Will we keep spending? Of course we will, but not as freely as in the past. Economic data continues to show an economy that is stagnant at best. Today’s data on October housing starts was unexpectedly weak with single-family starts completely reversing a much-vaunted gain in September. Slow activity in construction permits suggests that a renewed building boom is not likely. In a speech Monday, Fed chief Ben Bernanke repeated his mantra that inflation is not a near-term threat, an assertion supported by a rise of only 0.3% in the Consumer Price Index last month. On an annualized basis, CPI fell for the eighth consecutive month in October.

Why, then, are stocks continuing their upward march? One reason is that the weak dollar is making it cheaper for foreigners to invest in U.S. assets. Another is that corporate earnings are holding up better than we thought possible. We remain troubled, however, that so much of the profit margin is a result of layoffs and other cost-cutting rather than sales growth. Sharp gains in worker productivity indicate that business is squeezing more labor out of those who remain on the payroll. Notwithstanding what may be very high long-term costs for this strategy, the S&P 500 is consolidating a breakout of the October peak. Stocks appear set to move higher in the intermediate term.

Anyone who thinks gold can only go up in the presence of inflation may want to re-think that position. The yellow metal set new price records above $1,100 this week. If this were any other market, we would probably say it is overbought, but gold doesn’t always play by the rules. The ten-year Treasury yield ended today at 3.366%, a level it has crossed many times in the last six months. The government is still having no difficulty selling all the paper it wishes at historically attractive rates. Whether buyers will be happy in the long-run remains to be seen.

Sectors

Materials held on to the top sector ranking and distanced itself further from the pack. Technology climbed back into second place and is now #1 on a risk-adjusted basis. Telecom managed to edge back into positive territory but is still on the bottom of the list, with Utilities right above.

Styles

Large Cap Growth increased its lead over the other Style categories, leaving the next six in a virtual tie for second place. Small Cap is lagging and Micro Cap is lagging even more, though the smallest companies did manage to move back into a slight intermediate-term uptrend over the last five days.

International

As has been the case for most of the year, Latin America owns the top spot in our Global Edge chart today. The United Kingdom moved into the second-place slot, helped by a surging British Pound. The U.S., Canada, and developed markets in general are all near the bottom of the list. Other than Japan, however, all are performing well and making strong advances. Japan is a different story: its momentum reading is negative, indicating that it is weak in both absolute and relative terms.

Ron Rowland
Invest With An Edge

While a number of factors are responsible for this oversight, including relative geographical isolation (Uzbekistan, along with Liechtenstein, is one of the world’s doubly landlocked nations, requiring crossing two other nations to gain access to the oceans), which currently limits energy exports available for the global market, there are a number of pluses that the country has for investors willing to “think outside the box.”

With a population of 27 million, Uzbekistan is Central Asia’s most populous and dominant power. A conservative fiscal policy since 1991, including inconvertibility of the national currency, the som, has shielded its citizens from the hyperinflation that ravaged other former Soviet republics, but the policy previously diminished potential foreign investment.

Since the global recession that began a year ago, however, Uzbekistan’s fiscal conservatism, previously dismissed by the foreign investment community, has looked more and more like a pragmatic policy that isolated the country from the worst aspects of the recession in stark contrast to other post-Soviet states that fervently embraced free market capitalism like Lithuania, whose economy contracted 18.1% this year and is expected to shrink further by 3.9% in 2010. In a move certain to be welcomed by foreign investor Uzbekistan is slowly moving towards making its currency convertible but whenever it happens, for the present the country offers a fiscal stability unmatched by many of its more free-market neighbors.

And now, the good news about the country’s resources. In 2006 Uzbekistan’s natural gas reserves were estimated at 1.798 trillion cubic meters (tcm). During the Soviet era Uzbekistan was the USSR’s third-largest producer of natural gas, accounting for more than 10% of the Soviet Union’s production, trailing only Russia and Turkmenistan. In 1992, the country’s first year of independence, Uzbekistan produced 42.8 billion cubic meters (bcm) of natural gas. Uzbekistan currently produces 60 bcm of natural gas annually, an amount nearly equal to Turkmenistan’s production. Uzbekistan’s reserves are primarily concentrated in Qashqadaryo province and near Bukhara in the country’s south-central region. During the 1970s Uzbekistan’s largest natural gas deposit at Boyangora-Gadzhak was discovered in Surkhandaryia province north of the Afghan border.

Unlike its energy-rich neighbors to the West, Kazakhstan and Turkmenistan, nearly 80 percent of Uzbekistan’s production, about 48.4 bcm, is currently reserved for domestic use at heavily subsidized rates. Of the remaining 12 bcm of natural gas that Uzbekistan exports, more than half currently goes to Russia, with the remainder to neighboring Central Asian states.

Under Uzbekistan’s fiercely patriotic President Islam Karimov relations with Europe’s favorite bête noire, Russia’s state-owned gas firm Gazprom, have been subject to fierce negotiations to win an equitable price for the country’s exports. Like other former Soviet republics, the Uzbek government chafed under Gazprom’s "buy cheap, sell dear" policies and in early December 2008 scored a significant negotiating success by getting an agreement that in 2009 Gazprom would pay $305 per thousand cubic meters (tcm). To put the accomplishment in perspective, Uzbekistan’s state gas company Uzbekneftegaz sold gas to Gazprom for $130 per tcm in the first half of 2008, which then rose to $160 in the second half of 2008.

Those betting on the eventual pacification of Afghanistan and the subsequent pipelines that would crisscross the country to deliver Central Asian gas to the massive Pakistani and Indian markets would also do well to take note of Uzbekistan’s persistent, low key policies over more than a decade attempting to bring peace to its hapless southern neighbor. The initiatives put forward by Uzbek President Islom Karimov during the NATO summit in Bucharest in April 2008 take on heightened importance as one of the few foreign policy ideas offering some hope to quelling Afghanistan’s three decades of turmoil. The text of Karimov’s address is at http://www.jahonnews.uz/eng/sections/politics/address_by_president_of_the_republic_of_uzbekistan_he_mr_islam_karimov.mgr.

Nearly completely overshadowed by the Bush administration’s relentless efforts to have Georgia and Ukraine join the alliance, Karimov proposed that the UN’s Afghanistan "6 plus 2" assembly, established in 1999, be revived by expanding it into a "6 plus 3" ensemble by including NATO because of its anti-terrorist operations in Afghanistan among the "six" members Uzbekistan, Tajikistan, Turkmenistan, Pakistan, China and Iran and the "two," the United States and Russia.

Noting that that it is impossible to solve Afghanistan’s problems without the direct involvement of neighboring countries, which have felt the destructive impact of the Afghan crisis for more than 30 years, as Afghanistan’s problems are now of global nature, Karimov told his audience in Bucharest that their resolution must also be global, with the participation of members of the international coalition that comprise NATO’s International Security Assistance Force (ISAF). Karimov concluded by noting that the current situation in Afghanistan precludes a purely military solution and that while it is possible to continue increasing the foreign military presence there, without a clear model of national reconciliation it will be impossible to end the conflict.

Needless to say, one of the benefits of peace and the aforementioned pipelines for Uzbekistan would be that it could export its surplus gas through Afghanistan to southern Asian markets for a higher price than it receives at home or Gazprom’s miserly accountants. Acting on Tashkent’s belief that economic assistance is of greater utility than military operations, Uzbekistan has become involved in a host of reconstruction projects in Afghanistan, including railways, power generation, mining, agriculture, irrigation, education and the exchange of specialists as well as providing its neighbor with construction materials, metals, fertilizer, food and other goods. Uzbek companies and engineers have built 11 bridges in the Mazar-e-Sharif-Kabul area and are finishing the construction of a 275-mile high-voltage line capable of transmitting 150 megawatts from Termez to Kabul across some of the world’s most mountainous terrain, which when it becomes fully operational next month, will provide power and light not only to the capital but the country’s five northern provinces.

For now, Uzbekistan remains largely a transit country rather than a net energy exporter in its own right. But the fiercely independent nationalist policy that Tashkent has followed since 1991 indicates that any company whose policies most benefit the country will have an inside track, and as the old saying goes, “fortune favors the bold.” Chinese, Malaysian, Russian and South Korean companies have already begun investing in Uzbekistan’s energy infrastructure – what do they seemingly know that American and European companies do not?

This article was written by John C.K. Daly for OilPrice.com – Who offer free information and analysis on Energy and Commodities. The site has sections devoted to Fossil Fuels, Alternative Energy, Metals, Oil prices and Geopolitics. To find out more visit their website at: http://www.oilprice.com

My comment: I am shocked, shocked I say that a government sponsored entity would lie about oil reserves and future production.

The senior official claims the US has played an influential role in encouraging the watchdog to underplay the rate of decline from existing oil fields while overplaying the chances of finding new reserves.

My comment: The US politicians cant allow the sheeple to call into question the unsustainable suburban lifestyle of idiots living fifty miles from work and each person commuting to a cubicle downtown in a Ford F-350 or a Hummer.

The allegations raise serious questions about the accuracy of the organisation’s latest World Energy Outlook on oil demand and supply to be published tomorrow – which is used by the British and many other governments to help guide their wider energy and climate change policies.

My comment: Peak Oil is a fact and it is going to impact you more then healthcare, taxes, or anything else. The governments of the world are going to deny this until it is to obvious to ignore. Once peak oil is an accepted fact guess what happens to oil prices? They go up and they do not come down. The market is a discounting mechanism and will price a scarce resource now based on where it thinks supply/demand will be in the future.

(skip)

A second senior IEA source, who has now left but was also unwilling to give his name, said a key rule at the organisation was that it was "imperative not to anger the Americans" but the fact was that there was not as much oil in the world as had been admitted. "We have [already] entered the ‘peak oil’ zone. I think that the situation is really bad," he added.

My comment: Ask yourself this question. In the future will oil exporting nations be agreeable to exporting a nonrenewable commodity in sufficient quantities to allow Americans to continue wasting it driving around in cars? Will they choose to limit exports in order to preserve this commodity for their own use? Now ask yourself why we are really in Iraq which has an estimated 300 billion barrels of oil reserves. People laughed at me when I suggested this years ago but the evidence is mounting I was right. Another thing you might want to ask yourself is why is news like this always printed and discussed in foreign news outlets but never in the US? By the way the stock of the year pick for 2010, which I am finalizing, is a junior oil explorer that will be able to take advantage of this situation.

John Polomny
The Real Deal

That’s because a lot of people would really like to see target rates start moving up from their low levels.

Some argue for higher rates because they think the world is returning to normal and the emergency policy responses need to be removed sooner rather than later to avoid a date with inflation.

Others are concerned that all of the ultra-easy money will result in asset price inflation, another bubble and ultimately another bust.

But clearly, the central banks have different concerns. This week …

• The Federal Reserve kept rates unchanged and made no material change to its statement. The markets were looking for some language change that would open the opportunity for an earlier rate hike. But the Fed did not oblige. Result: Dovish.

• Next it was the Bank of England. The BOE kept its benchmark rate unchanged and went further in the easy money hole by expanding, for a second time, its asset purchase program. Result: Dovish.

• And finally the European Central Bank followed suit and left rates unchanged and its bank liquidity program intact. Result: Dovish.

This week, central banks, including the BOE, maintained their dovish positions.

To sum it up, the central banks continue to position themselves to accomdate the challenges in the real economy.

Now, for those who have been pleading for higher interest rates …

While I disagree with the first crowd, the one that thinks economies are returning to normal, I don’t completely disagree with the second crowd, those concerned about asset bubbles.

First, the U.S. economy and major global economies are nowhere near reaching a point of sustainable growth, much less normalcy. In fact the European Central Bank President, Jean-Claude Trichet, put it very plainly …

“I am a little a bit uneasy when I see [reports of a self-sustaining recovery occurring], because we have some green shoots here and there.”

The U.S. economy just printed its first positive GDP number in five quarters and most of it was attributed to government spending. Indeed, the purpose of government spending is to get the economy moving. But the idea is that in the process you create jobs … new industries … demand. And that just hasn’t happened.

So the people who think we’re back to business as usual have their heads in the clouds.

Now, for the second crowd …

Like I said, I don’t completely disagree with them. They fear another asset bubble. Some of my colleagues here at Weiss Research feel that way. And I think they’re dead right. It’s here. Stock markets, commodities, currencies … all 30 percent, 50 percent … even 100 percent higher in the past eight months!

I worry that another asset bubble is building in financial assets.

Financial assets have rocketed from their March lows and for no fundamental economic reason. Is it because of the mountains of capital that have been plowed into the system through stimulus programs has ended up in financial assets?

In some cases, clearly yes …

Take China for instance. Its economy couldn’t absorb the massive half-trillion dollar stimulus and uber-aggressive bank lending. So that money found its way into investments like the Chinese stock market. So easy money can find its way into financial markets, for sure.

But can the major economies of the world, namely the U.S., afford to tighten up the belt to keep this under control? In my opinion, absolutely not! And that’s where I disagree with the second crowd.

Financial asset bubbles are one thing, and they are a risk. But most of the risk, at this stage, is to investor and consumer confidence. A bust that would bring financial assets back in line with the fundamentals of the economy would be another major blow to sentiment. And that could be the trappings for another recession — even a depression.

But the guaranteed danger right now is the real economy, real asset deflation, and evaporated demand. The threat of a sharper deterioration in the real economy leads to a complete stand-still in economic activity … i.e. a date with depression. That’s the battle central banks are most worried about.

If you’ve concluded that this looks like a lose-lose scenario for the U.S. and the highly interconnected global economy — I’m afraid you’re right.

A likely best-case scenario is a very slow and painful rebuilding period, where weak demand and lower standards of living rule.

The worst-case scenario: A bout with global depression.

As for bubbles in the financial markets, better known as the “risk trade,” that day of reckoning is coming when prices revert back to fundamental sanity. And the time might be closer than many people think …

Regards,

Bryan Rich
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

Today they’re coming back—and getting roughly the same deal that was on the table during the summer. On Nov. 2, ENI initialed a contract to boost production in the Zubair field near Basra, which it estimates has 6 billion barrels of reserves. Shell, Exxon, and ConocoPhillips also are in talks that could help boost Iraq’s oil production to more than 6 million barrels per day—behind only Saudi Arabia in OPEC. "This is the window in which if anything can happen it will happen," says Alex Munton, an Iraq specialist at Edinburgh-based energy consultants Wood Mackenzie.

The big oil companies are reconsidering Iraq because they realize this may be among their last opportunities to get large volumes of crude.

My comment: The last sentence is interesting in that it is a validation of the peak oil theory. If so much oil exists around the world why do these majors need to accept the relatively low returns being offered by the Iraqi government. the answer of course is that new oil finds of significant size simply do not exist.

On another note I was able to pick up some more WesternZagros shares at around seventy cents per share. I would again note that this is a highly speculative stock.

John Polomny
The Real Deal

Today I give you a video about Russia and how a plan to fix the economy might throw off the political balance of power. I regard Moscow’s situation as a valuable lesson for our country – also in the throes of an economic crisis.

John Mauldin
Outside the Box & Thoughts From the Frontline

johnmauldin@investorsinsight.com

John Mauldin, best-selling author and recognized financial expert, is also editor of the free Thoughts from the Frontline and Outside the Box e-letters that go to over 1 million readers each week. For more information on John or his FREE weekly economics letters, go to: http://www.frontlinethoughts.com/learnmore

After only one project out of a possible eight was awarded in the first auction in June, the Iraqi oil ministry is now showing foreign companies, including the world’s majors, more flexibility. It has also improved terms for international oil companies that submitted offers at the country’s first licensing auction, but didn’t win contracts.

As a result, a line of bidders is forming for the remaining assets. The new ministry’s policy has convinced a number of companies to re-negotiate West Qurna-1 and Zubair, which Baghdad failed to award during the first auction.

My comment: This is good news and it is also what I expected to happen. The government in Iraq is desperate for revenue and the first round of bidding did not go very well for the government. They sweetened the pot and now there will be the investment I have been anticipating. This is good news for people like me who have been early investors in this frontier market. With western oilfield technology applied to these fields I expect production to increase fairly quickly. The other thing I would note is that I was home watching CNBC today as I am sick with the flu. CNBC had a whole segment on hedge funds and investment funds getting set up to enter the Iraq stockmarket. It was mentioned that the Iraqi stockmarket has a total market cap of only two billion dollars. The one manager interviewed echoed my previous sentiments. he said that frontier markets like Iraq have the opportunity to create life changing wealth as the market doubles several times over as investment floods into the country. Big risk and big reward.

John Polomny
The Real Deal

While the US government, under both Bush and Obama Administrations, spent unprecedented amounts to “stabilize” the economy, such spending only accounted for 24% of the deficit.  The real problem was a drop in tax revenue. Corporate tax receipts plunged a staggering 55% and personal income tax revenue dropped 20%.

Despite efforts to stem entitlement spending, the costs of those programs entitlements are still going up, adding more pressure to the federal income statement. The White House Office of Management and Budget projects 10-year deficits will total $9 trillion. These numbers can change dramatically, of course, based on economic conditions, war spending, and the prospects for health care reform.

So what does all this have to do with the investor? As you know, budget deficits lead to government debts.  Much like the citizens who elected them, politicians have grown accustomed to spending more than they make.  However, long-term debts degrade the productivity of an economy. As more taxes are used to pay the interest and debt, less is spent on infrastructure, healthcare, or business development.

If you believe that runaway debt is a bad thing for an economy, you should consider investing outside the United States. After all, the US economy is the biggest debtor nation on the planet. These days, it’s as easy to buy China as it is to buy the S&P 500. Here’s a 2008 list of countries with their total debt (public and private). I’m not recommending any country in particular, but here are some facts to consider.

(Data Courtesy of The World Factbook & Wikipedia)

Brandon Clay
Invest With An Edge

Last week I expressed my concern that we as a country are taking actions that could indeed "Kill the Goose" of our free-market economy. I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I have given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.

But first, two housekeeping items. I want to welcome the 150,000 members of the National Association of the Self-Employed to this letter. They have asked me to be a special consulting economist to their group, and they will send this letter each week to their members. Since its beginning in 1981, the National Association for the Self-Employed has pioneered support for micro-businesses and the self-employed, and been a forceful advocate for small business in this country. (www.nase.org) I am honored. I am pleased to add you to my 1 million closest friends. I hope you find it useful.

Second, I will be going to South America at the end of next week, to Buenos Aires, Montevideo, Sao Paulo and Rio. I will be speaking in those cities and traveling with my new Latin American partner, Enrique Fynn of Fynn Capital (based in Uruguay). If you would like to find out about this tour or what services he can help you with, you can go to www.accreditedinvestor.ws and sign up and Enrique will get in touch with you. And as always, if you are an accredited investor, you can go to that website and one of my partners in the world will get back to you. (In this regard, I am president of and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

Muddle Through, R.I.P.?

I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.

I am not surprised about the response of the Fed to the current recession and credit crisis, whether it’s the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there is nothing that would make me think we do not eventually recover, albeit at a very slow Muddle Through pace, with a jobless recovery that lasts for several years. It will not be pleasant, but we’ll survive.

However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.

And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics.

Savings Equal Investments

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

(For the wonks out there, GDP is usually termed "Y".)

You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.

This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it is not a guess or an approximation. It is simple reality.

Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.

In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth.

Japanese Disease

Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can’t we be like Japan? And my answer is that it is possible, but the cost that Japan has paid has been high.

In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management’s latest letter (last week’s Outside the Box):

"The federal government’s promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro’s book, Macroeconomics – a Modern Approach, p. 370).

"This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output."

For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President’s Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.)

In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it is 373%. We have added over $15 trillion in debt, yet total employment today is roughly where it was 9 years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I am sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease – a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).

Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.

The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have will not go into the investments we need, but into government debt.

Who Will Buy the Debt?

Now, let’s go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they do not disappear. They can only go back into a dollar-denominated investment. Up to now, that has typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.

Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate?

The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks’ lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.

So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.

And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we will see over 400 banks fail in this cycle.

One quick chart to further highlight the problem that banks are facing. I have been writing for several years that commercial real estate loans will be the next shoe to drop. Moody’s calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they are going to have to make. And my bet is they put those reserves they are not lending into government debt.

Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral.

The New Muddle Through Economy

This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won’t happen next year, and it’s unlikely in 2011.

I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a "New Normal," then I can decide that we are going to a "New Muddle Through Economy." Just not one as benign as I used to think.

In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.

As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.

On the Road Again

I am writing tonight from Detroit. Tomorrow I will be in New York watching the Yankees/LA game. I will be the guy in the second row behind home plate in the Dallas Cowboys jacket. I will be on Yahoo Tech Ticker on Monday morning, so you should be able to go to Yahoo and see me later that afternoon. Then Philadelphia on Tuesday, speaking at my partner Steve Blumenthal’s CMG conference for investment advisors. They have a very interesting platform of trading advisors. You can see them at http://cmgfunds.net/public/mauldin_questionnaire.asp

I had a great deal of fun at the New Orleans conference, being with old friends and meeting new ones. David Tice (of the Prudent Bear Fund) was an exceptional host for dinner at Emeril’s. I was surprised that Karl Rove actually remembered me after nine years. I thoroughly enjoyed spending some quality time with my friend Ron Paul. We share a lot of concerns about the future of the Republic. I was pleasantly surprised by how thoughtful Howard Dean was. And very personable.

I go to Houston on Wednesday, Orlando on Thursday, and then South America on Saturday. I will be doing a lot of writing from hotel rooms, but all in all it will be fun. You have a great week, and remember that in 10 years none of us will look back and want to return to 2009. 2019 will be better than we can possibly imagine. We just have to make sure we all get there!

Time to hit the send button and find an adult beverage. All the best,

Your going to miss the Old Muddle Through analyst,

John Mauldin
John@FrontLineThoughts.com

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PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273.

International oil companies are close to striking deals that would almost triple Iraq’s output and catapult it up the table of global producers. The firms walked away from those deals at an auction just over three months ago.

Lower taxes were the main factor that convinced firms they could turn a profit where they previously saw too much risk on punishing terms, executives at international oil firms said.

My comment: Slow but sure progress in Iraq with regard to the oil industry. I am still invested there and this is the type of news I expect to see going forward. If Iraq can ever get oil production up to 6 million barrels per day, which is where I think they can be in a few years then investments in the small stockmarket there should pay off massively. Nevertheless this is a frontier market and was ranked as one of the most corrupt places on earth to do business. But for the adventurous or those who are able to understand and deal with the risk a huge payout is possible. I am researching another frontier market, in Asia, that has the same type of upside as Iraq but its wealth is mineral based.

John Polomny
The Real Deal

But in a handful of countries overseas, central bankers are actually showing some spine. Unlike the U.S. Fed, they can see that the ocean of cheap, easy liquidity is forming mini-asset bubbles. They realize that the acute phase of the credit crisis is over, making it absolutely unnecessary to maintain “emergency” interest rates. And they’re taking action …

• The Bank of Israel fired the proverbial shot across the market’s bow in August. It raised its base interest rate to 0.75 percent on the 24th of that month from 0.5 percent.

• Indian central bankers have signaled they could soon raise that country’s benchmark reverse repurchase rate from 3.25 percent.

• Speculation is mounting that Bank Indonesia will soon raise its 6.5 percent benchmark rate.

• Ditto for the Bank of Korea and its 2 percent policy rate.

Australia’s central bank raised its key cash rate on Tuesday, indicating that the worst danger for the economy had passed.

And Australia dropped the biggest bomb of all this week …

The Reserve Bank of Australia increased the country’s overnight cash rate by a quarter-point to 3.25 percent, becoming the first “Group of 20″ country to take that step. Private forecasters currently expect the Reserve Bank of Australia to raise rates by a further percentage point in 2010.

Meanwhile, Our Fed Is Singing From
An Entirely Different Hymnal

The message coming out of our officials in this country couldn’t be more different. Here, we’re getting a virtual open-ended promise of government aid and monetary largesse for as far as the eye can see …

• New York Fed President William Dudley just told a Fordham Law School audience that the Fed’s “near-term focus should be to keep significant monetary accommodation in place for an extended period.”

• Boston Fed President Eric Rosengren sang a similar tune a few days earlier. He said, “It’s important that monetary and fiscal policy continue to support the economy until private-sector spending has resumed, and until we are confident that the recovery will continue once the programs that have supported the economy over the past year are removed.”

• And the Federal Open Market Committee’s own statement from its September 23 meeting contained the following, crystal-clear message: “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

The Fed seems determined to let the dollar crash and burn.

The consequences? The U.S. dollar plunged to new cycle lows against the Australian and New Zealand dollars. It got whacked by the Indian rupee, the Singapore dollar, and the Indonesian rupiah. And gold — the ultimate world currency that no central banker can print out of thin air — soared to close at $1,058 yesterday, the highest nominal price level in the history of the world.

The Forecast: More of the Same

From time to time, we’re going to see the dollar bounce. We’re going to see gold sell off. We’re going to hear the occasional throwaway comment from Fed and Treasury officials that they care about the buck.

But we all know the truth. That’s hokum! This is a deliberate campaign to drive down the dollar in order to help reinflate the asset markets. Everyone in Washington knows it. They just won’t talk about it openly!

Here at Money and Markets, though, we don’t mince words. We don’t subscribe to the whole “Fed worship” mentality that seems prevalent on Wall Street. If we see foreign central banks defending and supporting their currencies, while our Fed is doing all it can to throw the dollar under a bus, we’re going to tell you. And we’re going to tell you how to protect yourself. I trust you’d expect nothing less.

Until next time,

Mike Larson
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

The sheer scale of China is mind-boggling! Just think about it …

• 1.3 billion people — more than 4x the U.S. population …

• 3.7 million square miles …

• And borders that touch 14 other nations!

Communist China Turns 60.

Back in the 1970s, the Chinese government figured out that the whole “central planning” thing wasn’t working so well. And communist ideology gave way to a pragmatic mix of state ownership and entrepreneurial capitalism.

It worked … China’s economy is now 70 times bigger than it was in 1978, when the economic liberation began. Depending on how you calculate, China is either the second or third largest economy in the world!

The vast industrial base, concentrated in the coastal regions, is transforming China. Farm workers from the massive interior are drawn by the relative high pay of factories. New cities spring up out of nowhere to house these workers and provide for their needs …

… And now many of the products that were once immediately shipped to the U.S. or Europe are staying at home, snapped up by China’s newly-prosperous middle class.

A middle class in a communist society? Hard to believe, yes, but there really is such a thing in China now. And there’s an entire younger generation that now knows what they’re missing — and they’re working hard to reach the next level.

China’s new middle class is on a shopping spree.

So if long-term rewards are what you’re looking for, China represents an amazing investment opportunity. But how do you play it?

First, recognize that anything China-related is going to be a roller-coaster ride, just as it has been the last few years. Therefore don’t invest unless you’re prepared for the bumps and jerks.

Second, know how much risk you’re taking. Individual Chinese stocks can deliver amazing profits, but they can be hard to trade. That’s why I think exchange traded funds (ETFs) are the best way for most investors to get involved in China’s hot market. And you have several choices — some diversified, some more specialized.

Here’s a quick summary:

Broad-Based China ETFs

U.S. investors can pick from four ETFs that track diversified Chinese stock market indexes:

• iShares FTSE China Index Fund (FCHI)

• iShares FTSE/Xinhua China 25 Index Fund (FXI)

• SPDR S&P China (GXC)

• PowerShares Golden Dragon Halter USX China Portfolio (PGJ)

Each of these ETFs takes a slightly different approach to constructing a China portfolio. FXI holds the 25 largest Hong Kong-listed companies that are available to foreigners. FCHI and GXC are similar but add some mid-cap stocks to the mix. They’re a little more diversified than FXI. All three are capitalization-weighted.

PGJ takes a somewhat different tack. First, it includes only Chinese stocks that have a listing on U.S. exchanges. Second, PGJ uses a tiered-weighting method, which results in the sector mix being a little different from the others.

Specialized China ETFs

If you want to get a little more aggressive, Claymore offers two China ETFs that have a tighter focus:

• Claymore/AlphaShares China Small Cap Index ETF (HAO)

• Claymore/AlphaShares China Real Estate ETF (TAO)

HAO is a good way to get exposure to small, fast-growing Chinese companies. These stocks tend to be less dependent on exports and more related to China’s domestic economy. TAO gives you an opportunity to profit from China’s real estate and construction boom.

China is growing like crazy.

Inverse and Leveraged China ETFs

What if you think that China’s stock market has gone up too far, too fast, and is due for a quick drop? You may still be able to profit with ProShares UltraShort FTSE/Xinhua China 25 (FXP). This is a 2x leveraged inverse ETF. For instance, on a day when the underlying index goes down 2 percent, FXP is calibrated to move twice as much in the other direction — up 4 percent in this example.

On the other hand, if you’re bullish on the Chinese market, there’s the ProShares Ultra FTSE/Xinhua China 25 (XPP). This 2x leveraged “bullish” fund aims to give twice the daily move in the same direction.

The leverage factor for ETFs like these is reset daily, so the 2x math doesn’t always work for periods longer than a day. In other words, FXP and XPP are best used as tools by short-term traders, but if your timing is right you can make big profits from them.

Chinese Currency ETFs

If you want to bet on China’s currency, the renminbi (also called the yuan), you can do it with these two instruments:

• Market Vectors Chinese Renminbi/USD ETN (CNY)

• WisdomTree Dreyfus Chinese Yuan Fund (CYB)

There’s one key difference between the CNY and the CYB: CNY is actually an exchange traded note (ETN), not an ETF. Practically speaking, ETNs work much the same way as ETFs, but they’re actually a form of debt instrument. I wrote about the unique risks of ETNs earlier this year in my Money and Markets column.

Chinese law prevents the funds from directly investing in the renminbi, so they hold currency derivatives known as nondeliverable forwards. These are similar to futures contracts, which reflect a market’s expectations. As a result, these funds might not perfectly track the yuan.

As you can tell, there are plenty of ways to invest in China’s stunning growth story. I’ve only covered a few of them here, and ETF sponsors are planning many more. Do your research first, but don’t overlook China. The opportunity is too big to pass up!

Best wishes,

Ron Rowland
Money and Markets

They’re all worried about currencies. Specifically, how currencies will impact their own recoveries and the recovery of the global economy.

The G-7’s predecessors have a history of assuming an important role in currencies. The G-10 was created to stave off attacks on the dollar and the British pound in the 1960s. And the G-5 was formed in the 1970s to try to manage the new world of flexible exchange rates.

But with new power shift to the G-20 announced last week, the G-7 might not even release a communiqué this time. What we do know, however, is that they will discuss currencies.

Since March …

• The euro has jumped 21 percent against the dollar,

• The Canadian dollar has gained 17 percent,

• The British pound has risen 16 percent,

• And the Japanese yen has climbed 11 percent.

Most of this currency strength is explained by an improving global economic picture, which has translated into general weakness in the U.S. dollar. That’s because global capital has reversed back out of the safe haven appeal of the dollar and moved to the rest of the world.

The dollar has taken a beating as investors flocked to riskier assets.

But this dynamic has brought a sharp rise in these currencies and has become an extra threat to what is an already fragile economic recovery.

I’ve written several times in my Money and Markets columns about the mounting pressures that are building between countries as a result of the global recession and the tenuous global recovery.

As these pressures on recovery grow, there has been — and will continue to be — increasing actions to protect and defend that recovery. We’ve already seen a pick-up in protectionist activity. And we’ve already seen competitive currency devaluations, both of the verbal persuasion and via direct action. While both measures have been sworn off by G-20 members, those same member countries have been actively engaging in both.

For now, currencies represent one of the more troubling drags on economies. Governments and central bankers have poured stimulus into their economies only to have it counteracted by a strong currency. And many export-dependent countries are stuck with currencies that have been soaring against the currency of the world’s biggest consumer … the U.S. dollar.

In global trade, strong currencies put a country’s exports at a competitive disadvantage. So exporting your way out of this recession is a tough proposition. And that’s why leaders around the world have stepped up the public commentary on currencies.

Strong Dollar Speak Stepping Up …

U.S. Treasury Secretary Geithner adopted some new language on the dollar when he said: “A strong dollar is important.”

Even Fed Chairman Bernanke chimed in this week and said that “There’s no immediate risk to the dollar.”

“Sharp movements in currencies can cause adverse impacts.” — ECB president Trichet

The president of the European Central Bank, Jean Claude Trichet, has said he’s happy to hear that the U.S. is making statements to the world about the importance of a strong dollar. He added that the strong euro has been discussed among leaders in the Eurozone.

Canada has said that the strength of the Canadian dollar could derail economic recovery. Both the central bank governor and the finance minister have verbally threatened to take action on currency strength.

And last week the Bank of England’s governor said that a weak pound helps recovery.

Then There’s Japan …

The Japanese yen has been by far the strongest major currency over the past two years. When the housing bubble in the U.S. was finally pricked, so was the global credit bubble, and so was the yen carry trade. This is where investors borrowed in yen — paying a measly interest rate — and converted that yen to currencies like the U.S. dollar, the Australian dollar and the Brazilian real where they could earn 5 percent, 10 percent … even more.

Since the top in the housing market, the yen has soared 38 percent against the dollar as hundreds of billions of dollars worth of this carry trade have been reversed. This reversal has been so powerful that the resulting yen strength explains about 55 percent of the weakness in the dollar index over the past two years.

No member of the G-7 needs healthy exports more than Japan does. But the new ruling party in Japan has given some early, mixed signals on yen strength. Now, the new Japanese Finance Minister is also giving verbal cues that Japan will take action against a strong yen if necessary.

The bottom line is that the G-7 countries would like to see a bounce in the dollar. And so would the other large stake holders in the U.S.: China, Brazil and Russia — among the largest foreign holders of Treasuries.

And it appears they just might get their wish sooner, rather than later.

Markets Flashing Warning
Signals for Risk Takers …

If stocks continue their slide, the dollar could strengthen.

The caution-laden statement out of the Federal Reserve meeting last week has so far marked a top in the risk appetite for financial markets and a bottom for the dollar.

The global proxy for recovery and investor risk appetite has been the U.S. stock market. And after generating a key technical reversal signal last week, the slide in stocks has accelerated. In an environment where risk appetite is dictating where the dollar goes, a reversal in the recent trends in financial markets bodes well for the dollar.

And a bounce in the dollar would be a welcome sign for the world and for global recovery.

Regards,

Bryan Rich
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

The U.S. dollar has been getting a beating from all sides, but its woes may be far from over – recent developments in Japan, China, Germany and the United Kingdom, not to speak of domestic developments in the U.S., are pointing to a rocky road ahead. Today’s focus is on Japan and, more specifically, how a country on a downward economic spiral can have a strong currency.

Exchange rates are subject to the forces of supply and demand – the flow of funds – of the underlying currencies. While conventional wisdom dictates that a growing economy may attract more foreign investment, a better gauge may be to look at a country’s dependence on foreign investment. A country like the U.S., with a severe current account deficit, depends on foreigners buying about $2 billion worth of U.S. denominated assets every single day just to keep the currency stable. The current account deficit reflects a country’s trade deficit plus any financing requirements, such as government spending that is financed from foreigners rather than domestically. The currencies of countries with significant current account deficits, such as the U.S., Australia and New Zealand, tend to be more volatile during periods when market participants do not have a clear view on whether the economies will experience growth or not.

However, the Japanese economy is less sensitive to capital flows from abroad; instead, if market forces were allowed to play out, frightened Japanese consumers might even save more as their economy continues on its downward spiral. The Japanese yen may perform better the less effective the government is: as the former Japanese government’s leadership became ineffective and the Bank of Japan received no instructions to intervene in the currency markets, the yen was able to rise.

To further illustrate the point, consider that Federal Reserve (Fed) Chairman Bernanke has repeatedly emphasized that the U.S. emerged from the Great Depression because of a) a guarantee of retail deposits (think guarantee of the entire banking system in the most recent crisis) and b) the U.S. going off the gold standard to weaken the U.S. dollar and allow the price level to rise. Our interpretation is that the Fed wants to have a weaker U.S. dollar to induce inflation to allow home prices to rise and bail out those with debt. Think about it this way: if someone takes half your net worth (purchasing power) away, you may have a greater incentive to work, thus creating headline economic growth and employment. Destroying purchasing power may not be the Fed’s mandate, but this approach may be aimed at boosting employment. By making U.S. assets relatively unattractive, the Fed is, in our view, effectively attempting to weaken the currency. The Fed has been aggressively buying mortgage backed securities (MBS) and government bonds; these securities are now intentionally overpriced and thus may no longer be attractive to rational buyers. We are not just talking about foreigners potentially reducing their appetite for U.S. securities, but domestic buyers as well; we see this as an increasing number of U.S. corporations are hedging their domestic currency risk.

Now think about what happens to a region’s currency when the central bank is not as aggressive. Think euro zone – economic growth in the euro zone may be nothing to write home about, but it may be because the European Central Bank (ECB) has shown more restraint that the currency has been strengthening relative to the U.S. dollar. The forces that have driven the Japanese yen higher are similar to those supporting the euro.

Does it mean all is well in Japan and Europe? No. Quite the contrary, but flow-of-funds issues are more relevant to short- and medium term valuation dynamics than challenges in a country’s balance sheet. In the case of Europe, the banking sector has major challenges still ahead, but the European Central Bank’s approach of providing unlimited liquidity to the sector is likely to keep zombie banks alive; that bodes badly for economic growth, but can support a strong currency. In Japan, the massive government debt is a long-term issue that will become a short-term issue when financing issues arise. In a world where the Japanese banking system is perceived to be one of the safest in the world (what a scary thought!), and the market appears pre-occupied with only the most imminent financial issues, these problems, at least for now, appear to be in the distant future.

Or are they? Long-term challenges can become short-term headaches when someone rocks the boat too much. A new government stirring up dust is a perfect opportunity to have a lingering problem turn into a full-blown crisis. To look into our crystal ball where Japan and the Japanese yen may be heading, let’s look at the newly elected Democratic Party of Japan (DPJ) as it pursues an eclectic policy mix of decentralization, socialism and select pro-business initiatives. Some of the highlights relevant for the currency may be:

• The DPJ wants to take an axe to a system run by bureaucrats– that’s good for change; the party further wants to move power to the regions. However, rather than encouraging a less bureaucratic federal system, the DPJ intends to replace bureaucrats with politicians. Think political appointees at all levels of society. I can’t help but think of the French, where disillusioned citizens vote for change election after election, but get change in a direction they had never imagined or necessarily wished for. The U.S. has similar challenges when it comes to implementing change, but political appointees are not as pervasive (all things are relative…) as they are in France.
• Unions are the main backers of the DPJ; not surprisingly, the DPJ wants to halt the privatization of the Japanese Post Bank. As a refresher to a topic that has been out of the headlines for some time: the Japanese Post Bank has over USD $3 trillion equivalent in deposits, a consequence of what had been a very weak banking system where deposits fled to the one bank with state guarantees. The Post Bank has been instrumental in financing government deficits; we had argued a couple of years ago that a privatization may be inflationary, as a privatized institution might be more risk friendly and deploy its asset base more aggressively. As a result of the policy reversal, this potential boost to economic growth may not materialize.
• The DPJ has numerous populist ideas, from generous child allowances to cancellation of road tolls to generous pension and health benefits. To finance all these programs, “wasteful spending” elsewhere shall be cut. This sounds all too familiar and is likely to be the same as in any other country: expensive.
• The DPJ wants to move power from large businesses to small businesses, from the cities to the regions.

When the yen started to rise in the days after DPJ’s election victory, politicians boasted how this would strengthen domestic purchasing power for consumers. Well, it does, but it also hurts exports. Japan is traditionally one of the world’s best exporters and has the world’s worst consumers. While it is laudable that a government wants to strengthen consumer’s purchasing power, the question is whether the government truly has the willpower to pursue this policy.

From what we can see, the government stayed on course for about a week. When it comes to analyzing developing countries’ currencies, what makes our job traditionally quite easy is how predictable policy makers are. Not so in Japan. The new Japanese government has an array of ideas, but – in our humble opinion – not a clue of what they are getting themselves into. Since the election, the government has

• stated a strong yen is in Japan’s interest;
• stated the exchange rate should be set by market forces;
• denied it said it wants to have a strong yen; and
• threatened to intervene should the yen hurt the economy.

All of this within less than two weeks; so much for consistency of policies. Why do we care about the attitude of politicians with regard to the exchange rate? Because it is a great deal easier to weaken a currency through intervention than to strengthen it.

In the meantime, the markets are not waiting until the new government makes up its mind. One of the consequences of a less predictable policy environment is that speculators are staying away from funding their bets using yen. Commonly referred to as the carry trade, speculators have in the past borrowed money cheaply in yen, then sold the yen to buy higher yielding assets elsewhere. As the credit crisis erupted, the carry trade was largely unwound, causing the yen to rise. Thinking about it another way, the Japanese are one of the largest international investors, and when they got spooked and wanted to hide all their hard-earned cash under the mattress like everyone else, where did they get there money from? Well, they had to pull it out of international markets and back into the yen, putting upward pressure on the yen in the process.

However, now as the world is once again awash in money, the yen is no longer the preferred funding currency for speculators. Instead, the U.S. dollar seems to be taking its place. Given that U.S. policies seem more predictable – a determination to print and spend money, as well as a commitment to keep interest rates low for a considerable time – speculators have more confidence to borrow cheaply in U.S. dollars, and then sell those U.S. dollars to buy higher yielding assets elsewhere.

On a short-term basis, the yen may have benefited from the hope that the new government will help induce domestic economic growth, while reducing the risk of currency intervention. After all, it is marginal demand that pushes a currency higher or lower. To round out factors affecting the yen in the short-term, Japan has also allowed the tax-free repatriation of profits earned abroad by corporations, giving the yen a short-term, but non-lasting boost.

What do we make of all of this? While the new Japanese government is settling in, aside from some short-term profit taking, the yen may continue to benefit despite a continued downward economic spiral. However, the yen may be becoming an increasingly risky proposition because of the unpredictability of Japanese policies and potential Bank of Japan intervention. The yen is likely to continue to be considered a safe haven during times of crisis. And while that’s a topic for a different analysis, we do not think the global financial crisis is over and there may be funding issues in the weeks and months ahead. In case you are not confused, you have not paid attention. But that’s the nature of trying to understand the dynamics in Japan and that’s why Goldman Sachs suggests the yen should be trading closer to 200 to the dollar, while we would not be surprised if the yen strengthened to 85 or even 80 should market forces be allowed to play out. Instead, we can be assured that policy makers will do their best to keep everyone confused – including themselves. The result is likely to be an array of policies that may ultimately be very expensive.

The good news is that other regions in the world are – in our assessment – far more predictable.

By Axel Merk
www.merkfunds.com

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

The other thing to come out of Pittsburgh was a consensus that banks should be more careful with everyone’s money. All well and good, but what does it mean in practice? No one knows yet. The implication is that banks should be required to hold more capital, but how much and where it will come from has yet to be determined. Agreement will not come easily; certain European banks are, if possible, in even worse shape than those headquartered in New York. Leaders of nations with weak banks will be under pressure to minimize any new regulations. The group also agreed to enhance the role of the International Monetary Fund, launching a wave of new conspiracy theories that don’t sound nearly as far-fetched as they would have a year or two ago.

Even if the G-20 were inclined toward less talk and more action, their ability to make a difference to the global economy is questionable at best. As noted above, they all remain subject to pressure from politically powerful bankers. Moreover, the economic forces unleashed in recent years will take time to run their course. Here in the U.S., the vexing and intertwined problems of unemployment and housing show no signs of improvement. Today’s ADP employment report showed more job losses than expected and is a bad omen for Friday’s official report. The Chicago Purchasing Manager’s Index fell in September, suggesting that recent gains in industrial activity are not sustainable. Available housing inventory is down, but reports suggest millions of homes are still being held off the market either by struggling workers or by former lenders who foreclosed and are now owners.

Why then, one might ask, did the S&P 500 just mark its second consecutive positive quarter? The answer is expectations. Having been proven frighteningly wrong in their previously bullish forecasts, analysts are overcompensating in the other direction now. Companies that lose money see their share prices rise when they turn out not to lose as much as Wall Street thought they would. This situation can last for longer than one might think. The number-crunchers are much less likely to be sanctioned for underestimating earnings than they are for overestimating. Nonetheless, the stock market’s bullish momentum is fragile and caution remains a good idea.

Bond yields fell slightly in the last week, with the ten-year Treasury rate holding above support in the 3.3% area. This helped the dollar stabilize a bit, though overall trends are still quite bearish for the greenback. Gold is still trying to punch through the old highs just above $1,000 and might just make it this time.

Sectors

No sectors escaped the stock market pullback of the last week. The leading sector, Materials, was among the hardest hit but so far is still hanging on to the top spot in our relative strength rankings. Financials kept the #2 spot despite more ominous predictions for banks. The defensive trio of Health Care, Consumer Staples, and Utilities held up better than the growth sectors but still occupy the bottom three spots on the list.

Styles

Micro Caps moved to the top of the list while Mega Caps stayed on the bottom. The Russell index we use as a micro cap benchmark has a median market cap of just $134 million and constitutes less than 3% of the U.S. equity market, making it difficult and costly to actually invest in the group. ETFs and mutual funds are the best way for most investors to access the micro cap niche.

International
Pacific Ex-Japan regained the top spot as Australia’s materials sector outperformed similar stocks elsewhere. The re-election of Angela Merkel’s government in Germany provided a one-day boost for local markets, not unlike what happened after Japan’s recent elections. The boost proved temporary and Japan is still on the bottom of the rankings. China weakened further, though much of the country is fixated on the 60th anniversary party the communist government is throwing for itself.

Ron Rowland
Invest With An Edge

Meanwhile back in Washington, the Federal Reserve’s Open Market Committee issued a similar statement, proclaiming that “Policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability!” (They forgot to include an exclamation mark, so we added one to the quote.) Exactly what this means is not entirely clear. The financial markets reacted favorably at first, with the S&P 500 climbing to its highest point in almost a year, before retreating in the final hour.

CNBC appears, with its usual impeccable timing, to be preparing for another celebration of Dow 10,000. The first such observance was on March 29, 1999, more than ten years ago. Major benchmarks have strong upward momentum despite widespread pessimism among the proletariat. How can this be? The answer, we suspect, is that new government spending is offsetting the consumer slowdown. The impact is not uniform throughout the economy, however, and cannot be sustained indefinitely. Favored names in favored sectors (that’s you, bankers) are reaping an outsized share of the rewards. The problem with this is that greed and incompetence, having been rewarded and subsidized, will eventually create another crisis which will not be so easily resolved. For now, though, most indicators are pointing higher. This is no time to fight the tape.

Treasury rates seemed to stall out the last two weeks in the 3.40-3.50% range on the ten-year notes. Yields dropped to the lower end of the range following today’s FOMC announcement, driving the U.S. dollar down as well. Gold is still hovering around long-term resistance in the $1,000 range. The FOMC seems unconcerned about inflation and said it will likely keep rates low for an extended period. Given their record, this may mean inflation is exactly what we should fear most. Without a breakout in gold, however, we suspect the Fed has it right for now.

Sectors

The Materials sector had another good week and held on to its top spot in the rankings. This happened despite weakness in the commodity markets – proof that positive long-term correlation is not always dependable in the short run. Financials moved back up to #2 as a strong showing by brokers, real estate, and insurance offset weakness in regional banks. Health Care was the only sector to lose momentum this week as investors continued to exit the traditionally defensive stocks in favor of more growth-oriented sectors.

Styles

Gains in the Style categories were inverse to their capitalization this past week. Micro Caps made the strongest advance in terms of return, momentum gains and ranking improvement. Small caps also performed well, outpacing the S&P 500 by more than 1%. Mega Cap is still on the bottom, and the large cap categories are not much better.

International
The EU stayed on top, helped by strength in the Euro versus the U.S. dollar. Pacific Ex-Japan (which is to say, Australia) was behind by a whisker and could take first place soon. An upgrade of Brazil’s sovereign debt by Moody’s (Fitch and S&P had previously made that upgrade) helped Latin America climb to third on the list. The U.K. lost momentum; remarkably, the pound is actually weaker than the greenback right now. Japan continued to sink as euphoria surrounding elections faded.

Ron Rowland
Invest With An Edge

The forces of deflation are temporarily receding; and in the meantime, the forces of inflation threaten to roar back with a vengeance.

They are everywhere. They could be overwhelming. They must NOT be ignored …

Inflationary Force #1
Never-Ending, Out-of-Control
U.S. Federal Deficits

As Larry Edelson explained here one week ago:

• Through August, the federal deficit hit $1.38 trillion, or three times last year’s all-time record deficit of $454.8 billion. And in September alone, the administration expects another $200 billion in red ink, bringing the total for the year to $1.58 trillion.

• The U.S. government’s official debt is now at an all-time high of $11.8 trillion, or over $100,000 for each and every household in America.

• Both the administration and its opponents agree that, over the next 10 years, the cumulative federal deficit will be another $9 trillion, driving the burden per household up to $177,000.

• The Federal Reserve is also in hock up to its eyeballs, with more than $2 trillion in liabilities on its balance sheet. That brings the total burden up to $194,000 per household.

• Perhaps worst of all, the government’s unfunded obligations for Social Security, Medicare, and Federal pension payments are also ballooning higher and now stand at an estimated $104 trillion, or $886,000 per household.

Total burden per household: More than $1 million!

This is, by far, the largest federal deficit in U.S. history — in proportion to household income … in comparison to the nation’s population … or even as a percent of the total economy (other than during major World Wars).

It drives the Fed to print money without restraint. It pumps up demand for scarce goods. And in the months ahead, it’s bound to be the single most powerful pressure point on public policy, financial markets, the U.S. dollar and … inflation.

Inflationary Force #2
New Lows in the U.S. Dollar

Last week, the U.S. dollar sunk to a new, one-year low against a basket of major currencies.

It’s just five points away from its lowest level in history.

And, as Mike Larson detailed this past Friday, the U.S. dollar is now being driven lower by a new, unprecedented factor:

For the first time since 1933, it is now cheaper to borrow dollars than Japanese yen. Indeed, the three-month London Interbank Offered Rate (LIBOR) on the U.S. dollar has slumped to a meager 0.292 percent, while the equivalent rate on the Japanese yen is 0.352 percent.

This means that, instead of using Japanese yen to finance the carry trade — borrowing low-cost money to buy high-yielding investments — international investors will now start using U.S. dollars to finance the carry trade.

It means that, instead of the dollar being a magnet for frightened money, it is becoming precisely the opposite — a source of financing for the risk trade.

Most important, it means that, instead of buying dollars, they have every incentive to borrow dollars and promptly SELL them in order to purchase the higher yielding instruments.

End result: More momentum to the dollar’s decline.

Inflationary Force #3
U.S. Household Wealth
Now Expanding Again

For nearly two years, U.S. households were continually losing wealth. They lost trillions in stocks, bonds, insurance policies, real estate. And these losses, in turn, emerged as a major deflationary force, driving consumer price inflation to zero or lower.

Now, however, in the second quarter of 2009, that trend has reversed.

According to the Fed’s Flow of Funds released just last week, in just the last three months, U.S. households have enjoyed wealth gains of

• $1.1 trillion common and preferred stocks

• $494 billion in mutual funds

• $157 billion in real estate

These gains are still far from enough to recoup the peak asset levels of 2007. But the change in trend is enough to rekindle inflation, and that inflation is likely to take most economists by surprise.

Inflationary Force #4
Exploding U.S. Money Supply

Money pouring into the economy and chasing scarce goods is the classic cause of inflation.

But throughout 2007 and much of 2008, there was no growth whatsoever in U.S. money supply (M1).

During that period, despite the Fed’s efforts to shove interest rates down to practically zero, the total amount of money outstanding remained under $1.4 trillion — another deflationary force.

Now, however, as you can see in this chart provided by www.Shadowstats.com, the outlook has changed dramatically:

Since mid-2008, money supply has exploded beyond $1.65 trillion, with more rapid growth on the way.

Is Deflation Dead?

No. It will return.

But at this juncture, inflation is the primary concern, with far-reaching consequences on how you invest, when and where.

In the days ahead, my team and I will give you step-by-step instructions on how to protect yourself — and profit.

But first, I want to clear up a few basic points. Although we may sometimes disagree on the specific timing and magnitude of particular market moves, we are unanimous in our views about a few fundamental issues:

First, until and unless there is a dramatic change in these inflationary forces, it should be clear that the U.S. dollar’s decline will accelerate in the months ahead.

Second, despite its decline, the U.S. dollar will continue to be a viable, widely traded currency. It will not, as some seem to fear, simply disappear from the face of the earth.

Third, it is both impractical and unreasonable to abandon U.S. Treasury bills and other conservative dollar-denominated investments. They continue to provide U.S. citizens and residents the best safety and liquidity in the world today.

Fourth, the best way to protect yourself from a falling dollar is with contra-dollar investments such as precious metals, natural resources and assets tied to strong foreign currencies.

Martin D. Weiss, Ph.D.
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

The Chinese supply about 19 percent of the U.S. tire market. And the Obama administration just slapped a 35 percent tariff on those imports!

This isn’t a one-off incident. When global leaders met last April in London for the G-20 meeting, they addressed the “critical importance of rejecting protectionism.” But their actions have spoken louder than their words …

The recent World Trade Report from the World Trade Organization shows that, since the global economy took a nosedive, protectionism is on the rise with a sharp increase in new trade restrictions reported to the WTO.

Since April, when the G-20 last vowed to avoid such measures, 91 new protectionist initiations have been reported against G-20 member countries!

Protectionism is a natural response in recessions. When jobs are tight the perception by most workers toward globalization becomes more negative. And studies show that during these times, the number of people who favor the idea of higher tariffs on imported goods increases considerably.

The Chinese have retaliated against Obama’s 35% tariff on tires.

So politics play a huge role …

Commenting on the new tire tariff, the president of the United Steelworkers union said … “The President is enforcing our trade rules, and by standing up to China, is standing up for us.”

But protectionism has historically put weak economies in a deeper and more prolonged crisis.

A Glimpse at the Track Record
Of Protectionism …

What is said to be one of greatest mistakes made during the Great Depression was the Smoot-Hawley Act. Weakening U.S. labor markets in 1927 and 1928 motivated an American senator and a congressman to push for tariff increases across nearly 20,000 imported goods.

Hawley and Smoot’s legislation intensified nationalism throughout the world.

The heated discussions started in 1929, prior to the stock market crash. And by 1930, U.S. lawmakers had put tariffs on practically everything they could. What followed were a depression and three recessions over the course of two decades.

Meanwhile, investors who bought at the top of the U.S. stock market in 1929, were underwater for the next 25 years!

So what makes protectionism so dangerous?

Simply put: It brings about retaliation. Other countries tend to take similar action, further choking off global trading activity.

For example, China responded to the new tire tariff by launching a probe into alleged “dumping” practices of American automotive and chicken products. Dumping is when exporters sell a product for less than charged, or can be produced, in its home market.

Global Trade Already in Collapse …

Global trade has fallen off a cliff. And economies cannot afford to let the situation worsen.

The chart below shows the current fall in global trade (the red line) relative to the drop during the Great Depression (the blue line).

As you can see, despite the improvements in economies and the vast improvements in sentiment, global trade remains on a sharper sloping decline than it did in the Great Depression.

Another Pledge from G-20 Leaders:
Avoid Competitive Devaluations

Exports are typically a key tool in leading countries out of recession. And in typical run-of-the-mill recessions, countries can weaken their currencies to improve the competitiveness of their exports.

But in a global recession, currency devaluations have a viral effect. Just like with trade restrictions, if some countries devalue their currencies, others will follow suit.

And with the aggressive rise in many currencies against the dollar over the past six months, the pressure to curb currency strength is growing — which means central banks are dealing with a threatening situation.

A strong currency can hurt countries that depend on exports.

A strong currency can derail fragile recoveries, particularly for those countries with highly export-centric economies. Strong currencies undermine the easy money policies central banks have enacted, and they make exports more expensive and less competitive on a global stage. Alternatively, competitive devaluations could fuel unrest and retaliatory moves by other countries, which could damage a weak recovery.

The bottom line is that global economies are walking on a high wire toward recovery. And the threats that could quickly prompt a fall back into recession are numerous.

Could protectionism be that catalyst that sets the global economic recession into round two? Next week, leaders around the world will meet in Pittsburgh for another G-20 meeting. And you can bet that protectionism and currencies will be a hot topic.

Regards,

Bryan Rich
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

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But back to China. How could China affect the price of gold? We live in China and spend a lot of time with local industry leaders and policy makers. We hear repeatedly that the time has come to think seriously about how to survive the perceived dollar devaluation. In some cases we note serious concern, and in other cases absolute dread over a perceived dollar crash. Over the past six months Beijing has made a series of moves to protect itself against a dollar devaluation.

In a recent "BRIC Summit" in Russia several months ago, Chinese leaders came out strongly in favor of a new reserve currency to replace the dollar (including the IMF’s "SDR" currency). China is also quietly purchasing mining assets and gold bullion. But the government has recently gone further.

According to Financial Sense: As recently as 2002, the private ownership of gold was prohibited in China. You could be jailed if caught with any in your possession. Beginning in 2009, in a stunning about-face, the central government removed all restrictions. In fact, as Mineweb and other sources report now it is actively pushing folks to buy some personal metal, with China’s Central Television, the main state-owned television company, running news programs cum infomercials, letting the public know just how easy it is to purchase gold and silver as an investment.

My comment: I have been writing for years that China was going to eventually spit out the US dollar. It has been obvious for over a year that China has basically been buying any hard asset it can get its hands on and divest itself of increasingly worthless US dollars. The government actually actively encouraging citizens to buy gold and silver and setting up state retail gold shops and doing infomercials also bodes well for the emergence of a mania stage in precious metals. There is one thing that Chinese investors like and that is a market moving higher.

John Polomny
The Real Deal

Labor Day weekend opened on Friday with the unwelcome news that the U.S. unemployment rate had risen to 9.7%, the highest since 1983. Lest anyone forget, it was only 7.2% as recently as December 2008. Both these figures understate the employment problem: the broader “U-6” measure that includes those who have given up looking for work and those who are working part-time for economic reasons is now 16.8%. Add to that the unknown but very large number of workers who have taken involuntary furloughs, pay cuts and reduced hours, and the total percentage of unemployed and under-employed workers is almost certainly more than 20%. In some regions it is much higher. These are the customers of corporate America, whose spending is supposed to restore prosperity. Forgive us for being skeptical.

The stock market seems not to believe any of the above. A strong rally over the last week brought the S&P 500 back over 1000 and near the August high. Some pundits are calling today the six-month anniversary of the new bull market. Bears remind us that next week marks the one-year anniversary of the Lehman Brothers collapse, also known as the straw that broke the financial bubble’s back. The S&P 500 needs to gain 22% from here in order to regain its pre-Lehman value and more than 50% to make a new high. However you choose to define it, a new bull market for many will require overcoming the losses.

As noted above, the dollar is breaking lower. Meanwhile, and not coincidentally, interest rates are bouncing higher. The ten-year Treasury yield dropped as low as 3.29% last week and traded today above 3.53%. Chinese officials are again making noise about the dwindling value of their dollar holdings and threatening to take their business elsewhere. Actually it was more than a threat – the Chinese Ministry of Finance said on Tuesday it would issue 6 billion yuan worth of government bonds in Hong Kong. This was the monetary equivalent of a shot across the bow; the amount was too small to have an impact but the message was clear. Whether China truly has any better alternatives for its excess reserves is known only to them. They may simply be maneuvering for a better yield. If so, they’re getting it.

Sectors

The Sector categories normally move in unison, directionally if not in magnitude. This week was an exception. Three sectors showed a decrease in momentum, one made a strong increase, and the others had a small increase. Materials was the big gainer, jumping 13 points and taking over the top spot. The Financial sector was the big loser, but its previously large lead allowed it to fall only to second place. The other losers were the classic defensive sectors of Health Care and Utilities. We are watching closely to see which sectors are first to hit new 52-week highs, something that could start happening by the end of this month. Technology is probably the leading contender at this point.

Styles

Last week our Style categories had momentum scores ranging from 30 to 51. This week the range is 30 to 50. Not much changed despite a significant dip and rally in the broad market benchmarks. Mid Caps occupy three of the top four spots with Mid Cap Value hanging on to first place. The Small Cap and Large Cap categories are spread through the bottom two-thirds of the table.

International

The momentum of the U.S. market was almost unchanged for the one-week period, though the sharp fall and then rise left some traders with whiplash. The weakened dollar and strong gains in overseas markets made the U.S. fall considerably in relative strength, however. Pacific ex-Japan held on to the top spot while China’s latest surge lifted it out of last place. Other emerging markets also performed well. Japan slipped to last place, the only global region to actually lose momentum this past week. Election results in Japan have the potential to create some action, but as yet we see no big changes.

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

Ron Rowland
Invest With An Edge

Cheng Siwei, former vice-chairman of the Standing Committee and now head of China’s green energy drive, said Beijing was dismayed by the Fed’s recourse to "credit easing".

"We hope there will be a change in monetary policy as soon as they have positive growth again," he said at the Ambrosetti Workshop, a policy gathering on Lake Como.

"If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies," he said.

"Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets," he added.

The comments suggest that China has become the driving force in the gold market and can be counted on to buy whenever there is a price dip, putting a floor under any correction.

My comment: This is a great article and you can see from the comments by the candid comments by the Chinese official that they are not happy with US monetary policy. I have been saying for years that China was going to dump it’s dollars and buy whatever hard assets it could get its hands on. The Chinese are now the worlds largest gold miners and I can just about guarantee that none of the gold mined in China makes it to world markets. The government buys it all as it is a race to get out of paper before the US government completely craters the dollar. If you think gold at $1000 per ounce is fun just wait.

John Polomny
The Real Deal

After spending three days visiting the restive eastern province of Zhejiang, Premier Wen Jiabao argued for maintaining the loose economic policies implemented under the stimulus program, saying it’s too soon to be “blindly optimistic,” according to a statement by the State Council.

His remarks are likely to fuel an ongoing debate between government officials over whether it’s time to rein in bank lending.

After the government called on Chinese banks to provide increased liquidity to the economy, they lent about $1.08 trillion (7.37 trillion yuan) in the first half of the year – almost 50% over the government’s target of $732 billion (5 trillion yuan), and nearly double the total loans extended throughout all of 2008.

Most analysts credit the stimulus program for China’s economic rebound, as GDP expanded by 7.9% in the second quarter, up from 6.1% in the first quarter. But now some officials have voiced concerns that asset bubbles and non-performing loans could threaten a long-term economic recovery.

Last week, Chinese Legislator Yin Zhongqing called for limiting new loans to 10 trillion yuan for the full year, according to the Wall Street Journal.

The benchmark Shanghai Composite Index (SSE) is down 15% this month, amid fears that the government will move to tighten bank lending in the second half of the year to throw a wet blanket on the economy. The SSE, Chinas’ benchmark index, zoomed 91% from Jan. 1 to Aug. 4, hitting a high of 3,478.01.

China’s cabinet yesterday (Wednesday) said it’s watching for signs of overcapacity in industries including steel and cement and will increase “guidance” in the coal, glass and power sectors.  It will also place new restrictions on stocks and bonds sold by companies in those industries.

And continuing another trend, the People’s Bank of China last week in an internal memorandum notified its branches to curtail lending for the remainder of the year.  Other Chinese banks, including the Industrial & Commercial Bank of China (ICBC) and China Construction Bank (CBC), have also curbed lending in recent months, Reuters reported, citing anonymous sources.

The Chinese bi-monthly Caijing reported that with the new ceilings in place, ICBC has already lent 83% of its full-year new lending total, while CCB has lent 79%.

Other bankers reported that liquidity appears to be drying up and that loan approvals are taking longer than normal.

“It takes more time to process credit approval from Beijing headquarters now, and the pricing for onshore deals has been heading north in recent months, particularly for U.S. dollar deals,”a banker familiar with the process told Reuters.

And while the going rate for loans to top-tier multinational companies in the first half of the year were made at a margin of 150 basis points above the London Interbank Offered Rate (LIBOR), margins have now soared to over 200 basis points, according to the same banker.

Still, Beijing is unlikely to pull back from the massive stimulus program and the resulting liquidity that has bolstered the world’s third-biggest economy.  Even with the slowdown, analysts still expect total lending to exceed $1.5 trillion ($10 trillion yuan) this year.

And Premier Wen has called on policymakers to maintain “moderately loose” monetary policy and “active” fiscal policy.

That means the Chinese economy will remain flush with liquidity for the foreseeable future. And just to be on the safe side, the China’s State Council has issued a directive to banks to provide more loans to smaller firms.

“We will give appropriate subsidies to financial institutions to support them in extending loans to small companies,” the council said following a regular weekly meeting.

It also will extend measures to reduce the social security contributions paid by smaller firms that are facing difficulties and will increase tax support and direct government funding for them.

“This is tightening but it’s not a total shutdown,” Ken Peng, an economist with Citigroup Inc. (NYSE: C) in Beijing told Bloomberg News. “Policy hasn’t reversed but they are contemplating moves that have a lesser impact on the broader economy.”

By Don Miller
Money Morning

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The SSE, Chinas’ benchmark index, zoomed 91% from the start of the year to Aug. 4, hitting a high of 3,478.01. Even with the recent pullback it remains up about 67% from last year’s low of 1,664.93.

Since Aug. 4, however, the SSE has slumped 19.8%, including a 4.3% drop yesterday (Wednesday) to close at 2,785.58. Contributing to the market’s decline has been a sharp drop in lending, concern about an imminent possible tightening of credit, a strain from an increase in initial stock offerings, and the failure by Beijing to take action to put a floor under China’s stock prices. But the biggest reason for the drop has almost certainly been profit taking.

“There are any number of rumors and reasons for why the China markets have been falling,” Peter Lai, a director with DBS Vickers Securities, told Reuters. “But ultimately, those are all excuses for investors to take profit on the big rally this year.”

To be sure, investor panic over tighter lending and Beijing’s reluctance to throw the stock market a lifeline have contributed to the decline, but they – like the profit-taking that has driven the downward spiral – is likely to be short term in nature. And while the correction probably has more room to run, Asian analysts believe there’s good reason to believe that this bear-market swoon will turn back into a bull-market rally before October, due to a looming national day of observance.

To begin with, the Shanghai index is historically volatile. Shanghai Class A have in the past traded as low as 10 times earnings and as high as 60 times earnings. They’re currently about 25 times their projected 2009 earnings, which suggests there is still room to fall, but a much greater potential for a rally.

“The Chinese market is very trend-oriented because there are many individual investors,” Philippe Zhang, chief investment officer at AXA SPDB Investment Managers in Shanghai, told Bloomberg. “It can rally very quickly and go down strongly as well.”

And, as stated earlier, there are some very good reasons why investors chose now to take a breather – beginning with lending.

New bank lending plunged to $52 billion (355.9 billion yuan) in July from $220 billion (1.53 trillion yuan) – a 77% drop. However, that drop was largely expected as China’s $585 billion stimulus package and lax lending policy helped pave the way for growth in the first half of the year.

Chinese banks lent about $1.08 trillion (7.37 trillion yuan) in the first half of the year, nearly double the total loans extended throughout all of 2008. Even with the slowdown, analysts still expect total lending to exceed $1.5 trillion ($10 trillion yuan) this year.

That means the Chinese economy will remain flush with liquidity for the foreseeable future. And just to be on the safe side, the China’s State Council has issued a directive to banks to provide more loans to smaller firms.

“We will give appropriate subsidies to financial institutions to support them in extending loans to small companies,” the council said following a regular weekly meeting.

It also will extend measures to reduce the social security contributions paid by smaller firms that are facing difficulties and will increase tax support and direct government funding for them.

“The slowdown in new lending is an excuse for investors to exit a market that’s risen too fast and gotten too expensive,” AXA SPDB’s Zhang told Bloomberg.

Another reason Chinese stocks have slipped is that the government hasn’t stepped in to put a floor under prices.

“Investors are disappointed that regulators failed to take any concrete steps to support the market, while sentiment is extremely shaky after the market’s tumble over the past two weeks,” analyst Chen Huiqin at Huatai Securities Co. Ltd. in Nanjing told Reuters.

But that could change – and soon – due to the looming observance of the 60th anniversary of the Chinese Communist Party’s rule. That celebration is scheduled for Oct. 1.

Jing Ulrich, head of China equities and commodities at JPMorgan Chase & Co. (NYSE: JPM), said that “in the event of future correction, the Chinese authorities will be prepared to put a floor under the stock prices.” That support could include an elimination of taxes on stock transactions and a slowdown of measures that are designed to absorb excess liquidity.

“Liquidity conditions will remain favorable, as authorities may accelerate mutual fund approvals and insurance and pension funds could step up their equity purchases,” she said. “We believe the ‘A’ share market will resume its upward trajectory after this period of correction.”

If the market doesn’t stabilize quickly enough, or if government measures don’t have the desired impact on the market’s momentum, then the Communist Party may be prompted to more direct action as its 60th anniversary approaches. In fact, the approach of the anniversary alone could trigger a rally by spurring a shift in public sentiment.

“The widespread belief that Beijing doesn’t want the markets to fall before Oct. 1 will become a self-fulfilling prophecy,” Guoyuan Securities Co. Ltd. strategist Simon Wang told The Wall Street Journal.

Wang pegs support for the SSE at 2,600 – which is about 7% below yesterday’s close, and which would represent a total decline of 25% from the Aug. 4 peak.

By Jason Simpkins
Money Morning

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The guy who made this video is a hedge fund manager and in the video he shows several buildings in China that are worth hundreds of millions of dollars with no tenants. This is what happens in a credit fueled bubble as misallocations of capital take place. China will be heading for a fall when the credit bubble pops. I will be using the Proshares China Ultra Short Fund (FXP) on the NYSE to trade this. This is a dangerous trade because credit fueled bubbles can go on for sometime and if you are wrong on the timing you can take serious losses. The Chinese market has been down severely over the last few weeks. I will wait for a relief rally and if it fails without breaking the previous top then I will get short. This fund gives you 200% the move of the index. For example, if the the index falls 2% this fund will go up 4%. The recent rally in China was based on a 28.5% increase in money supply which fueled speculation. Credit is now being withdrawn so the market is crashing.

John Polomny
The Real Deal

Here in the United States, at a cost of a mere $3 billion, the “Cash-for-Clunkers” program appears to have given new hope to the U.S. auto industry.

But that new hope is destined to be short-lived.

It’s true that – in terms of value delivered for the money invested – “Cash for Clunkers” has eclipsed every other stimulus program that has been tried. But the program has a projected lifespan of only three months, meaning it can’t reverse the powerful global forces that are destined to turn the U.S. auto market from leader to laggard on the global stage.

Financial Crisis Fallout Reshapes Sector

Thanks to the financial crisis whose impact continues to be felt, worldwide automobile demand had dropped on an overall basis since 2008.

But regional differences are already emerging.

In the United States, for instance, the benchmark seasonally adjusted annual sales rate (SAAR) finally jumped up past the 11-million mark in July after failing to eclipse the “breakeven point” of 10 million vehicles in any prior month this year. But the actual year-to-date sales of 5.81 million vehicles through July was still 33% below the 8.55 million that had been sold by that point in 2008, and is 67% below the all-time annual record of 17.4 million achieved in 2000 and 65% below the decade average of 16.4 million.

(Prior to the global financial crisis and accompanying recession – which prompted the U.S. auto industry to restructure and shift its breakeven point down to 10 million vehicles – the breakeven point was actually 16 million vehicle sales in a year. Below that point, several or all of the U.S. “Big Three” would be spinning their wheels in red ink.)

It’s a much different story abroad, however, where several markets are in a long-term growth mode. In India, for example, sales were up 31% on a year-over-year basis, while auto sales in China were an astonishing 70% above those of a year ago. Even if U.S. auto sales continue to improve, China’s automobile market may outsell its U.S. counterpart for a full year for the first time ever.

Granted, India’s auto market – around 2.5 million cars and light trucks a year – is still much smaller than either China or the United States. However, its growth makes it comparable to the Japanese or German markets, the next largest automobile markets after its U.S. and China counterparts.

Thus, global automobile sales are undergoing a major reorientation towards Asia and away from the United States and Europe. This will inevitably have a huge effect on the structure of the sector.

That’s why Asia will become the new Detroit – the future center of the automaking world.

Gone For Good?

In the United States, General Motors Corp. and Chrysler Group LLC have lost market share because of the government takeover. They are unlikely to get it back in spite of the debt costs they have relinquished through bankruptcy.

For Chrysler, the partnership with Fiat SpA (OTC ADR: FIATY) is unlikely to help much. Fiat is among the weakest of the European companies, and has not been competitive in the United States since the 1980s. The U.S. market is undoubtedly moving toward smaller automobiles. That trend is being “fueled” by the new Corporate Average Fuel Economy (CAFE) standards for 2015 and probably by higher fuel taxes for environmental and budget reasons. Nevertheless, it seems unlikely that the Chrysler/Fiat partnership will have the models to compete.

General Motors has the model range to compete in the United States. However, GM is doing much better in China, thanks largely to its joint venture with Shanghai Automotive Industry Corp., which expects to sell 1.4 million vehicles in 2009. Since GM is also selling Opel, its European operation, GM will find itself driven primarily by the demands of the Chinese market. Given the growth of that market, it will probably make the most economic sense for GM to become Chinese-owned. Politics may delay this, but probably only for a few years.

The United States’ One “Better Idea”

Ford Motor Co. (NYSE: F) has picked up market share in the United States from GM and Chrysler’s problems. It should benefit both from "Cash for Clunkers," and from the early stages of the U.S. market recovery. If GM and Chrysler continue to have difficulties, Ford may be in a good position here in the large U.S. market – as the most-effective manufacturer of the large automobiles that Americans continue to prefer – no matter what the government tells Ford to do.

Nor is that Ford’s only competitive advantage going forward. Ford Europe is big and viable enough to allow Ford to remain credible as a producer of smaller cars, primarily in the higher price brackets.

Outside the United States, European manufacturers will find themselves increasingly confined to the luxury end of the market. However, as global incomes rise and the newly wealthy become brand-conscious – particularly in the emerging economies of Asia – that upscale portion of the auto market should continue to be strong.

Japanese and Korean manufacturers will continue to dominate their domestic markets. And such companies as Honda Motor Co. Ltd. (NYSE ADR: HMC), Toyota Motor Corp. (NYSE ADR: TM) and Kia Motors Corp., will also do well in the United States and Europe, and in countries where they have been able to establish viable local manufacturing operations, and lower labor costs.

But it will be the players from China and India who are destined to be the big market-share gainers on a global basis.

The New Leaders

For U.S. investors, India’s Tata Motors Ltd. (NYSE ADR: TTM) is the best known of the newly emerging global auto elite. Tata’s $2,500 for-the-masses “Nano" car has been well received. Over the long term, the Nano may expand the entry-level portion of the worldwide auto market, forcing other manufacturers to produce equivalent low-price models.

Indeed, the introduction of $2,500 cars may greatly expand the market’s size in India and other emerging markets, much as Ford’s Model T did after its introduction in 1908, or the Volkswagen AG (OTC ADR: VLKAY) VW Beetle did in the 1950s and 1960s.

Tata looked to be in financial difficulty after it bought the loss-making Jaguar and Land Rover brands in 2008 at the top of the market. However, the $300 million loan for its Jaguar Land Rover Unit announced on Aug. 10 gives Tata the room it needed to maneuver. Market growth in India, combined with the strength of its Tata Group parent now suggest that Tata Motors has the strength to survive without dismemberment.

The bottom line: Tata and its India-based competitors – Maruti Suzuki India Ltd. (Mumbai: MSIL) and Mahindra and Mahindra Ltd. (London: MHID) – as well as such top China carmakers as Chery Automobile Co. Ltd. (still publicly owned), Geely Automobile Holdings Ltd. (OTC: GELYF) and Great Wall Motor Co. (OTC: GWLLF), are thus the companies that will see most growth in the automotive market of the decade to come.

By 2020, the global auto sector will look nothing like it does today. Given that most of the muscle will be in Asia, investors shouldn’t be surprised.

By Martin Hutchinson
Money Morning

P.S. “No one can predict the market.” Right? Wrong!

But Obama’s high-speed rail initiative has gotten off to a sluggish start, while a much bigger, $300 billion plan to create the world’s largest and most sophisticated high-speed rail network is already rapidly unfolding in China.

“Railroads were always the pride of America, and stitched us together. Now Japan, China, all of Europe have high-speed rail systems that put ours to shame,” Obama said in April.

In a proposal called “A  Vision  for  High-Speed  Rail  in  America” Obama and the Federal Railroad Administration outlined a plan to develop 10 “potential” 100-600 mile corridors in the United States, “similar to how interstate highways and the U.S. aviation system were developed in the 20th century.”

Developing all 10 high-speed corridors could eliminate 6 billion pounds, or about 3 million tons, of greenhouse gas emissions each year, the FRA said.

But the plan was pitched as more than a way to make travel cleaner and more efficient. It was touted as a way of creating jobs. In April, when Obama gave his speech, the unemployment rate stood at 8.9%. It’s since risen to 9.4% in July and will likely test 10% by the end of the year. 

Meanwhile, the FRA has until 2012 to disperse the first $8 billion of the total $13 billion allocated to high-speed rail. And when that money is finally paid out, it’s more likely to go towards upgrading existing infrastructure than laying new high-speed rail.

"No one expects we are going to begin, let alone complete, the high-speed rail system with $8 billion," FRA spokesman Warren Flatau told CNNMoney. But the stimulus funds represent the "groundwork for a more sustainable program of funding in the future."

The remaining $5 billion has been included in the president’s budget over the next five years.

Already, it that amount seems to be woefully inadequate. Last month, more than 40 states submitted 278 pre-applications for stimulus-funded high-speed rail projects. The total amount of funds requested amounted to $102.5 billion in requests, according to CNN.

China Fast-Tracks High Speed Investment

High-speed rail may be on its way to the United States but it’s already arrived in China.

China introduced a 270mph maglev train service in March 2004 and regular high-speed train services in April 2007. But it’s not stopping there.

Beijing will spend $50 billion on high-speed rail this year alone, and the central government plans to spend another $250 billion over the next decade. By 2020, China will have laid nearly 16,000 miles of high-speed track capable of carrying the fastest trains on the planet. By comparison, America has just 457 miles of high-speed track.

And unlike in the United States, China’s high-speed railroad initiative is already producing jobs. So far, the construction of the Beijing-Shanghai high-speed route alone has created about 110,000 jobs and is playing an enormous part in China’s economic recovery.  

Spending on railways jumped 126.5% year-over-year in the first half of 2009, leading to a huge increase in the nation’s steel production at a time when global demand was decidedly weak. China’s crude steel output in July reached a record 50.68 million metric tons, up 12.6% compared with last year, according to figures from the National Bureau of Statistics.

There is no doubt that “the acceleration of [the massive railroad build-out is playing a key role in China’s recovery,” David Li, an economist at Beijing’s Tsinghua University told Fortune.

Liang Yi, the vice CEO of the China Railway Construction Co. (CRCC) subsidiary working on the Beijing-Shanghai route told Fortune that his company may hire up to 20,000 new university grads to meet the growing workload. Liang said his unit alone is absorbing 8,000 more workers this year than it did last.

Of course, that doesn’t mean Chinese companies are the only ones profiting from China’s railroad expansion.

International Business Machines Corp. (NYSE: IBM) won a contract to provide software for high-speed trains the Guangdong province. Also, IBM last month announced that it was opening a “Global Rail Innovation Center” in Beijing.

“In the next five years, China is investing more in high speed rail than the rest of the world combined,” Keith Dierkx, the director of this new center, told TheInfrastructurist.com. “This enormous build out of the HSR frees up their traditional rail network for freight. So, they’ll have more high-speed rail than the rest of the world combined–but they’ll also be getting better freight capacity.”

Canada’s Bombardier Inc., the world’s largest rail equipment manufacturer, also got in on China’s massive HSR initiative when it won a contract for work on 40 high-speed trains, as well as a signaling system.

Fortune estimates that foreign companies have won about $10 billion worth of contracts for work on China’s high-speed rail system.

Still, Money Morning Investment Director Keith Fitz-Gerald believes that the best way to capitalize on China’s massive rail build-out is by investing in Chinese companies that will have a long-term presence.

“There’s certainly hay to be made on high-speed rail development in the United States, but if you really want to capitalize on this trend you should look at China, which accounts for 25% of the world’s railroad traffic but has only 6% of the world’s rails,” Fitz-Gerald said. “To the extent that China builds high-speed rail, then effectively railroad companies across the country will benefit from increased traffic.”

In a recent Money Morning Webinar, Fitz-Gerald named Guangshen Railway Co. (NYSE ADR: GSH) as company that has good long-term prospects in China’s transportation sector.

“Guangshen is involved in high speed, it’s involved in capacity and it’s got relatively low debt,” said Fitz-Gerald. “It’s just another example of a Chinese company capitalizing on a huge infrastructure expansion that’s backed by billions of dollars in government investment.”

Guangshen’s 2008 operating revenue jumped 11.23% in 2008, in part because of HSR development.

By Jason Simpkins
Money Morning

A move higher in the dollar on good U.S. economic data might make perfect sense in most environments. But in this crisis environment, it’s unusual …

From the middle of 2008 until February 2009, the dollar had been the safe haven vehicle. But in March, when risk appetite came back into the market, the safe haven trade began to slowly unwind. That means, since March, good news for the economy has meant bad news for the dollar.

You can see it in the chart below of the British pound vs. the U.S. dollar. The pound dropped sharply (U.S. dollar rose) on risk aversion as investors fled to the dollar. Now the pound is riding higher on a wave of surging risk appetite.

Source: Bloomberg

Within this risk environment, the relationship between financial markets and risk has been abundantly clear: When risk appetite is high … stocks, commodities, interest rates and all currencies (except for the U.S. dollar) rally. When fear creeps back in, the dollar benefits, the U.S. Treasury market benefits and almost everything else goes south.

So, when last week’s employment report showed a lower unemployment rate and fewer jobs lost, the dollar should have taken a hit. But it didn’t. Instead, it rallied!

Well, one day doesn’t make a trend.

And after the markets digested a cautiously positive statement by the Fed this week on the economy, the resulting activity in the currencies spoke clearly: For the moment, it’s still all about risk appetite.

I do, however, expect a shift in market focus to take place in the near term, to accommodate this growing sentiment of recovery. I think that global capital will begin shifting toward those economies that are relative outperformers. And for 2009 and 2010, consensus estimates have the U.S. outperforming other major developed market economies.

What a Difference a Month Makes …

Last month, the IMF downgraded its forecast on the Eurozone, expecting the region’s economy to fall 4.8 percent in 2009. And for 2010, while all other economies are expected to grow, the Eurozone is expected to fall more.

Then Germany and France, the two largest economies in the Eurozone, shocked the market this week by posting actual growth for the second quarter!

The ECB recently upgraded its forecast for 2009 and 2010.

On top of that, central banks are now upgrading economic forecasts for 2009, a year that was first thought to be a complete disaster. And the 2010 numbers are being boosted even more.

In fact, the European Central Bank has now revised its expectations for 2009 and 2010: Expecting just a slight contraction in 2009 and growth in 2010.

But in a period where less bad is the new good, and economies have stopped free-falling and are now showing signs of improvement, the recovery story is about sustainability, not just data points.

Beware of Statistical Recoveries …

Let’s take a look at Germany, the world’s fourth-largest country and the world’s largest exporter. The second-quarter GDP number shows that the economy is out of recession. But other numbers tell a story that doesn’t look so convincing …

• Unemployment continues to rise,

• The work week has been shortened,

• Consumer prices have fallen for the first time in 22 years,

• Producer prices have declined at a rate not seen in 40 years,

• And retail sales continue to fall.

Source: Bloomberg

Germany’s all-important exports jumped in June, yet they were still down over 22 percent from the same period a year ago. And global demand, although ticking up in recent months, is now falling fast again. In just 10 days, the Baltic Dry Index, a good proxy for global demand, has tumbled 25 percent.

So is this recovery sustainable? Will 2011 be a return to normalcy or will recession return?

The IMF has published a study on similar recessions, those highly synchronized across global economies with the added element of financial crisis. The study concluded that they tend to be deeper and take a slower path to recovery than other recessions. These comparisons suggest that the global economy will bounce around the bottom for another two years or more.

In this risk-centric investment climate, what’s bad for the global economy has been good for the dollar, and there’s no reason to think that will change.

With that, I think the U.S. dollar will again regain its appeal. Meanwhile, as markets focus more and more on the near-term growth prospects for global economies, the dollar should begin to gain favor on a relative growth basis. It’s potentially a win-win scenario setting up for the dollar.

Regards,

Bryan Rich
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

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What is not being adequately discussed is the loss of rice production in India due to the failure of the monsoons. India, with more than 1.1 billion people, has a near dysfunctional system of providing water to agriculture. That ramifications of this dire situation are made more apparent when the monsoons fail. A significant portion of the Indian Agri-Food harvest will be lost this year due to the water situation. And note, rice and sugar are not produced in factories, but must be grown in a field. Once part of a crop is lost, it is permanently lost. Not till a year later will a new crop be available, unlike the production of a factory.

India will likely be forced to enter world grain markets to make up the shortfall in domestic production. Unfortunately, the global grain bins cannot supply unlimited amounts of grain at today’s prices. An important bottom, therefore, is being put in place in global grain prices.

Many do not understand that the global Agri-Food network is much like a Rubik’s Cube. A change of one block influences all sides of the cube. The same is true with global Agri-Foods.

My comment: This is something to follow in both the short and long term. In the short term the worst drought in India in 80 years is going to force India to enter the world grain market to buy sufficient grain for its people. India will buying into a market that is already at near record low inventories. Depending on what happens with harvests in the US and how much grain India buys I suspect grain prices may be going higher.

In the long term India has a serious water problem. The Indian government gives farmers free electricity to run irrigation pumps. As the water is essentially free the farmers have no incentive to conserve or use more sustainable irrigation techniques. Consequently they are pumping water from rapidly diminishing aquifers that have taken hundreds if not thousands of years to fill.

John Polomny
The Real Deal