Chinese economic growth was 9.5% in the second calendar quarter of 2005. Indian GDP growth is 7%. European growth is small, but steady. Japan is growing steadily, solving their banking crisis, and selling off the post office. Also, U.S. economic growth is stronger than expected. All of these indications point to stronger global economic growth than many had expected. There are further indications that global economic growth may continue. This is very salutary for world stock markets. How do we ensure that we not only take advantage of the current improving situation, but also foresee the problems that may be forthcoming?


If we can forecast Chinese economic expansion, we will know how long the world economy will grow. China is now the engine of global economic growth. India, the U.S., Europe and Japan are trailing behind. As long as the global engine is growing, we all benefit.


The big risk for the world today is the residential real estate bubble that has formed in Europe, parts of China and other Asian countries, Australia, the U.S. and many other developed countries. Our big challenge is forecasting the eventual deflation, or more dangerously, the collapse of the worldwide real estate bubble. The global real estate bubble is being created by excess liquidity circulating in the world economic system as a result of the inflationary monetary policy currently in place in many countries.

It is being exacerbated by the irresponsible fiscal policy and tax incentives being pursued in the U.S. Further, the sophisticated real estate investor has been inspired by lower interest rates in the U.S., and the expectation that fixed assets will be a hedge against inflation.

The unsophisticated investor has been given home ownership incentives through a combination of irresponsible marketing programs for home loans and irresponsible loan terms from lenders (i.e. interest only, no proof of income etc.) Also, please note that lenders are known for periodically making mistakes, causing them to flirt with insolvency. A cult of real estate speculation, engendered by get-rich-quick real estate entrepreneurs, and a sorrowfully low level of economic knowledge by the public, all have led to a substantial real estate bubble in the U.S.

The unsophisticated investor may think that this can go on forever, but the wise know it will come to an ugly end. The question is, when will the prices of real estate on the coasts of the U.S. stop rising, and level off or decline? When this happens, what will be the fallout on consumer spending, consumer credit, and wealth effect psychology? In other words, people will feel less wealthy and their consumption will decline. Since about two-thirds of the U.S. economy is consumer driven, less consumption rapidly leads to a recession. This is the big risk. We are keeping an eye out, and will be quick to exit the markets when the bubble popping appears to be near.

No one can forget the recent example of the Internet bubble and the unsophisticated investors’ absurd claims about how companies were worth outrageous amounts based on hyperbole and hope. The end was not pretty for these speculators.

Real estate has not yet reached that point of implosion, but that point may be close. Greenspan and others in power know very well that the real estate bubble has gone too far and could be very injurious to national economic health. They are trying to let the air out of the real estate balloon slowly, a very difficult trick to pull off. If they are not successful, the residential real estate market, and financial stocks in general could be dangerous places to be investing. Precious metals may do very well as the U.S. authorities try to re-inflate the economic landscape to avoid serious consequences.


We have heard from many people that the problem in Iraq has only to do with internal Iraqi politics, that being Shiites vs. Sunnis. We have long disagreed, believing that the neighboring countries, and many western countries, have many other vested interests in Iraq. We were interested to note the following article in the Financial Times dated July 8, 2005.

The headline reads, “IRAQ UNVEILS PLAN FOR IRAN TO HELP TRAIN ARMED FORCES.” The article states, “Iraq and Iran yesterday heralded a new chapter in their relations by signaling their intent to sign a military cooperation agreement, dismissing U.S. concerns about Iranian meddling…on his first official visit to Tehran, Saadoun al-Dulaimi, Iraqi minister of defense, asserted his country’s sovereign right to seek help from wherever it saw fit in rebuilding defense…” Mr. al-Dulaimi states, “Nobody can dictate to Iraq its relations with other countries…”

Certainly this article speaks for itself and the news is clear. As we have been repeatedly saying for a very long time, many groups with differing agendas continue to operate within Iraq. These outside forces have had ties to Iraq for a long period of time. Whether these ties are historical, cultural, religious, secular or economic, they will not be easily replaced. The influence of these groups is, and remains, much more powerful than the U.S. influence in Iraq.


The quick and easy answer is that so far, this is a non-event for currency valuations. It may be a bigger event in the context of Asian purchases of U.S. Treasury paper. I think we will have to wait and see. Of course, a great deal of ink was spilled on articles that missed the point; that the Chinese will move slowly and gradually.

The Chinese still have a pegged currency. They have pegged their currency to a basket of trade partners’ currencies. This is good for the Chinese because their currency has risen substantially versus the European currencies, as well as the Yen, in recent months. It means that they can deflect U.S. pressure by saying that their currency has to move in concert with all of their trading partners, not just the U.S. dollar. If the dollar keeps rising against the Yen and Euro, it is also possible that they will be able to argue that their currency should fall against the dollar, not rise. Unless their currency rises by a very large amount, they will continue to be a very low cost producer and be able to produce goods at a small fraction of the costs of the developed countries.

As they are now pegged to a basket, they will still have a big trade advantage over all of the developed nations with whom they trade.


As is customary each spring, the doubters begin to say that the Chinese economy is slowing down and will start to grow very slowly. This slow growth, it is posited, will decrease demand for energy and many other commodity and transportation products or services. This year, the doubters were crying wolf again. Recently, the Chinese announced preliminary GDP growth in the second quarter of 2005 of 9.5 %, a rate that is far from slow or slowing growth. We believe that this strong growth is an indication that Chinese demand for energy, transportation and many commodity products will stay strong. This source of demand will create good incremental demand and profit increases for the world’s commodity producers, as well as those who make production equipment for commodities production, those who transport commodities, and those who process and refine commodities.

The key issue, with regard to the Chinese currency, is the effect on the continued buying of U.S. government paper by the Chinese and other foreign governments. We believe that the strength of the Asian economies is a much more important variable in this equation. We see the very strong growth of the Chinese economy of 9.5% in the second quarter of 2005 as very salutary for the growth of demand for natural resources including gold, oil, natural gas and many other commodities. While it is very true that the Chinese will by more Pound, Euro and Yen denominated bonds in the future, they will still buy our U.S. dollar bonds as well. Please refer to my letter dated May 21, 2005, where I refer to our views on currency revaluations in the section entitled “The U.S. Dollar and the Chinese Yuan”. As previously stated, “be careful what you wish for, you may get it (and its unintended side effects)”.


Is the U.S. dollar going to change direction? After rallying since the start of 2005, the U.S. dollar has, in recent days, begun to look like it is slowing its upward trend. British interest rates are expected to fall. The Canadian and Australian currencies have been rallying for a few weeks, and the Euro, Pound and Yen all look like they may try to rally in coming days. Clearly, it is too early to say a bottom has been found, but we will closely monitor the trends. From a fundamental point of view, if U.S. interest rates keep rising for another few months, the dollar could keep rising for a bit longer. We note, that the recent rise in the foreign currencies versus the dollar was over two years in length. The corrective rally for the dollar is only 6 and 3/4 months old. Thus, this rally in the dollar could go a while longer before reversing.


Stocks in the U.S. and abroad are strong and the current rallies may continue for a while. We are keeping an eye on the possible risk areas, especially the residential real estate bubble in several developed countries.