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DISCUSSION OF MACRO ECONOMIC TRENDS

DISCUSSION OF MACRO ECONOMIC TRENDS

Well, it’s summertime and I hope that the living is easy for all of you. I write to share some general insights and to give thanks to friends who have aided our research and understanding of markets, economies and companies.

TRENDS

As you all know, we are global investors who look for major trends that are forming, or have formed and are in the process of manifesting. From these, we select areas for investing. A big part of this is to select the industries that will benefit from the trends that we see developing. We look for global economic, social and political trends that lead to the creation, destruction, growth and shrinkage of industries, which may create opportunities for investment. It isn’t really rocket science, but it does take constant attention and dedication to keep after the facts. We do our own research and speak to our friends, who we believe to be wise advisors, and then make a final decision ourselves about what course of action to take.

We believe that it is important to figure out a way to get in on those trends just as they begin to be recognized by the investing public on a global basis.

Major Trends:

1) India, China and other Asian countries are joining the world economic system. This continues to be a big theme as they consume more raw materials (i.e. copper, oil, coal, iron ore) produce more manufactured goods of all types, and consume a great deal of capital, while generating a lot of demand for U.S. treasury securities with their cash surpluses. This trend impacts every sphere of our lives and we have to consider its influence in every decision we make.

The obvious beneficiaries are:
a) Suppliers of raw materials (especially energy and heavy equipment makers who export to these countries)
b) Retailers and manufacturers who import from these countries.

2) Aging populations in economically developed countries. This trend will create current and growing demand for medical, investment and retirement services. Beneficiaries are hospitals, medical technology, drugs and biotech, retirement communities, nursing homes, vacation homebuilders and bond fund managers.

3) The growth of the Internet. We look for companies that have created communities, and /or service offerings that are well received. Some fast growing Internet related companies are beginning to learn how to spin profits from their businesses. Investing here is tricky because the customer can be fickle (i.e. community site Friendster.com has shrunk, while their competitor, Myspace.com, has grown rapidly)

4) Governments have been making unwise decisions in order to curry favor with voters. The U.S. and other governments are cutting taxes, while increasing spending and deficits. This will lead to loss of faith in U.S. currency, and the currency of other countries with deficit policies. In our opinion, this will lead to demand for precious metals, and the currencies of countries with more responsible policies.

SOCIAL SECURITY

It looks like the self-directed social security idea is dead. As we predicted, many people were afraid of the idea, and the campaign of the opponents was persuasive. The new program will mean longer work before payments are received and lower payments for the prosperous. A recent article in the Wall Street Journal, pointed out that Nobel Prize winners in economics were generally unsuccessful investors. The question was asked, how could the public do it if these people can’t?

U.S. INTEREST RATES

Most economists agree that world economic activity is slowing down. They cite higher oil prices, higher interest rates and more cautious consumer psychology. Many groups are putting pressure on the Federal Reserve to stop raising rates after August. They are arguing that if rates continue to rise, the yield curve will invert with short-term rates rising above long-term rates. They believe that this will precipitate a recession, and they are probably correct. The question is, do they want a recession? Often, the Fed likes to create an economic slowdown in the first part of a presidential cycle, so that when the presidential elections begin in 2008 there will be a new wave of economic growth underway. Why would this cycle be any different?

The problem this time is that real estate has formed a bubble just like the Internet bubble of the late 1990’s. As we remember, the Internet bubble ended in tears for many. The Fed is more political than ever. Let’s see how hard they will squeeze the real estate bubble. Clearly, if you squeeze too hard there is a bust, and consumer spending will fall, leading to a recession.

MAJOR STOCK MARKETS ARE GENERALLY UNCHANGED IN 2005 IN U.S. DOLLAR TERMS

U.S. stocks have recently recovered, as have European and some Asian markets. In U.S. dollar terms, most developed countries’ stock markets have had little change for the year, thus far.

HARD CURRENCIES

Both oil and gold have risen in recent weeks, as the demand for hard currency and energy supplies has expanded. It is uncommon for oil to rise in June, and we view the rise early in the summer as confirmation of the fact that demand continues to grow. Apart from a major recession in the U.S., I see many reasons for gold and oil to both move higher as winter arrives. Further, the U.S. dollar has been rising versus the Euro, which, over the last two years, would mean lower gold prices. Recently, gold has confounded this pattern and moved higher. To us, this is an indication that hard currency buyers do not think any of the global currencies are hard. They think they must own gold to protect themselves from the profligacy of currency issuing countries.

OIL SUPPLY AND DEMAND

Contrary to the pronouncements of many observers, oil demand has continued to rise with oil at $50 per barrel. Many observers would have bet that $45 oil would cause a decrease in global consumption. This has not been the case. Where will price equilibrium be found? $60 per barrel? We will soon see what the effects of $60 oil are on energy consumption patterns. If demand does not decrease, higher price levels will follow. It is based upon our analysis of demand that we have consistently argued for higher oil prices.

RECESSION?

If a recession were to occur next year, it would be due to higher oil prices and the deflation of the real estate bubble in the U.S. The bubble has already begun to deflate in England and Australia. In the case of England, lower house prices have preceded higher default rates on credit cards, and lower consumer spending.

Is a similar scenario in store for Europe, Canada and the U.S.? Many wise observers believe that the U.S. economy is going to slow down substantially, as consumers retrench when the real estate bubble eases. Clearly, the consumer feels poorer when the value of his home falls. We believe that the outlook for a recession, the outlook of oil prices and the outlook for stock prices are all a function of how long the U.S. raises interest rates. If rates continue to rise after August, and the economy of the U.S. weakens as the year progresses, then commodities, stocks and corporate profits will diminish. In other words, the U.S. and European consumers have been the engine of global expansion. If European consumers are currently retrenching, and then U.S. consumer begins to retrench as well, the world economy may fall into recession.

Optimists say that there is a lot of pent up demand of consumer goods in China. They point out that only government policies to restrict credit for auto and appliance purchases are keeping this demand in check. We believe this to be true, but will a big increase in Chinese consumer demand help economies outside of East and Southeast Asia? We can see how it would help Japan and Southeast Asia, but not how it would help Europe and the U.S. in the short run.

FRIENDS AND WISE ADVISERS

As you may know, I have a circle of ten or twelve friends, who are primarily very successful investors, with whom I discuss these trends and the fundamentals of companies. Some friends are brilliant on macro trends, some are commodities mavens, and some are thorough and knowledgeable on the fundamental activities and prospects of individual companies. Two are very good at technical market insights. I engage in conversation and argue about analysis with all of these brilliant minds and decide which ideas I can relate to, and which we believe the market will receive well. The idea sharing goes on daily.

I would like to take this opportunity to congratulate and thank three of our valuable friends and contacts in this memo.

Steve Emerson—private investor. What can you say about a friend who is so thorough and knowledgeable that just visiting a company with him is an educational experience? I may have visited 8,000 companies in my career and a good proportion of them I have visited with Steve. Steve is brilliant and, has a huge storehouse of investment knowledge and experience. He possesses nerves of steel and he is always, and I mean always, continuing to thoroughly research the stocks he holds. He is constantly rethinking every idea and no one works harder than him. We first met in 1969 when we were both young analysts in the L.A. area. We have been in touch sharing ideas and insights almost daily since the early 70’s.

Jim Sinclair— Jim is brilliant, and he is also very experienced as an economic analyst, trader, mining executive and a private investor. As CEO of Tan Range Exploration, he has dealt extensively with the mining community, and yet he has many years of irreplaceable experience with markets as a trader and market maker. This makes for the complete investor. I always try to have a position in Tan Range stock. To my knowledge, Jim is the only person who combines deep economic knowledge with executive experience in the gold mining industry and superb gold trading talent. In my opinion, Jim Sinclair is peerless for economic knowledge and understanding of how global central banks, currency markets, metals markets and the global economic framework operate.

Harry Schultz—The dean of investment letter writers and proprietor of the popular and important Harry Schultz letter. Published in Switzerland, Harry has more insights in each letter than many people do in a lifetime. I met Harry in 1971 through Jim Sinclair, and I continue to grow in admiration for Harry’s sharp mind, grasp of large amounts of information, work ethic and brilliance at technical market analysis.

Thanks to all of you for your friendship, insight and wisdom.