GLOBAL FINANCIAL LANDSCAPE

May 16, 2008

Groping and hoping the bottom is near, the Federal Reserve and the Treasury Dept continue to suggest growth will resume in the third quarter of 2008. As housing continues to decline and consumer spending droops, it is premature to predict growth will resume. The reality is this, the fall in U.S. housing prices has taken a dramatic turn for the worse and along with it consumer spending. Economist Robert Shiller has warned that the severity of the decline threatens to exceed that of the great depression when prices dropped 30%. Prices have fallen 14.8% since 2006. As you can see from the chart, housing has rolled over and no bottom is yet in site. As housing goes, consumer spending goes. Consumer spending will now depend on their available credit limits.

Around the globe, central bankers face two unforgiving issues. Asset deflation and goods inflation, and both are accelerating. Together these issues present a problem central banking has never faced. Their tool to fix one problem exacerbates the other. Not knowing which issue will be worse or the most predominant central bankers face a huge dilemma as they ponder their next interest rate move. This comes at a time

The two charts above clearly show the dichotomy in the economy and the strength of goods inflation pitted against asset deflation. Since there is no historical precedent for these two issues appearing simultaneously it will be interesting to see how central bankers deal with the problem.

when the banking industry is facing solvency issues within its own ranks. To keep bank capital requirements at a sound level and to encourage inter-bank lending the U.S Federal Reserve has undertaken a bold step in letting the banks swap AAA rated mortgages for U.S. Treasuries through the Term Auction Facility, (never mind these AAA mortgages are sub-prime thanks to the rating industries). As well as giving the top five brokerage houses access to money through the discount window.

Inflation

Inflation by definition is primarily a monetary phenomenon. However, two sources are fueling this round of inflation. The first is the overly accommodative monetary policy of the past two decades and the second is from the basic law of supply and demand in the natural resource sector. The demand for natural resources is exceeding supply, particularly in oil and foods. Low-income economies are rapidly becoming middle class, boosting demand for all commodities and, lucky for us, creating the bull market in commodities we have so far enjoyed. Natural resources globally are in a high rate of depletion. Discoveries when found are proving to be of lower quality and more difficult to extract. On May 8, the IMF issued a strong warning that “inflation concerns have resurfaced after years of quiescence”. This is a marked change from past warnings of the risk to low growth.

We are in an inflationary period with real inflation in the double digits. Before the Term Auction Facility began, the Federal Reserve held nearly $850bn in U. S. Treasuries. Now they have roughly $650bn. According to their announcement last week they will double the size of the auction. This gives you a hint as to where this thing is headed. It also means that in approximately three months the Federal Reserve will be buying Treasuries from the U.S Government. It is called monetizing the debt, which will be even more inflationary. [Shortly thereafter, we could even see hyperinflation, but not to worry. The core rate will be pegged at 3%. The Fed will still be wondering where they went wrong, and Paulson will still be seeing light at the end of the tunnel. ]

The two charts above clearly show the dichotomy in the economy and the strength of goods inflation pitted against asset deflation. Since there is no historical precedent for these two issues appearing simultaneously it will be interesting to see how central bankers deal with the problem. It may very well be that this crisis exposes the weakness in a fiat or paper based money society. It may not be the end of central banking but it will be the end of central banking, as we know it.

                 U.S. Equities as an Asset Class

    The P/E ratio and earnings figures show the DJIA deteriorating fundamentally but not yet in price. The P/E ratio topped 85.97 last week, up from 57 two weeks ago and up from 17 a year ago. Not wise to buy a stock when it takes 85 years for the company to earn enough money to buy back the stock you just purchased. The best range for P/E is between 11 and 18.

Last week earnings were 148 compared with 756 a year ago. Nearly an 80% drop. Unless consumer spending jumps, in the next couple of months, the DJIA is heading south in a big way.

Since the financial sector is usually the first to rebound after a downturn, it is only right that we should begin looking at this sector in preparation for buying. However, since the Federal Reserve, in all its good intentions, is distorting the free market economy by placing artificial floors underneath this sector, we will wait this one out. Our biggest challenge now is learning to how to gauge risk in a bi-polar economy, and learning how to invest in this new financially engineered economy. The only thing we are still confident in is the overall global trends, which still show commodities in a bull market, as well as currencies in commodity-based countries. Commodities may remain in the doldrums for awhile presenting good buying opportunities.

Cheers,

R. Van Hudson

 next up... ALTERNATIVE INVESTMENT STRATEGIES

 

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