June Strategy Meeting

Roman Denarius CoinUSA Economic Update:

In the May Stock Meeting, an examination of Q1 2010 GDP was found to be indicative of a weak recovery. Since then there have been two additional poor to terrible economic reports: Jobs, and Retail Sales. If this is the recovery, it would be the weakest ever after such a sharp contraction. When adjustments are made for broad statistical smoothing (e.g. revisions and business Birth-Death Model adjustments), it appears that the economy lost 31,000 jobs in April. The Retail Sales report was just plain terrible versus expectations as well as in isolation. If people don’t have jobs, they tend not to spend money. Apparently the radical decline in consumer confidence this year has been another good reason for caution. Its minor movement higher this past week does not give much in the way of comfort.

It is instructive that the NBER has not declared an end to the current recession, so while there is temptation to use the term double dip, the recession merely seems to be a re-intensifying. This is similar to eras such as the 1970s Stagflation, 1930s Great Depression and 1870s Long Depression. None of these environments were friendly to US equity investing.

It is notable that these accumulating indicators paint a much dimmer picture of the economy than is generally held. While there may be an opportunity for the market to move higher, downside risks are intensifying both in real terms and versus consensus expectations.

When Additional Debt Growth Does Not Lead to Additional GDP GrowthGenerally, economic contractions have similar characteristics. The current example is the first one in the USA where leverage has been center stage. With the CBO recently projecting a worsening in deficit spending versus their initial forecast, a reduction in tax receipts may push our government to attempt to goose growth through additional stimulus programs. When these programs are paid for with borrowed funds, we can extrapolate the result as seen in the adjacent chart. Debt no longer can be relied upon to automatically contribute to growth.

So if tax receipts are on the eve of a slowdown, at what point will a broadening deficit cause interest rates to rise? No one ‘seems’ too have the foggiest idea. However, a study was recently compiled by Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business at the University of Basel) which details 28 episodes of hyperinflation of national economies in the 20th century, of which 20 occurred after 1980. The 12 largest episodes of hyperinflations were each caused by financing huge public budget deficits through money creation. He concludes that the tipping point for hyperinflation occurs when the government’s deficit exceeded 40% of its expenditures. The USA is currently at 42%+ (>$1.5T deficit on $3.55T budget) and likely to be much higher in 2011. Regardless of hyperinflation, history also shows us that re-rating of interest rates is a swift process. The recent immediate change in sentiment towards Greece and Hungary are case in point. Interest rates radically moved up once funding sources began to balk at debt issuances.

This rapid rise in interest rates on the heels of unanticipated deficits is precisely what may lead to inflation rather than the deflationary scenario widely discussed and assumed by some. This can be seen when it is considered that the only way to avoid a hangover is to keep drinking. The European Central Bank seems to be writing this prescription now as it lines up the necessary votes to get their $1,000,000,000,000 continental bailout moving. All of this financing and outright monetization (printing of money) tends to be inflationary – even if the pricing environment is deflationary at first.

International Comments:

On the international front, it appears that the Chinese are managing to navigate their robust economic expansion with a relatively moderate interim slowdown.This year’s rising electricity production (which is impossible to store large quantities of) is cross checked not only by the robust economic figures released last week, but by the continued foul air rampant in China’s mega cities. Interestingly their equity markets may have anticipated a far steeper economic decline. It is notable that many of the popular associated China‘trades’ of domestic equity markets, BRICs, AUS$,CDN$ and others have seemingly declined in unison.Could it be that there has been selling by institutional investors for the sake of selling? Lesser known investment destinations such as Indonesia, Turkey, Columbia and Chile (to name a few) are actually in the green on the year. It just might be that there are a gaggle folks with the same crowded trades that are panicking to the exits due to fears of a 2008-2009 global type economic shock. It is instructive to note that the economic‘shock’ in 2008-2009 was actually restricted to the so called ‘Advanced’ world (mostly westernized in terms of culture and finances).


In addition, the value of global energy and related companies has also come down more quickly than one might assume that the GOM catastrophe would indicate. Of interest here is that over the past two years or so the non-Advanced economies have been very thankful for our reduced consumption as it has given them a chance to enhance their economic growth with reasonably priced energy inputs. In fact,those countries have slurped up every drop that we vacated during the shock. China has now surpassed the USA as the leading destination for Saudi Arabia’s oil production. It might be concluded that if the Advanced Economies were to see a re-intensification of economic difficulty that it could serve to benefit the Emerging and Developing Economies. Thus, while large cap integrated energy companies may take time to recover from new layers of regulation and taxation,any weakness in the land locked and easy to access Canadian dividend producing energy names would likely be relatively short lived as Emerging and Developing Economies demand picks up where we left off.

Portfolio Adjustments:

Based on a flurry of positive economic reports out of China, certain consumer related positions become attractive due to a focus on the fractured consumer marketplace. While the Chinese economy begins tosort out which brands are relevant, Chinese workers will be voting with their rising wages. Columbia and Chile are both resource rich countries that stand to benefit from growing trade with Emerging and Developing Economies. While both are up on theyear, caution is warranted as they may be pulled down to some degree due to fears associated with faltering Advanced Economies.Brazil just increased short term interest rates to levels higher than that country a) can grow GDP, and more seriously, b) corporate average returns on equity.When these two areas are exceeded by short term interest rates, broad economic slowdown can follow.Also, Brazil has higher leverage than many non-Advanced economies, which gives one pause after the recent Hungary debacle because the Brazilian government has also been accused of playing fast and loose with accounting.Adding to gold and silver exposure should assist with stabilizing portfolios in the current economic environment.The relationship between these positions, the economy and broader strategy will be reviewed in an upcoming note.

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