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THE NEW ECONOMIC REALITY – PART II

THE NEW ECONOMIC REALITY – PART II

“Entire ignorance is not so terrible or extreme an evil, and is far from being the greatest of all: too much cleverness and too much learning, accompanied with ill bringing-up, are far more fatal.”
-Plato

THE NEW ECONOMIC REALITY – PART II

Last week, we began to discuss this subject, sharing our views on the history and economic back drop for the past twenty years. If you missed it, you can go tohttp://www.guildinvestment.com/ARThome.aspx?ModuleId=0&Itemid=389&SType=F for a copy of the letter.

Over two decades ago, Japan fell into an economic malaise due to the deflating of a bubble in real estate and the restructuring of an extremely over-levered banking system. After twenty years, they are still in a malaise.
The U.S. began a major contraction in 2007 as a result of the implosion of a major real estate bubble. The banks that lent money to inflate the bubble are undergoing a forced de-leveraging, and it is an ongoing process that we believe will continue for another five or ten years.
Europe is also over-levered, and has recently entered a sovereign debt crisis. Greece, Spain, and other countries are having a hard time refinancing their debt because creditors fear not being repaid. Many European governments have borrowed much more than their current ability (and future ability) to repay. In our opinion, the de-leveraging by European governments and banks will continue for at least a decade.
A TUG OF WAR EXISTS. CURRENTLY, THERE ARE THOSE WHO BELIEVE THAT INFLATION WILL RESULT FROM THE CRISES AND FROM THE VARIOUS GOVERNMENTS’ CRISIS MANAGEMENT SOLUTIONS…AND THERE ARE THOSE WHO BELIEVE THAT DEFLATION WILL RESULT.
As current readers of the business press know, a debate is raging in the world of economics and finance. Some see the future as deflationary and others see the future as inflationary.
Let us look at both sides of the debate and see if we can say which is most likely to develop.
Argument #1-The Events are Deflationary
All of the influences that we mention above will decrease leverage in the Japanese, U.S., and European banking systems and the European sovereign debt market.
Should no action be taken to counteract these deflationary influences, the outcome would be a severe economic contraction. This will be especially true in the three geographic areas most affected, but also in the world as a whole. These deflationary influences must be counteracted by loose monetary and fiscal policy, or they will lead to lower bank lending, lower business activity, lower domestic and international trade, lower prices for goods and services and a much lower standard of living for the countries affected.
This downward spiral in business activity is known as an economic depression. The deflationists believe any government action will fail to resolve the crisis.
Argument #2-Policymakers have done (and will continue to do) much to counteract the depression and to feed inflation.
In Japan, which was the first country to get into a mess, officials ballooned their fiscal spending, began the practice of spending money on Japanese infrastructure, and forcing the value of their currency down to stimulate exports. This worked for a few years, but then, because the aging Japanese population lacked the manpower to manufacture as much domestically, Japan began outsourcing the manufacturing of their products to China and other Asian countries. This served to cut their production costs, so their large companies were more profitable, but it did little to increase domestic Japanese economic growth.
In short, Japan engaged in fiscal and monetary stimulus, lowered the costs of exports by moving production abroad and then reshipping the goods to consuming countries. The effect of these approaches has kept Japan in an economic malaise, but allowed them to avoid an outright depression.
In the U.S. over the past two years, government has engaged in many fiscal and monetary manipulations, whose purpose is to forestall or reverse the deflationary impact of a collapse in the real estate values and a severely weakened banking system. These policies include: slashing interest rates to zero, quantitative easing, guaranteeing deposits, lending to banks and allowing the Federal Reserve to lend against inferior collateral, providing capital infusions into banks and insurance companies, lending to foreign banks which operate within the U.S., and many other mechanisms to help return the banking industry to a near normal operating condition.
The U.S.’s massive fiscal and monetary programs may produce inflationary influences that are hard to reverse.
Europe has moved down the same road, and will eventually implement many of the same measures to stabilize and protect the European banking system, which owns a great deal of European government debt. This stimulation will include fiscal and monetary expansion and will lead over the intermediate term to a rise in inflation in the European economy.
THE TUG OF WAR IS NOT YET RESOLVED, AND THE MARKET IS REACTING IN A VOLATILE MANNER AS EACH SIDE PREVAILS ALTERNATELY

In summary, argument number one says deflationary influences will lead to an eventual great slowdown in world economic activity, and thus a worldwide depression. This fear is causing some investors to sell stocks, buy bonds, and short sell commodities, believing that demand for commodities will fall soon.
Argument number two says the government actions to forestall the deflation will end up creating inflation, and thus will cause and entirely different set of problems. This group is buying commodities, buying stocks that can grow and avoiding bonds which will be hurt by inflation.
OUR VIEW

In time, one view or the other will be proven correct. As the two sides pull the tug of war rope alternately in one direction and then in the other, market volatility will continue. To deal with the volatility, we have chosen to hold a large percentage of client assets in cash and to hold gold, which we believe can rise in either an inflationary or deflationary situation.
We see the potential of war in the Middle East, and we believe that the crisis in European sovereign debt will continue and spread. Both of these potentials are bullish for gold. Clearly, there will be other ways to benefit. For example, if war breaks out in the Middle East oil producing regions, we suggest that buying high yielding Canadian oil stocks could be profitable. If the European crisis continues, investors might consider shorting the currencies of the most over levered countries that have poor economic fundamentals, like the British Pound.
There are also investment alternatives outside of the problem areas. For example, we believe China’s stock market continues to be undervalued given their economic growth and under-levered economy. Chinese consumers have cash to spend and the desire to travel and see their country. Our research tells us that Chinese airlines are experiencing strong growth trends, so we continue to see them as attractive.
Thanks for listening


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