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RUSSIA, INDIA, AND VENEZUELA

RUSSIA, INDIA, AND VENEZUELA

INTEREST RATES

U.S. interest rates continue to rise and even though we are seeing a slight decrease in economic activity, the Fed is concerned about the continuing and growing use of home loans to finance a lifestyle that is beyond the means of many Americans. This will have a very deleterious effect on the economic growth environment in the U.S. as interest rates rise.

U.S. consumers have been living beyond their means. They have been financing their spending programs with periodic refinancing of their homes. As interest rates declined for twenty-three years, this type of behavior was rewarded. Recently, a new layer of unreality has been added to this pattern. Debtors have been buying speculative real estate with the proceeds of low interest loans on their existing properties. In our opinion, speculation in real estate can be successful only when the cost of money is below the rate of inflation.

INFLATION

This brings up the question what is the rate of inflation in the U.S.
There are two rates of inflation:
1) The number published in the government statistics.
2) The rate by which people believe their cost of living is rising.

Today, the public at large is scornful of the unrealistically low government inflation numbers, which show inflation at 3.1% over the last twelve months. Instead, they have chosen to react to the cost of the basket of goods they personally purchase, which they believe to be about 6 % per year. If the cost of money is below 6%, then they believe that they can make money borrowing to buy real estate. Further, tax benefits and low down payment real estate financing options have clouded their view. The combination of these factors have led to speculation and rapidly rising prices in many urban areas of the U.S. Further, exacerbated by wealthy foreigners who want the security of real estate outside of their home countries. Now, mortgage rates are closing in on 6% and the door is closing on this type of speculation.

ECONOMIC IMPACT OF HIGHER INTEREST RATES

In the U.K., when real estate prices stopped rising rapidly, consumer spending began to decline decisively. I believe that the same syndrome will be felt here and the Fed will then have a serious problem on their hands. If the U.S. consumer stops spending when their source of cheap cash from an ever rising home price dries up, how will the Fed be able to stimulate the economy? Since the U.S. consumer has been an important component of the world economic expansion, this could cause a slow down in global economic growth. Fortunately for Mr.Greenspan, it will probably be his successor who will catch the blame for the problems.

By the way, did you notice that one of the U.S. Senators was trying to blame Greenspan for the tax cuts and their devastating effect on the budget deficits? Greenspan endorsed the tax cuts with the caveat that if deficits rose, the tax cuts should be abandoned. According to the Senator, the Fed chairman should have known that his advice on stopping the cuts if deficits rose, would be ignored.

Although I fault Mr. Greenspan for conditionally agreeing to the tax cuts in the first place (as Chairman of the Federal Reserve, his job is monetary policy not tax policy), it takes a lot of gall to blame someone, who warned you about a possible problem, when the problem arises. But of course, politicians do have a lot of gall.

CURRENCIES, CHANGE IN VIEW

We have held the view that the dollar would rally for a few months and the bottom in the foreign currencies would be at the end of March, or in April. Our view has changed, and the reason is higher U.S. interest rates. The higher interest rates in the U.S. are strengthening demand for the dollar, and simultaneously decreasing foreign anger over the valuation of the Chinese Yuan, which is pegged to the dollar. We anticipate that U.S. interest rates will rise for a few more months. Thus, we expect the U.S. dollar to remain strong versus foreign currencies for at least a few more months.

NATURAL RESOURCE ACQUISITION BINGE CONTINUES

The great natural resource acquisition binge continues as China and India and others try to line up resources to continue their rapid growth. They have purchased assets in Canada, Latin America, Australia and Africa, and alliances have been put in place to assure a flow of resources and energy to these fast growing nations. Now, it looks to us as if the spike in base metals’ prices is ending as demand moderates into a steady growth pattern. We have not owned base metal stocks for many months, but we may purchase them later.

FINANCIAL ACCIDENT ON THE HORIZON?

In my last memo, we printed a summary of a statement by former Federal Reserve Chairman Paul Volcker. He mentioned the possibility of a financial crisis. We believe that gold may act as an anchor to windward in periods of financial crisis, and is therefore a natural resource which may be sought by China, India and other asset rich nations desiring to diversify away from paper currencies. I have heard from three friends who I respect that a crisis is brewing in the derivatives market. It may be insurance derivatives, or it may be speculation against the Chinese Yuan, which has cost some big hedge funds enough money to precipitate a crisis.

PRESIDENT CHAVEZ OF VENEZUELA AND HIS PLANS FOR LATIN AMERICA

Mr. Hugo Chavez the president of Venezuela, who is violently anti-American and anti free market, is viewed by many as the successor to Fidel Castro for power within the far left Latin world. Venezuela has been a relatively rich oil producing country, but Chavez is rapidly dissipating wealth and bringing poverty to the middle class of his country, while making headlines with his rhetoric.

He has recently bought a large quantity of weapons from Russia and is making a lot of noise about how the U.S. is trying to destabilize his government. The fact is that he is trying to destabilize many governments in Latin America. Many Latin nations have large groups of far right and far left guerillas who would love to get power, Mr. Chavez sees it as his responsibility to strengthen left wing revolutionaries in Latin America and bring as many into office as possible. Most recently, he has been meddling in Ecuador and Columbia. He plans to export his revolutionary fervor. In other words, he longs for more power.

It will be interesting to see how much power he develops over the next few years, as he meddles in the political systems and economies of as many neighboring nations as he can. He is clearly a wild card that bears close watching in this asset rich region.

INDIA’S STATUS RISING IN GLOBAL DIPLOMATIC CIRCLES

It is obvious that much of the world is aware that China is fast becoming the next economic superpower. Some believe that it may be the only economic superpower forty years from now. China’s new found status has also had the effect of creating an interest in having strategic partnerships with India among many countries. Many nations see India as an important ally. They take note of India’s tradition of non-aggression toward its neighbors on a global scale. They note that the U.S., Japan and China appear to be taking each other’s measure. Thus, many want to be aligned with India, if only to subvert the growth of China, or possibly a U.S./Japan alliance from gaining too much power in the Asian geographic area.

HIGHER INTEREST RATES LEAD TO LOWER STOCK AND BOND PRICES – WITH A FEW EXCEPTIONS

I began investing in stocks in the 60’s, and since that time I have repeatedly seen an eerie relationship that I think it will continue. Higher interest rates means lower P/E ratios for stocks, lower investment in foreign stocks, lower bond prices and more cash held by investors. Incidentally, higher interest rates mean lower housing prices and commodity prices too.

RUSSIA— FIRST, ESTABLISH POWER, AND THEN DEAL WITH THE CONSEQUENCES OF YOUR BEHAVIOR—-SUBTLETY IS NOT A RUSSIAN VIRTUE

Recently President Putin was visiting with western capitalists seeking new investments in Russia at the same time that Russia added a new, unexpected and arbitrary tax bill to a British-Russian joint venture. Some observers say Putin doesn’t know what is going on or that he can’t control his own tax authorities. Russians that I know have a different opinion. They say it is just that Putin, and the Kremlin in general, believe that all capitalists are stupid and blinded by greed, and that the old maxim “give a capitalist enough rope and he will hang himself”will be true in the end.

If the Russians want to confiscate all the foreign assets, then why don’t they do as the Chinese may do, and allow big foreign investment, do not interfere while new investments are being made and then seize or heavily tax them when the investments is very big and very valuable? This serves two purposes. First you get more assets, and secondly, you allow your people to get good prolonged training in how to manage things effectively.

I have no doubt that Russia will end up stealing a great deal of the assets that are invested in their country. In my opinion, the Chinese are smarter to be patient and learn as much as possible before the inevitable rift occurs.

SUMMARY

Interest rates are rising and that is bad for stocks globally, bonds, real estate and possibly commodities. It is good for the U.S. dollars’ value versus foreign currencies. This does not mean that short-term stock rallies will not occur, however the operative words are “short-term”.

The demand for commodities will depend upon the growth rates of China, India, Eastern European and smaller Asian countries. The growth rates of these countries in part depends upon growth of demand for products and services from the developed economies in North America, Europe and Japan. If the U.S. and Europe go into recessions and if Japan’s growth remains modest, there could be a prolonged lack of demand for commodities and energy developing in 2006. At this juncture we do not see a recession, but should we see one on the horizon we will take profits in energy and growth stocks and wait on the sidelines.

At Guild Investment Management we are holding a large percentage of cash in every client account, and will wait patiently for a buying opportunity, which may be precipitated by lower stock markets.