Gold Rising on Insolvency Risk, not Inflation...

In one way, gold's surge to $1150 simply reflects the tidal wave of excess liquidity that is lifting all asset prices from US junk bonds to the most obscure emerging market indices. That unprecedented money supply growth, while largely insulated from the real economy thus far by excess reserve accumulation by commercial banks in most of the developed world, has nonetheless very directly buoyed financial assets. Central banks from the Fed to the BOE have gone into the markets and bid for government bonds and investment grade corporate paper with newly created 'virtual' money, and the cash finding its way into institutional balance sheets as a result is then being reinvested into riskier assets like equities and high yield debt. In China, the 29% annualized M2 growth has flushed directly through the banking system (where lending is only now slowing from an annualized rate over 30%) directly stimulating both the real and financial sectors. Constrained physical supply growth is another factor amid an underweight position at Asian central banks, which have built up vast piles of paper assets while allowing their share of gold to slide in recent years. India's IMF purchase, which was a key trigger for this latest rally, was inspired by this rebalancing, having seen gold drop to just 3.5% of total reserves. Gold has risen less dramatically in currencies other than the dollar, reaching its highest since late February in euro terms, since early March in GBP terms, and since early May when priced in the Australian dollar. It's still trading at about half it's all time high in real dollar terms back in the early 1980's.


Although CPI inflation remains subdued globally (and TIPS are currently implying 2.25% 10 year US inflation, hardly a hyperinflationary panic), investors have clear misgivings on the outlook. The key underlying concern, which is still only vaguely articulated but is keenly felt by many private investors, is that the $20trn in budget deficits that the CBO expects the US to accumulate over the next decade is simply untenable. That's particularly valid considering that many other nations from Japan to the UK are staring into a similar fiscal abyss, and once the current QE policies run their course in early 2010 the 'crowding out' effect of trying to fund these deficits with real investor demand may well precipitate a crisis, and at the least significantly higher long bond yields. It's notable that sovereign CDS spreads are rising again, Japan's having doubled in a month for instance. Gold as an asset offers better insolvency insurance than inflation protection.

 China became the world's biggest producer in 2007, and has retained that status since, but the PBoC's intentions in terms of its desired gold holding from the current 1.9% of reserves will be key. A rise to 5-6% following India's example would probably push gold another $200 higher, although it would likely be a gradual policy shift. Leading hedge funds such as David Einhorn's Greenlight Capital and John Paulson's Paulson & Co have been actively accumulating gold exposure all year (Einhorn via physical bullion and Paulson via several billion dollars invested in key producers). The general thesis among hedge fund investors is that monetary policy is now recklessly out of control, with soaring CPI inflation and interest rates the likely result over the next few years. Gold stocks have broadly lagged the bullion price move so far, despite average global cash production costs of $440 making the current move hugely profitable, especially as most have now removed forward hedges (Barrick being the last of the majors to do so). Key to gold's next move will be whether the dollar finds a near-term floor around current levels.  

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Healthcare Costs Devouring US Growth Prospects...

Total annualized US domestic savings have fallen from their peak of $2.2 trillion dollars in the third quarter of 2006 to just $1.4 trillion on the latest Fed data. That represents a drop from 16.2% of GDP to 10.2% in 3 years, and is the lowest level since 1934. I've discussed the ongoing crisis in US infrastructure investment previously, but including all investment, private and public, the current level at 14.7 percent of GDP barely covers depreciation (the calculated rate of capital consumption is 12.9 percent of GDP). Economics 101 teaches spotty faced teenagers that economic growth is a function of the growth in human and physical capital and the productivity of both as enhanced by technical innovation. A growing labor force, in the absence of rising per-capita capital formation and of innovation with a broad multiplier effect on productivity, results in the 17.5% broad unemployment that the US is now suffering. The contribution of private investment to GDP growth in this decade has been the lowest since the 1930s; on any measure, the US is barely maintaining its capital base.


There is a tendency among investors and financial analysts to apply a microscope to markets rather than zooming out with the telescope that gives crucial perspective. The stagnation of median real US incomes and steadily falling labor force participation rates have been evident thropughout this decade, and their economic impact on final demand and growth were disguised only by an historic accumulation of debt at all levels of the US economy. But even doping an economy with ever larger doses of leverage suffers diminishing returns, and indeed the ratio of debt applied to growth generated has risen from just over 2x 30 years ago to over 5x in the recent credit boom. In fact, if we consider that the share of residential construction in US GDP doubled from 3 to 6% during the housing boom (a classic example of the distorting effect of inflation on asset allocation), then the underlying investment picture is even worse. It's hard to argue that colonies of sprawling McMansions added productive capacity to the US economy. A key issue in recent years has been the exponential growth in healthcare costs, now eating up 18% of GDP, or over twice the levels in seen other advanced economies with similar health outcomes, from Canada to France.

This has had two adverse economic effects; firstly, it has raised the costs of employing US workers (up 17% in real terms this decade, almost all the growth being in benefits), while suppressing their take-home wages. Secondly, it has (like the outsized financial sector) diverted human and capital resources from more productive uses in the wider economy. The chart below is instructive, because it indicates that the consumption surge in recent years was driven less by a spendthrift rush to the malls than the soaring cost of health insurance for the average American family.

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US Shale Gas Challenges Oil...

There is only one energy source in the world right now with declining marginal production costs, soaring reserves and extraction rates, and compelling cost competitiveness with crude oil. Unsurprisingly, it has emerged not as the result of subsidized government 'green energy' initiatives, but from a handful of entrepreneurial small US exploration companies whose technical innovation has transformed the US gas market, to the extent that multi-billion dollar LNG import terminals built over the last decade lie unused as surging local supply has supplanted foreign. Could crude oil follow the fate of LNG imports, as the US slowly moves toward energy independence? Conceivably, if Washington stops wasting resources on hopelessly immature alternative energy technologies and focuses on rapidly transforming the country's truck and car fleet to natural gas in compressed form.


Mandated corn ethanol use has been one of the most ludicrous and wasteful policies to ever emanate from Washington, and that takes some doing. Not only is the energy return on investment marginal to negative (i.e. you use more fossil fuel energy in its production that you get back in biofuel energy) but it will act to boost food inflation globally. Solar and wind are not only hopelessly uncompetitive at much less than $200 oil, but without a revolution in large-scale energy storage and a digital transmission grid, their contribution will be marginal both to cutting carbon emissions and improving energy security. Gas has none of these issues, and its use in both power generation and as a vehicle fuel is based on proven and easily scalable technologies. There is a real urgency to a rational and coherent US energy policy, as non-OPEC production has failed to respond to soaring prices over the last 6 years, as seen in the chart below. Russian production now seems to be peaking, partly because of re-nationalization of key producers like Yukos. This underpins the secular rise in the real cost of oil, with discovery costs alone up from $4 to $24 in a decade, and the marginal production costs of key new discoveries at $70 plus.

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The Dollar Bear Trade is Dangerously Crowded...

A bearish frenzy has developed in the US dollar, and is probably the strongest consensus I've seen since the bullish stampede in oil futures crashed last Summer. With publicity hungry commentators from historian Niall Ferguson to journalists spinning lurid Chinese/Arab conspiracy theories weighing in with their economic insights, and hedge funds leveraging up aggressively again on the global carry trade using the dollar as a 'free' funding currency, it's time for a reality check. There is no alternative to the dollar as the global reserve currency for the foreseeable future; while the dollar's share of CB reserves has declined from 72% to just over 62% this decade, this is the result of the Euro's emergence, with the Yen still a paltry 3% of global forex holdings. Total dollar holdings have steadily risen, and even this year, China has continued to accumulate dollar assets, while grumbling about US economic policy. It will be at least a decade before Yuan convertibility is a real prospect, and only then if China can radically overhaul its financial markets in the meantime, developing deep capital markets and hedging mechanisms and gradually opening its capital account. At the moment, even in Hong Kong, less than 2% of trade is conducted in Yuan. As for that complex proposed IMF basket currency, which dollar bears offer as a real alternative, call me when a Colombian drug smuggler is caught with a suitcase full of the things.

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Japan: Who will Switch the Lights Off?

I wrote several times in 2008 on Japan's secular economic decline, determined by the developed world's worst demographic outlook. Over the next 20 years, the workforce will decline by 20%. Five years ago, the population was 127.7 million, today it marginally lower, but the composition has changed radically. In 2004, the population below the age of 15 was 17.7 million, the population aged 15 to 64 was 85.1 million and the population aged 65 and over was 24.9 million. Now, the population below the age of 15 has dropped 3.5% to 17.1 million, the population between 15 and 64 has dropped 4% to 81.6 million, while the number of people older than 65 has increased 16% to 28.9 million. This devastating trend is set to accelerate over the next decade, with the working age population declining by 0.9% a year, implying a major drawdown of Japan's savings mountain, with adverse implications for the Yen and JGB yields. The household savings rate relative to disposable income has fallen to 2% from 14% in the early 1990's at the beginning of Japan's long decline, while government debt will probably hit 200% of GDP by next year. The country's birthrate has plummeted since the 1950s and has been below replacement level (2.1 births per woman in developed countries) for decades.

Today it is at a mere 1.2 births. As a result, Japan now has the highest proportion of residents over the age of 65 (20%) in the world, and the health ministry estimates the country's population will decline by 25 percent by 2050 despite rising life spans; (Russia will be similarly depopulated over that period). At some point, the markets will realize that the Yen at sub 90 to the USD and 10 year bond yields at 1.3% are economic anomalies in the context of Japan's deteriorating economic fundamentals, and sell both aggressively.

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Australia Hikes Rates: Who's Next?

Don't expect to be crushed underfoot in the rush; while rate cuts were tightly co-ordinated to stem last year's systemic panic, their reversal will be piecemeal and grudging. The decision by the RBA to raise rates by 25bp, while hardly unexpected, underlines the resilience of the Australian economy throughout the credit crisis. I've long favoured the Australian and Canadian dollars as both countries enjoy growing resource wealth per-capita, a well regulated banking system, relatively strong fiscal balances, and substantial exposure to Asia, which has led the global rebound. Both have this week hit new one-year highs against the US dollar, reflecting not only anticipation of a widening yield premium (and yield differentials are now firmly back on the agenda for currency traders, as a period of unsustainably low global interest rates brought about by central bank efforts to offset the impact of the financial crisis starts to slowly reverse) but the huge carry trade now developing in the US currency. It's likely that Canada and Australia will be the fastest growing developed economies in 2010. Carry trade investors sell the low-yielding US currency to fund purchases of riskier, higher yielding assets such as commodity-linked currencies.

The overwhelming consensus is for further dollar weakness in the fourth quarter, but that may be badly misplaced given current extreme investor positioning, particularly against the Euro and Yen where anticipation of  widening yield differentials will offer little support. The RBA’s bullish stance stands in stark contrast to the Federal Reserve, which is expected to keep US interest rates on hold through most of 2010. Although Israel had already tightened last month, Australia is the first major economy to do so, and candidates for the next move include Norway, Singapore, South Korea and India over the next few months. Norwegian manufacturing production came in at its fastest pace in 16 months in August, support the thesis that the country’s economy has survived the worst of the current slowdown, although downside risk in oil prices this quarter amid a global supply glut may stay the bank's hand. New Zealand and Canada are other candidates for a rate hike, although officials in both countries have suggested that their sustained currency strength will delay any move, as it is proving drag on growth.

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America as Argentina?

With Hilary Clinton as Eva Peron singing 'Don't cry for me Obama'? One of the most remarkable economic reversals over the last decade has been the impressive macroeconomic discipline shown by leading emerging markets from Brazil to India, while developed nations such as the UK and US have become increasingly reckless and profligate. While the former have been steadily re-rated by investors leading to a huge secular bull market in emerging market equities and bonds, the latter have yet to pay the price for their growing fiscal irresponsability. Argentina's troubled history in recent decades leads many to forget just how prosperous and advanced the country was a century ago; in fact, it was one of the ten richest countries in the world on a per capita basis until the 1930's. Any analysis of the country's stunning decline into inflation and dictatorship a few decades later must begin with the role of an entrenched economic elite who pursued their narrow interests regardless of the national cost. Rather than investment bankers, Argentina had an elite of a few thousand landowners who equally dominated the economy via agricultural exports. The pursuit of naked self-interest by these 'oligarchs' led to an increasingly unbalanced economy that underinvested in education and infrastructure and was dominated by inefficient monopolies protected by political patrons. That effort to protect the status quo at all costs via a captive political system led to the failure of attempts to modernize the economy and income inequalities growing to a destabilizing extreme. Effectively Argentina metamorphosed from a productive to a rentier economy, with a small elite redistributing stagnant national wealth to their short-term advantage. Sound even vaguely familiar?


America's strongest remaining economic advantage has been its ability to reallocate capital and talent to the 'new thing', the innovative business models and technologies that can transform broader economic productivity and generate new wealth. That depends on both social mobility and an effective reallocation of capital and people from dying to rising industries, what Austrian economist Joseph Schumpeter termed 'creative destruction'. Regulatory and political capture by entrenched elites runs counter to both, and helps explain the unhealthy domination of the US economy by the finance and healthcare industries over the past decade, whose political lobbying and funding dwarfs any other sector. An economy riven by narrow vested interests seeking to direct public policy and profit from public funds becomes one saddled with perverse economic incentives that undermine the purging and renewal process that is central to capitalism.


The end result is secular decline, imperceptible at first, but eventually leading to a crisis of confidence in a nation's currency and its debt obligations. The Soviet Union began an irretrievable decline from the late 1960's, caused by slumping productivity as real energy costs soared but also political capture by the military-industrial elite, as Kremlin factions competing recklessly to divert resources to their political constituencies. At one stage in the 1970's, the USSR was simultaneously producing five different battle tanks from four different decades, simply because military lobbyists in Moscow could work the system to obtain funding. Every Soviet leader from Kruschev to Gorbachev attempted to control runaway military spending, but they were too weak to overcome entrenched interests until the whole shoddy edifice collapsed.

Where Argentina became dominated by absentee estate owners, and the USSR by military bureaucrats, America has allowed a massively disproportionate financial sector to effectively control public policy, a sector which despite its role in precipitating a systemic meltdown remains untamed. Competitiveness is in secular decline, as evidenced by the structural nature of the trade deficit; even in the depths of the current economic slump, it has remained stubbornly high at $25bn a month, and will likely revert to $40bn plus a month in a muted recovery or nearly 4% of GDP.



The US hasn't generated a trade surplus since the early 1990's recession, all the while since accumulating a mountain of foreign obligations. Now, as aggregate debt approaches 400% of GDP, the necessary deleveraging of the US consumer and financial sector has been postponed by massive government intervention. Total debt for the US financial sector was US$16.5 trillion in the second quarter 2009, almost identical to the level reported a year earlier. The apparent reduction in financial sector leverage (which reached over 30x for several investment banks) is due to a bigger capital base from equity issuance and a transfer of off-balance sheet liabilities into the public sector. The huge shadow banking system, comprising hedge funds and non-financial entities from GM to GE, remains intact if somewhat chastened.

Despite the asset reflation of recent months that has relieved the pressure on bank balance sheets and avoids the need to recognize huge residual losses (of over $1trn globally), regulatory reform has descended into the sad spectacle of posturing over bonus controls, missing the point that it is the obscene profitability of the financial sector (a tax on the wider economy) that drives that huge remuneration relative to other sectors. Until banks become subservient to the wider economy and regulated as the essential utilities they are, the US will continue to suffer a chronic misallocation of capital and talent and inexorable economic decline. Argentina never had the advantage of a global reserve currency, and that certainly postpones the inevitable adjustment, but only for so long.




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Deleveraging the Fed's Balance Sheet...

In recent days, it's being reported that the Fed is structuring a new securities reverse repo program with Wall Street money market funds, in the first practical sign of a policy 'exit strategy'. At some point soon, the Fed will be buying new securities by borrowing money from the dealers/funds rather than simply 'printing' fresh dollars as electronic accounting entries. The Fed will place its securities with the dealers as collateral when it borrows (although it may borrow against the existing securities as well). This will neutralize the liquidity impact of further security purchases ie tighten policy without hiking official rates.

It's almost Chinese in its subtlety, but reflects serious misgivings among some voting Fed members about the risks of current loose policy if a recovery proves surprisingly robust in the near-term. The Fed balance sheet has flatlined at around $2trn in recent months, despite hundreds of billions in ongoing large-scale asset purchases in the Treasury and corporate bond markets. In fact, the Fed now holds $1trn more in financial securities than it did in February, and in total has amassed the equivalent of over 10% of US GDP. However, much of the emergency liquidity facilities put in place last Autumn, both in terms of liquidity provided to US commercial banks, and to foreign counterparties via dollar swaps, have seen reduced demand (the blue line in the first chart).

While the TALF program continues to expand, it's a very small proportion of the overall balance sheet. Additionally, as can be seen from the nicely symmetrical chart below, the Fed's purchases this year of assets from corporate bonds to Treasuries via its Quantitative Easing program, have been offset by the deleveraging of commercial banks. Bank borrowing from the Fed has collapsed from $1.7trn in March to barely $500bn now, offsetting the quantitative easing impact and restraining money velocity and hence near-term CPI inflation risks. But now that the patient is showing at least twitches of life, how can the Fed switch off its elaborate monetary life-support machine?

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Inflation or Deflation?

Early this year, I advocated building exposure to long-term inflation hedges such as TIPS and resource equities, because they were radically mispriced as investors fled in fear of a sustained deflationary environment. That strategy played out well, and TIPS are now implying around 2% CPI inflation over the next decade, or broadly in line with experience in the last. We face a tug of war between inflationary and deflationary forces in coming years, and key to the outcome will be the scale of excess liquidity (ie a rising money-to- GDP ratio) and how swiftly it is drained from the system in a recovery. Currently, the huge expansion of central bank balance sheets hasn't translated into higher credit via the banking system and therefore a broadening of money. In other words, the velocity of money remains very subdued as banks focus on deleveraging (with the exception of China). This can be seen by the remarkable 6% of GDP parked at the Fed as reserves by US commercial banks, and similar bank risk aversion is evident in the UK and Europe.

Monetary policy has been astonishingly loose for most of the past decade, in response to a series of financial panics starting with the 1998 LTCM/Russia meltdown, proceeding via the IT bubble bursting in 2000, and now the systemic banking crisis of 2008. Ironically, like a doctor feeding an addict's drug habit with ever higher dosage, the response to each crisis has precipitated the next. Between 1996 and 2009, nominal GDP in USD for the top five global economies grew 60%, but narrow money grew 230% and broad money 210%. Much of the excess leaked into a fast sequence of speculative bubbles from Internet stocks to oil futures. You can picture the current monetary situation like a dam, with a lake of fresh money rising even higher, held back only by weak supply (and indeed demand) for credit. When that dam breaks, and credit growth resumes, even at much lower levels than seen in recent years, the inflationary risks become substantial. When looking at inflation, it is a mistake to consider it simply in terms of narrow CPI statistics (which are in any case arbitrary in their calculation). Volatile asset inflation has been a characteristic of the last decade precisely because the real economy hasn't been able to absorb the flood of money issuing from central banks and amplified by a secular rise in bank leverage until last year's crash.

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US Investment Slump Endangers Recovery...

While markets are celebrating an imminent return to US economic growth, the composition of that growth is critical to its sustainability. US economic fragility predates the credit crisis, which in fact was simply a dramatic symptom of the underlying structural weaknesses. Over the past decade, the US economy has generated no net new jobs (and in gross terms, healthcare and government have been the biggest job generators), while the contribution of capital investment to GDP growth has been the lowest since the 1930's. The productive capacity of the US economy has been severely impaired as excess consumption funded by ever growing leverage has squeezed out long-term investment in public infrastructure and corporate fixed assets, while leaving a huge pool of wasted human capital. In Q2 2009, fixed capital investment slumped to sub 15% of GDP, a new post-war low.

That same debt accumulation has postponed the impact on living standards of stagnant real median household incomes, and a low labor force participation rate (so that almost 17% of the potential workforce is now unemployed or underemployed on BLS statistics). Without the capacity (or indeed appetite) to expand an already crushing debt burden, and with clear evidence in recent data of higher-earning US households using discretionary income to pay down borrowings, the medium term trend for US consumption is distinctly negative. The charts below track the long-term trends in total US consumption (private and public) and fixed asset investment, highlighting the remarkable divergence of both from trend since 2000.

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Is China Poised for a Global Buying Spree?

Investment bankers on starvation rations as the M&A slump bites should get busy learning Mandarin, because there are growing indications that China is about to make its presence felt in global capital markets. Chinese policymakers have been debating with increasing urgency how to divest themselves of the $1.7 trn of dollar paper assets they have accumulated, without precipitating a dollar crisis in the process. While recent bilateral trade deals with commodity exporters like Brazil help to stem the flow of fresh dollars, even China's much reduced trade surplus with the US means its dollar pile keeps growing. Buying $50bn in IMF SDRs offers only a marginal diversification against $800bn of Treasury holdings alone (although it does help to internationalize the yuan). The $300bn CIC, which is effectively China's sovereign wealth fund, is now exporting dollars at a furious pace, largely to invest in private equity but also recently buying 17% of Canadian miner Teck Corporation.

In recent months, the approval process for overseas investment by private Chinese companies has been greatly simplified, as has access to foreign currency credit lines. Although we continue to see large energy focused deals, such as the $1.7bn PetroChina investment in Canadian oil sands, strategic acquisition targets span a range of second-tier companies operating in resource markets from uranium to rare earth metals. The debacle surrounding the attempted Rio and Unocal investments has convinced Beijing to set its sights lower in terms of corporate targets.Technology also remains a key focus, particularly battery and alternative energy know-how that can help domestic manufacturers achieve critical mass. As well as accelerating M&A, China is also likely within months to allow local retail investors access to foreign markets for the first time, via global ETFs and managed funds, again releasing domestic capital into international markets. The roadmap to full Yuan convertibility within a decade or so so becoming clearer. How significant could these moves be for international markets?

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Equities: As Good as it Gets?

After a stunning six-month rally in equities, commodities and corporate bonds, we are reaching a critical juncture for markets, which have swung from despondency to euphoria since March. Incoming data have moved the investment debate from whether a recovery is imminent to how strong and durable it will prove. I said back in March that 'the free-fall sensation will soon be over and economies will level out, albeit at lower altitude' and that the depression/deflation scenario was misplaced and predicted a 40-50% trough to peak rally as deflation fears abated. Indeed 10 year inflation expectations in the TIPS market had jumped back to near 2% by June. The six leading global economies this time around have applied 300% more fiscal stimulus and 500% more much monetary stimulus relative to GDP as occurred in the 1930's, and that was always going to be hugely reflationary.

Key factors that turned a hoped-for recovery in 1930 into the disaster of the Great Depression were a sharp hike in interest rates in October 1931 and a decline in the overall price level of 10% per year in 1931 and 1932. History isn't going to repeat and indeed the Bernanke Fed is loathe to risk tightening policy before any recovery is self-sustaining as reflected in capacity utilization climbing to at least 75-80% (ie not before end 2010 if markets don't force their hand). In fact, reflating asset markets was a crucial objective of public policy as much as avoiding CPI deflation, as balance sheets were so dangerously stretched in the US and Europe, and it has proved successful. Three factors have proved supportive of the ongoing risk asset rally in recent weeks.

Firstly, not only is the cycle bottoming earlier than seemed likely back in March, but the recovery is increasingly synchronized on a global scale (with Q3 marking the inflection point for the US and UK, and Europe already modestly rebounding as are the key Asian exporters). Secondly, central banks from the Fed to BOE, far from removing the punch bowl of monetary stimulus, are raiding the drinks cabinet for any leftover monetary hooch they can thrown into the mix to keep the party going. Thirdly, 10 year government bonds have sold off modestly so far, supported by a natural bid from commercial banks seeking to flatter their capital ratios, and central bank's own buying as well as still declining CPI inflation.

However, a number of risks loom large in coming months to unnerve complacent sentiment.

On the one hand, there is a risk that the early stages of recovery prove unexpectedly robust, and precious central bank credibility comes into question, leading to a flight from bonds and indeed the dollar. A full-blooded cyclical recovery may prove far riskier than the consensus anemic affair. Despite most equity indices at their highest since the Lehman debacle, 10 year bond yields remain very modest, and well off the highs seen in the June inflation scare. Would that calm survive a not inconceivable 5% quarterly GDP print for Q1 or Q2 2010?

Alternatively, if inventory restocking, particularly in Asia, has already run its course (and inventory to sales ratios are back to long-term averages, having undershot considerably), then it's possible that indicators like the Baltic Freight Index are signalling that a brief economic 'sugar high' is already subsiding and bullish survey data is misleading.
China, which has been a cornerstone of the bull case, has flattered to deceive in terms of reported growth figures and reckless lending fuelling commodity, real-estate and stock market speculation. Policy is now tightening by stealth and as that becomes increasingly apparent, and as China seeks to diversify its dollar exposure (possibly via surprise measures to partially open the capital account) it will inject volatility into markets.

Finally, the US and European (notably Germany, Switzerland and UK) banking sectors remain dangerously leveraged and undercapitalized, and vulnerable to a further round of write-downs from commercial real-estate and private equity loans as we see the refinancing schedule for boom-time loans surge in 2010/11.

A sustained zero interest rate policy prods investors along the risk curve, but also prods consumers to spend. On balance a weaker rather than stronger outcome seems more likely, but leading cyclical indicators suggest the strongest near-term rebound since 1983. Watch the next set of US savings data for a lead on which scenario will play out ie an upside or downside growth surprise in Q4.

Three secular trends will define the investment landscape for the next decade in the developed markets; they are the rising marginal cost of energy, demographic decline, and ongoing balance sheet deleveraging. All of these are negatives for sustained growth rates. However strong a reflex rebound, once the US stimulus expires, and budget deficits start to narrow, global demand will settle at a new lower level defined by real consumer income growth and productivity. Under those circumstances, the world economy cannot sustainably return to 2003-7 levels of growth, or anything close.

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Europe Leads a Global Recovery...

If there is one clear upside surprise in recent economic news, it surely must be the remarkably fast rebound of the core European economies. Not only have France and Germany reported marginally positive Q2 GDP growth, but forward looking data like the German PMI, which jumped to 54 in August, suggest the rebound is no blip. The services sector in both countries has been particularly strong, as consumers have avoided the leverage bubble afflicting the US and UK, and consequently fiscal and monetary stimulus has apparently found greater traction. While US consumers are saving their tax refunds and the windfall from lower energy prices, Europeans are spending. Neither has there been a residential real estate boom to unwind, with real prices essentially flat in Germany for a decade. There is no question that Southern Europe, and notably Spain, are still suffering the fallout from a manic local property and construction boom, and Spanish unemployment will likely hit 20% in 2010.

However, it seems likely that overall Eurozone growth will turn positive for Q3 and forecasts will have to be upgraded for 2010. The ECB will be vindicated for not following the Fed and BOE in slashing rates to microscopic levels; Europeans are essentially savers, while Americans are spenders. The vast surplus savings of conservative German retirees have been recycled into speculative schemes from Hollywood movies to Spanish golf courses and the fly in the ointment is the German banking sector, which remains hugely exposed to further writedowns, particularly in Eastern Europe. An additional risk is corporate debt at 100% of Eurozone GDP, almost twice that in the US, which is forcing rapid deleveraging via equity and bond issuance and asset divestment.

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Will the US Fiscal Deficit Undershoot?

Investors across all markets should pay close attention to US tax receipts in coming months, because if the economy is truly at an inflection point in the current quarter, it should swiftly translate into monthly revenue increases of 4-5% for the Federal coffers. Anything less would signal that the much lauded recovery has been postponed, or is so anaemic as to be inconsequential for personal and corporate income and hence taxes. If that recovery is as rapid as risk assets are currently discounting, then investors who have been fast to discount the implications for corporate earnings should reflect that this scenario also implies a smaller than expected deficit. It's increasingly possible that the deficit will undershoot the forecast $1.3trn in the fiscal year beginning in September by about $150-200bn, which has implications for the dollar and Treasuries as a 'positive' surprise. It's even conceivable that the Obama stimulus plans may be scaled back in order to save the cherished healthcare project, which is foundering on cost as much as principle. The chart below indicates a slowing in the rate of decline in tax receipts since the Spring, to a 3-mth annualized decline of 10% in July.

The original Treasury and CBO estimate was for a $1.8trn deficit for this fiscal year, and we're up to $1.3trn as of end July. Key factors have been tax revenues plunging 17%, adding $353 billion to the deficit. That decline has been particularly sharp for corporate incomes taxes (down 57%) and individual income taxes (down 20%). The CBO estimates that spending to date on TARP will have net cost to taxpayers of $169 billion (the government has injected $83 billion into Fannie Mae and Freddie Mac, the two housing GSEs making a total of $252 billion to the deficit). Spending on other programs has increased 14%, adding $325 billion to the deficit. The most dramatic increases are for benefit programs like unemployment (up more than 160%) and Medicaid, which have been boosted by the weak economy and expanded Federal programs. Going forward, the key variable will be IRS tax receipts, which are highly geared to an economic rebound.

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The Problem with Leveraged ETFs...

The Exchange Traded Fund (ETF) market has exploded in recent years to total over $600bn in the US alone, offering both long and short exposure to most asset classes. It is now used by institutional as much as individual investors to hedge risk and rapidly change portfolio exposure. They are a very useful tool to create a sophisticated and flexible portfolio at low cost, but I've often warned of their significant tracking error, particularly for inverse and leveraged ETFs, as many investors have discovered to their cost this year. Short ETFs have a non-linear relationship to their index; as an ETF loses value, its exposure also decreases. The reason for this curved decay line, is that short ETFs, unlike their underlying indices, are rebalanced on a daily basis. At the most basic level, the return of a leveraged fund is path dependent so that a rise and subsequent fall in the underlying market generates a radically different return to a fall and subsequent rise over the same period, even if the underlying asset move is the same in both cases. Given the path dependance, the more volatile the return pattern over time, the higher the ETF's tracking error. (A different issue with funds tracking commodities is the rollover costs associated with popular funds like USO or UNG and their relative size to the physical market, producing wide tracking error to the underlying futures.)

The charts below simulate this effect to demonstrate the relationship between asset volatility and tracking error. Leveraged ETFs seek returns that are between +300% and -300% of the return of an index or other benchmark for a single day only. Due to the compounding of daily returns, over periods other than one day returns will likely differ in amount and quite possibly direction from the target return for the same period. Many retail investors have misunderstood the interplay between correlation and leverage in these products, which are frankly suitable only for aggressive day trading strategies, and that's not a game I'd feel confident playing.

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