the current housing slowdown which we first saw in September '05 is somewhat unique. It is the first downturn in 40 years in the 40 years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macro economic factors. Instead, it seems to be the result of an oversupply of inventory and a decline in confidence." (Toll Brothers, August 2006 Conference Call)

Equity markets in North America have closed at 3½ month highs just before the Labor Day. Could it be that a celebration phase may just be ending ... the end of the hopeful reaction to the Bernanke's Fed "pause" in early August and a decisive break in oil prices? After 17 consecutive rate hikes, the Federal Reserve board for the first time had elected to stand pat. The bond market since that time has soared, optimism carrying through to the stock markets, which of course. are also dependent on the valuation effects of lower interest rates. That's all clear, but from this point, things get a little more gritty.

Markets have responded to the positive interpretations of these welcome advents -- lower inflation, lower interest rates, and therefore, more favorable prospects for stock markets and the long-term outlook for the economy. Overlooked to this point, have been the more sobering possibilities of a slowing economy, abrupt dislocations in international capital flows, the negative implications for corporate profits trends and emergent stagflationary conditions. We expect that these sand storms will blow in shortly, as the US economy shows more evidence of a marked slowdown in the months ahead.

Therefore, the major "sandy" questions that chafe investors at present concerns the timing and nature of the monetary and government responses to an economic downtrend and the dangers of a careening housing bust.

Most important for the near-term outlook are the questions of how effective these policy actions will be in delaying the unwinding of currently-existing bubbles. For example, what would be required for the current downturn -- increasingly looking like a proverbial crash -- in housing markets to be arrested. What is required for borrowers to again have the confidence to undertake large mortgages at continuing lofty real estate price levels?

Could the world continue to accommodate the large foreign financing needs of the US economy for much longer, and if so, how much longer? When will China blink with its huge, burgeoning US dollar reserves? When will Japanese savers pale in face of the world's most massive bond bubble ... the home of the antiemission Kyoto Accord, but yet the world's greatest monetary polluter?

The Many Shifting Dunes

With respect to international capital flows and the US dollar, the Dragon is now being joined by the Leviathan. It is well known that the international distribution of savings and net capital and trade flows are as imbalanced as ever. Notably, the US, Britain, Australia and others -- amongst the most developed nations in the world, no less -- are relying on savings from the rest-of-the world to fund their excess consumption.

In recent years, the incremental supplier of this debt was Asia, notably Japan and China. Recently, China broached the $1 trillion level in foreign exchange reserves (70% of which is estimated to be invested in the US-dollar securities) cumulating from its huge trade surpluses in general, and with the US in particular.

China may this year even export more goods and services to the Eurozone than America. But it is America that has the negative personal savings rate and a large trade deficit. Europe or the Eurozone, does not. Yet, China will be exporting more to the Eurozone this year than to America in 2006, according to the latest estimates.

But now a second group of players has come to the fore ... the oil exporting nations. Oil exporters this year will likely generate upwards of $450 billion in surplus export earnings, tripling since 2000 (then approximately $150 billion). Therefore, two major groups now hold sway over the supply of international savings to the deficit countries -- China/Japan and the oil exporters (more narrowly, we can use the 6-nation Gulf Cooperation Council as an indicator).

Benevolent Inflationary Times

Let's deal first with the biggest sand pile of all - the institution of central banking -- what Kenneth Rogoff so eloquently explained as the "The Myth of Central Banks and Inflation." (Financial Times, August 29, 2006). In recent decades, central bankers in the developed industrial countries have had the benefit of warm monsoon winds to their backs. It was an easy time managing inflation (at least, the kind that manifests itself up in the Consumer Price Index - the CPI -- the bouncing ball to which most people affix theirs eyes as the official inflation bogey).

The reasonably low CPI levels of the last half-decade or (at least as compared to the averages of the last 3 decades of the last millennium) cannot be attributed to any successful policies of central banks. Far from it. It was simply the best of times for central banks who chose to guide their policies by inflation targeting (rather than monitoring monetary aggregates, credit volumes, external economic imbalances, asset market prices ... etc.) As fate would have it, a number of moist "winds" were at their backs.

For one, a world-wide reallocation of labor-intensive manufacturing occurred, thanks to the emergence of Newly Industrializing Countries (NICS) of the world -- first Japan in the late 1950s, then South Korea, and then most significantly, latterly over the past 25 years, the populous behemoths of China and India. These dynamics, particularly over the past decade, have played a crucial influence in suppressing consumer goods inflation in the "import deficit" countries as well as optically boosting their productivity results. It made for a wonderfully virtuous cycle -- producing an inflationary debt boom that seemed to have no consequences other than enriched asset values, soaring housing prices and seemingly solid economic growth. "Oh debt, where is your sting?" would be an apt revisionist quote for the times.

What is the point of this discussion? Back to history. Behind most successful ventures and prosperous eras (and inversely, also failed ones) is history ... in other words, having lived at either the right or lessopportune time. Big secular shifts were working in the background domestically and globally -- i.e. post-war population booms, globalization (namely the ascendancy of the multi-national corporation and cross-border capital mobility), a widening wealth skew (the flip-side being rising "median" household indebtedness), the increasing role of funded pensions to mention just a few.

The most nefarious result of all these secular shifts is the change in popular wealth theory that has served to give the current state of affairs an air of permanency and academical theoretical pedigree. Now, in this new Age of Global Capital, wealth is seen as being the market value of financial paper and "balance sheet" assets. Quoting an article that famously laid bare this shift to disregard income and profit as the real underpinnings to wealth:

"Securitization -- the issuance of high-quality bonds and stocks--has become the most powerful engine of wealth creation in today s world economy. [...] Overall, securitization is fundamentally altering the international economic system. Historically, manufacturing, exporting, and direct investment produced prosperity through income creation. Wealth was created when a portion of income was diverted from consumption into investment in buildings, machinery, and technological change. Societies accumulated wealth slowly over generations. Now many societies, and in- deed the entire world, have learned how to create wealth directly. The new approach requires that a state find ways to increase the market value of its stock of productive assets." (John C. Edmunds, Securities--The New Wealth Machine, Foreign Policy, Fall 1996, p. 118.)

Paper wealth and anything that can inflate its mirage, not underlying income power, is the emphasis of the times. Unfortunately, an aging population -- a booming retirement class that is just beginning to unfold as the leading wedge of the "Baby Boom" starts pondering its retirement lifestyles -- cannot live on paper, only the underlying income that it represents.

The lesson therefore is that a new secular era is at the door where it will be the wrong era for fate to call a central banker -- especially so in the US -- to use as his guiding monetary light the measure of price inflation. Indeed, current monetary policies and the unstable financial edifice it has bred, is built on a foundation of sand -- soaring indebtedness and asset values relative to underlying income power.

An Stagflationary Sand Storm Coming

Our prediction therefore is this: Price inflation will remain stubbornly high in the next half-decade or so. Why? A stagflationary "supply-side" boomlet will set in where America's trade deficit will sharply narrow. At first, this will be attributable more to declining import growth, but in time (as is already occurring) exports will rise faster than domestic final sales. The result?

Many of those dead bodies of workers hidden in the rising trade deficit (i.e. to which outsourcing has surely played a part) will come back to life. Like the old Southern gospel song implores, parts of the manufacturing oriented and basic industrial sectors will be resurrected: "... dem dry bones [...] your toe bone connected to your foot bone, Your foot bone connected to your ankle bone ... etc."

The simple mathematics of this shift to lower trade deficits (as a % of GDP, which we will not detail here) will cause apparent productivity growth to slump. Also, not to forget, will be the impact of imported inflation, thanks to a lower US dollar as well as relatively high commodities prices, though likely not as high as experienced over the past year.

What will be the trigger? Actually, it is already beginning to unfold. However, the Significant Event that will trip the switch to this outcome in earnest is the capitulation of US monetary policy. We may be only a few weeks or months away from this advent.

As mentioned, we think therefore that the most likely scenario to emerge is what we call the "Stagflationary Supply-side Boomlet" (SSB) Most likely, it will be a smaller version of the one that developed in the post- Plaza Accord period of the second-half of the 1980s. The main features include "sticky inflation", rising exports from the tradable goods sectors, and rising wages vis-à-vis corporate earning share of GDP.

At least for a time, the long-running hollowing out of North America's manufacturing and basic industries will be abated if not reversed. The trigger? A slumping US dollar as result of the Fed's urgent responses to a slowing economy and a slumping housing market. It is the next Significant Event that awaits.

The "Stagflationary Supply-Side Boomlet" Explained

Fact: Only a surge in exports can save the US from a recession in the next few years. It is hopeful that this can happen, but it will be a challenge. Why? Only about 25% of what is produced currently by the US economy can be sold across borders.

It's worth thinking about that statistic. It also has implications for the exporting nations of the world, particularly Asian surplus nations and specifically the Chinese growth-miracle economy. There comes a point where Asian market shares become so large in the tradable good sectors, that incremental exportdriven growth becomes ever more difficult and marginal. With respect to consumer goods in North America, it is already hard to imagine any product sector that has not already fallen victim to foreign imports. What's left to take over? Perhaps China will yet become a major player in the North American car market. Already, we are seeing the capital goods sector facing competition from Asian producers.

Andrew Tilton of Goldman Sachs has calculated that to boost exports and narrow its external deficit to 2.5% of GDP by 2010, America would need to increase its manufacturing capacity by 17%. That is a massive shift. Provided that the rest-of-world economic growth does not fall flat, this will be positive for any supplyside sector in North America. While it is likely that all market sectors will suffer losses in the initial adjustment period, this sector will be the first to emerge as well as being the strongest investment performer.

We therefore call it the "Stagflationary Supply Side Boomlet" and not a boom. Why? At least at the outset, it will take place during a time that the backdrop is generally deflationary in asset markets, inflationary in production and consumption structures, and one in which the world economy is slowing, not accelerating.

Here are the main features of the next investment theme that could dominate over the half decade or more ... one that has already begun.

  • Falling US dollar to major new lows ... in the regular zigzag pattern, at the very least.

  • A slowing world economy led by the US, also with a major slowdown in China. A adjustment period -- perhaps even a crash -- is long overdue for China. However, this does not necessarily imply that China's long-term potential may be diminished.

  • Inflationary pressures remain high - in the 3 to 4% range (import inflation will spurt upwards, for example) even as the economy experiences real negative growth for several quarters (over the next 18-24 months.) There are other factors at work that will push up the inflation statistics.

  • US long-term interest rates will also stay sticky. In fact, there is a not-insignificant chance that interest rates could actually trend much higher should there be a US-dollar "funding crisis." As we have explained, there exists a massive "carry trade" which is long US fixed-income securities that is very sensitive to a rising yen (i.e. a falling US dollar). Also, the US is vulnerable to a slowing in foreign capital flows or even a reversal given its immense dependence upon foreign excess savings (heading to 8% of GDP). If so, it will be crucial to lock-in income investments at that time of the "funding crisis" ... if and when it arrives.

  • P/E multiples in general can be expected to decline to a more sustainable 12 to 15X range given long-term rates and inflation conditions. Observing the rather larger expansion of the financial service sector as well as the resources and energy industries in equity market capitalizations (where price-earnings multiples are already below average) the bulk of this downward adjustment will fall heavily on other market sectors.

  • The US trade deficit is anticipated to narrow, as exports in the industrial, manufacturing and capital goods sectors continue to rise and consumer imports fall dramatically. Actually, US exports are already growing sharply ... up 10.3% year-over-year in May. This is an early indicator of the next investing theme. And, once this environment is underway, we think that the US equity market will outperform most other developed equity markets. However, that does not mean that we can expect high absolute returns -- just relatively better or less bad ones.

  • All the above favors sectors such as metal bending, fabricating, general manufacturing, capital goods, chemical, foodstuffs, coal ... etc., in short, the old industrial America. Financials will be in a significant downtrend as the asset side of the balance sheets stands to become significantly impaired.

  • In emerging markets, opportunities can be expected to appear first in non-manufacturing intensive countries. First, we would look for a buying opportunity on India (still much too early for now.)

For all the above to begin gaining momentum, we first must experience the next Significant Event ... a capitulation of US monetary policy. To repeat the question: When will the US Fed blink on its "hawkish" inflation stance in view of a declining real estate bubble?

Knock-On Effects

We have a great respect for Stratfor's geopolitical commentary and analysis. But, its views on economies and markets often verges on the incredibly naïve. Contemplating the prevailing view that the US economy is vulnerable to a slowdown, they recently posited this piece of bravado "Error ... the US economy is huge, diverse and relatively even-keeled." (Stratfor, July 28, 2006)

Only one of the three observations is exactly correct ... that the US economy is "huge." Its economy has been hugely and grotesquely commandeered by the cancer of bubble wealth, bloating the financial services sector as well as household consumption relative to savings levels. In this sense, the US economy as some others are not "diverse" and hardly "even-keeled." When this distorted structure reverses, it is sure to have knock-on effects around the globe.

The US Fed will invariably see the necessity of rescuing its economy and friends on Wall Street. However, it is now a global world in which even large countries such as America have long ago lost sovereign control of monetary policy ... most certainly, monetary conditions. As it was, the US could not have enjoyed the upside effects of a massive credit inflation at such low interest rate levels were it not for the monetary effluent from across the Pacific. Japan has been the lowest-cost supplier of liquidity to the world borrowing and speculative community for years. That means that the Fed's desire for a lower dollar, will have its rivals. Japan does not want a strong yen. This would undercut its trade competitiveness. We can therefore expect that Japan will again intervene heavily in exchange markets, selling yen.

However, there is another group that would not welcome a rising yen -- the world's carry traders and leveraged speculators. Early this year, we already witnessed how a rising yen (slumping US dollar, actually) quickly turned into a liquidity crisis for the "carry trade" players. Over-extended investors in bubbly over-valued investments -- emerging market debt, commodities, and other leveraged positions spanning the board -- needed to quickly off-load investments. As such, markets around the world witnessed sharp declines from mid-April until early June. What turned it around? A US dollar rally, partly ignited by strong "anti-inflation talk" by almost every member on the US Federal Reserve Board. Of course, now such talk wouldn't be as convenient as US economic growth is slowing and real estate markets are indeed more than just slumping.

Also, not to be forgotten is the other big player that has monetarily compromised with the US Fed, that being China. This country has openly pursued the façade that supplying unlimited credit to the US (trading exports for US-dollar IOUs) was a sustainable policy. We have always wondered why, thinking there must be another agenda of this "value free" elephant on the world geo-political scene.

After several decades of break-neck economic growth in the 8%-plus range per annum, this country is brooking more than a few stresses. Its growth is heavily dependent upon exports worldwide and domestic investment spending growth. Yet, China is showing signs of drowning under excess supply. Manufacturing capacity has boomed, creating huge excesses. Despite high GDP growth, touching 10% per annum in recent quarters, domestic profits are falling. Over the first 6 months of this year, corporate profits of the companies listed on the Shanghai and Shenzhen stock exchanges have already fallen 15%.

What would happen if the US consumer fell into a deep funk? Here the connection to China, where 13% of the economy is dependent upon exports. The downdraft in America could easily bring China to the brink of its first major slowdown in years (if not something worse). We can hardly expect China to allow its currency (the renmimbi) to rise in an environment as this comment contemplates. And, this all may occur because the US housing bubble has finally reached its tipping point. The indefatiguable US consumer -- actually, largely a myth in recent years -- is up against the wall of spent-out earnings, the average household running a savings deficit 14 months running. There are little resources and reserves, if any, to counter an economic downturn.

Final Conclusions: Get Ready for Shifty Sands

The world economy continues to look strong, showing little signs of buckling under higher commodity pressures and higher interest rates. With a few exceptions -- mainly in America -- today's economic statistics look ebullient. As such, the world's commodity and energy price boom is considered unassailable for as long as the eye can see. The reality is, however, that much of the current situation is resting on unstable sand piles. We can't predict exactly just which new wind will trigger the acceleration of the shift foreseen ... including the high likelihood of a transitional financial cave-in. The specific tipping point cannot necessarily be discerned with logic ... just its outcome and probably course. What we do know is that even a small disruption can unleash some mighty sand slides.

Could it be that the crack in the US housing bubble is the final straw that breaks the camel's back? Is it the dynamic that triggers the critical point, that cascades its effects in the rest of the world ... spilling the cart of derivatives and "carry trade" speculators, tremoring Japan's bond bubble, and pricking China's export balloon?

All of these global factors and many more are definitely inter-related. Although, our short-term predictions are surely imprecise, we simply want to make this point: The financial sand pile is unstable and vulnerable to any dislocation, even minor ones. Therefore, the US Fed cannot allow a US housing collapse. Herewith some final conclusions and observations.

How Long Can the US Fed Maintain its Anti- Inflation Rhetoric? Currently, the new US Fed has made a concerted effort to prove its "inflation fighting" credentials. This has resulted in a rising USD over the near term. The latter, we feel, is only a temporary phenomenon ... a question of timing. The anti-inflation posturing is not credible, certainly not once a significant real-estate related downturn is underway. Once this occurs, shortterm interest rates will be reduced drastically. This pivot point we consider a Significant Event. It could occur at any time, depending up how quickly the economy slows and markets sniff out a "bluff." The key will be the extent to which consumer spending stalls in tandem with a declining housing markets (and the related equity cash-outs).

Housing Bubble Has Started its Decline. We anticipate that there will be a strong response from the Fed as this development gains momentum ... at some point likely no later than early 2007, and very possibly much sooner. Undoubtedly, the North American housing bubble has begun to deflate. This sets a key backdrop to the economic and financial outlook over the next 18 months to several years. As its upswing was the primary underpinning to an economic upturn -- providing the wind beneath the wings -- now it has become a retarding headwind.

A New Equity Rally? Anything is possible, however, facts indicate that this is very unlikely. A new equity bull market has never started when valuations have been as high as we see currently, nor at the peak time of corporate earnings (let alone, a record 40-year high as a % of GDP) nor likely so soon after a supposed peak in equity prices and interest rates has been attained. In any case, have profits topped ... or can they stay at an elevated level for some time yet? Profits margins and business profit share of GDP are at typical cyclical highs and appear to have begun a declining phase. What therefore is a reasonable price for 2007 earnings? We conclude that corporate profits are near their top. Near-term, P/Es are expected to drop as inflation pressures remain significant.

Commodity Harbor Seeds of Own Demise. Investment demand for commodities has exploded. This has a unique impact as most commodities are items that are not produced for stockpiling, but rather for consumption. Therefore, as the "investment role" of commodities has grown, this has an outsized impact on commodities prices, which normally are considered a "flow" item as opposed to a "balance" sheet entry.

There is a certain circularity in this effect. As the investment demand for commodities rise, it in turn boosts share prices of resource companies which rise on the stimulus of higher commodity prices. It suggests that when corrections come, adjustments can be quite abrupt on the downside. This risk is hardly priced into current market levels. Far from it. Many commodity price gains (metals particularly) have gone parabolic and the take-over mania of resource companies again being self-evidently logical -- an industry that has always been highly cyclical.

Japan's Monetary Policy - Still the World's Biggest Bubble. International monetary (credit) liquidity is the guiding factor for any country -- particularly the US. Here, it has been Japan's actions that have been the major determinative force behind global liquidity conditions. (Japan's central bank monetary base is bigger than that of the US!) Here, then, is the salient point: Has Japan stopped its policy of quantitative easing? The answer is not clear despite its stated intentions that this is the case. It is the most crucial question. Why? The entire speculative bubble -- from commodities to hedge funds -- rests on this factor. The US is rightly accused of being a big engine of world inflation and excess credit. However, Japan may have even been a bigger culprit in feeding global financial distortions.

Will Japan indeed follow through on its talk of monetary restraint? It is doubtful. We can look to a least three key indicators that will signal or confirm any shift-- the Yen/USD rate, yen short rates versus G2 5-years yields, and less and the US and Euro yield curve. Yen rate and currency movements may help signal another Significant Event -- a concerted counter-move to US Fed easing. It's this tug of war between the differing agendas that anticipates the visibility problems (blowing sands) over the foreseeable future.

High Energy Prices. Energy prices have risen sharply over the past few years ... with nary a breather. Yes, it is possible that oil prices may indeed head to $100 and more in the future ... eventually. But not without intervening adjustment periods.. In response to energy prices to date, enormous counter forces are currently kicking in. Firstly, energy consumption growth is now actually declining. This trend has only begun. Alternative sources of energy will be pursued. Nuclear power generation will again grow sharply. However, all of these adjustments take time. Yet, eventually these counter actions will cumulate in another cyclical low for hydrocarbon-based energy prices. Should world economic growth slow (as we expect) and the Chinese "export hub" face a slowdown, oil prices can first fall to levels as low as $45 per barrel, before again resuming its secular upward trend.

Massive Speculative Build-ups in Commodities and Derivatives. Without a doubt, the major wildcard remains the derivatives arena and hedge fund activities. It is here that the new "rope lengthening" has occurred. An opaque world, it is difficult to discern where the weak links are. As mentioned, however, we can look to a least three key indicators -- the Yen/USD rate, yen short rates versus G2 5-years yields, and also the US and Euro yield curve. Also possible, is that certain "3 sigma events" could cascade into a major liquidation of higher-risk assets and then spill over into the major asset markets.

Expect shifting dunes ahead, along with the requisite sand storms. Our portfolios are high in cash, and to this point fully-weighted in bonds. Fixed-income securities may have further to rise, but probably not much more in the US, before the next Significant Event -- a capitulating Fed -- ushers in destabilizing winds across the globe.

However, when these sand storms hit, we will be looking for opportunities in the emerging "Stagflationary Supply-Side Boomlet."


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