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					Market Notes by Chris Belchamber Investment Management LLC
          21/4/04 (

      Inflation/deflation still unresolved

      If this economic cycle was in any way normal then everything would be nice and
simple. Policy stimulus leads to growth and inflation, then we get policy tightening with
higher interest rates to cool everything down again. Ho Hum. But don‟t rush to this
conclusion. The current cycle has already been a clear departure from the norm, and
without a doubt, quite a few surprises are still in store.

       Today‟s recovery is based on unparalleled policy stimulus. The list is long but
includes the lowest interest rates, the biggest fiscal stimulus, a substantial currency
devaluation and an incomparable creation of debt. That we should finally be getting a
response from the economy should not be a surprise. The major issue now is how to
unwind the massive policy measures and all the imbalances it has created without killing
off the recovery. This will not be easy.

        One of the major differences with this recovery is that labour costs have remained
very low and unit labour costs have been falling. This factor is still restraining a surge in
inflation. Furthermore, with $34 Trillion of debt, debt service will constrain the economy
as never before. Of the $2.3 trillion increase in consumer debt over the past three years,
44% is tied to short rates (home equity loans $385 billion, adjustable rate mortgages
$300 billion, and instalment debt $320 billion). The Fed needs to be convinced that
consumer incomes are rising too, which will make debt service more manageable at the
consumer level.

       The most pressing issues are the twin bubbles of Anglo-Saxon debt and China‟s
investment and property excesses. The current pick up of growth and inflation may well
start out with the conventional response of higher interest rates, but there is a great deal
that could go wrong.

      The Anglo-Saxon Debt Miracle
       In the last five years Australia, Britain and the US have substantially outperformed
other developed economies. Anglo-Saxons like to imagine that this follows from their
superior economic model, but it could, of course, just be faster debt creation. The table
below shows the massive increase in household debt. More than likely this has been the
fuel for higher spending and growth. Interestingly, the Euro-Zone‟s growth has been just
as strong as in the US without the debt creation. The Euro-Zone may have been
supported by the weakness of the Euro, at least until recently.

       Debt and GDP growth are connected through property prices. Low interest rates
translate into rising demand for property and so rising property prices. This combination
of low interest rates and high property prices encourages debt creation, which in turn has
a very powerful impact on consumption growth.

Market Notes by Chris Belchamber Investment Management LLC
          21/4/04 (
       Theoretically a massive property bubble supported by record levels of debt can last
for a very long time. Just as long as low interest rates and household optimism persist.
But inevitably like any other bubble, it will eventually burst. The damage created by the
subsequent bust is proportional to the level of debt created in the bubble and the extent
that house prices reached extremes during the bubble. There can little doubt that both
debt and house prices have reached unusual extremes.

      The Leverage Game (% of GDP)
                 US       UK     Australia   Euro-Zone Japan

      Household Debt

      1988      57.9     66.6    36.8                      59.7

      1993      62.2     74.8    42.9                      63.3

      1998      67.1     72.5    61.2          41.7        65.1

      2003      83.5     91.8    100.3         48.3        67.3

      Current Account

      1988      -2.3     -4.1    -3.0                       2.7

      1993      -1.2     -1.8    -2.7                       3.0

      1998      -2.3     -0.5    -4.5                       3.0

      2003      -4.8     -1.7    -6.3           0.4         3.2

      Real GDP Growth between 1998-2003 (%)

                 11.5     11.3   20.9          11.1         5.7

      Source: ECB, RBA, Bank of England, the Fed, CEIC and Morgan Stanley

Market Notes by Chris Belchamber Investment Management LLC
          21/4/04 (

       China is experiencing an investment bubble that is unprecedented in international
history. On many measures this is up to twice as large as its previous bubble in 1993.

      China‟s Investment Bubble (% of GDP)

                      Gross Fixed     Domestic

                      Investment       Credit

      1993            37.6             96.7

      1998            35.0             116.8

      2003            42.9 est.       160.3

      Source: CEIC and Morgan Stanley Research

       Sales of new properties in Shanghai rose 50% last year and reached 20% of the
city‟s GDP. This is happening at a time when prices per square meter as a percentage of
average disposable income are almost reaching the same levels reached at the peak of
the property bubble in Hong Kong in 1997. This same story is happening all over China as
local governments are borrowing massively with property as collateral to build urban
infrastructure. However, housing starts are rising faster than sales and double digit
vacancy rates are common in major cities.

       Chinese policy makers are all too aware of the excessive nature of the current
boom and have now introduced three rounds of policy measures to hold back growth, but
so far with little evident effect. There is little doubt that policy will continue to be
tightened until growth slows down but it may already be the case that engineering a soft
landing will now be exceedingly difficult to achieve.

      Today‟s inflation
       Typically inflation and economic growth have resulted from wage inflation and labor
market tightness. It is clear that this is not the case today. Not only is there an almost
unlimited supply of new labour in China and other developing economies, but technology
and productivity improvements have also reduced employment needs. Whatever the
reasons, the US labour market has shown remarkable weakness during the current
economic recovery, producing jobs at a rate far below any post war recovery.

       Although the latest payroll report suggested that job growth is finally picking up,
the closer you look at the data the more doubtful this seems to be. Although payroll
employment grew 308,000, a number that is constantly revised, nothing else seemed to
suggest a strong labour market. Wage growth was still weak at 0.1%. The “employed
population ratio” actually FELL to 62.1% and the average workweek fell 0.1 to 33.7, which
is near a 40-year low. Finally almost all the new jobs created were part time or temporary
Market Notes by Chris Belchamber Investment Management LLC
          21/4/04 (
jobs. A record number of the unemployed are losing unemployment benefits and the only
jobs they can find are part time or temporary jobs. This is a strong labour market?

      In this cycle whatever growth and inflation we are finally seeing is based primarily
on massive policy intervention and debt creation. In the short term, interest rates and
bond yields may well rise to slow the momentum that has built up. However, with high
debt levels, higher interest rates will bite more quickly than usual. It is anyone‟s guess
how high bond yields will have to go, but ultimately, runaway inflation will be hard to
achieve with a massive global labour market surplus.

       Indeed, in Alan Greespan‟s testimony on 04/21/04 he states “As yet, the protracted
period of monetary accommodation has not fostered an environment in which broad-
based inflation pressures appear to be building.” This hardly suggests any urgency for
policy action as yet. At the same time this statement undercuts his statement the
previous day that “deflation is no longer an issue”. Once again we are asked to believe
that we are somehow perfectly balanced between the risks of either inflation or deflation
on a more or less permanent basis.

      The Federal Reserve‟s dangerous gamble
       Going back to 1831, a 1% interest rate has only been reached once before – during
the great depression of the 1930‟s. The current 1% interest rate must therefore be
considered extraordinary or an “emergency” rate. Strangely, though, Fed governors admit
to no emergency. Inflation is no threat and deflation is no problem, we are told again and
again. So often, in fact, that we have to wonder.

       The Federal Reserve have clearly decided that the world needs to be saved from
deflation. And it even seems to believe that it can achieve this. The experience of the US
in the 1930‟s and its perception of Japan in the 1990‟s and 2000‟s has convinced the Feds
that deflation must be stopped at all costs. Never mind that the Japanese seem to have
survived persistent deflation relatively well and there are periods in history when deflation
has been benign. The period between 1873 and 1900 in the US resembled a deflationary
boom rather than a shock, indeed it was this deflationary period that catapulted America
into the role of the world‟s leading industrial power. At that time the Federal Reserve
didn‟t even exist.

      Deflation naturally involves many adjustments and, just as with any other economic
environment, there are winners and losers. The Fed could have chosen to allow deflation
to occur and worked hard to try to make sure that economic imbalances were contained
to minimise any undue disruption. Instead it has deemed deflation to be an unacceptable
curse and every weapon in its arsenal has been employed to avoid it. In this process
economic imbalances and debt have exploded and we still have to wait and see if in the
end they will successfully beat deflation.

      Whatever the outcome it seems unlikely that the Feds can change the reality of a
global labour market glut which arguably should produce a downward price level
adjustment in the developed economies. This may have caused a benign deflation that
would benefit consumers, but caused debtors some problems. Instead, monetary
Market Notes by Chris Belchamber Investment Management LLC
          21/4/04 (
authorities, mainly the Fed, are using cheap money to fight this transition. In the process
they are creating a massive global debt and property bubble which creates superficial
demand and stops prices from falling at least temporarily. However, as soon as the bubble
bursts, the world will need a bigger downward adjustment because of the extra capacity
formed during the bubble. Indeed, so much debt has been created that it may lead to
debt deflation.

      This leaves investors with an unusually difficult outlook. As the famous Austrian
economist Friedrich Hayek remarked, “the more the state „plans‟ the more difficult
planning becomes for the individual”.

       The markets are currently focused on economic recovery and the prospect of higher
interest rates and inflation. At the current time this is the trend to trade, but do not get
too convinced that this trend will last more than a few weeks or months. This cycle is
highly unusual.

      The labour market is still unusually weak and debt will act as a constraint as never
before. Removing policy stimulus will be a difficult process and the Feds are likely to be
very careful in how they proceed in raising rates. They simply cannot afford to kill off the
recovery. Indeed, they may well still need stronger conviction that the economy has
become sufficiently self-sustaining before they act.

       Then again there is now a problem in waiting too long. To the extent that there is
now a worldwide bubble in property prices and an investment bubble in China, if they wait
too long it will become increasingly difficult to engineer a soft landing.

       Longer term the issue is that the Federal Reserve have taken an extreme view
about the consequences of deflation and an enormous policy gamble in order to avoid it.
This is the key investment issue over the next year or so. Whatever, the immediate
market obsession - inflation, growth, or interest rates - the key issue that every investor
needs to watch is the final endgame in the great Federal Reserve Deflation battle.

Market Notes by Chris Belchamber Investment Management LLC
          21/4/04 (

         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. Chris Belchamber (the author) may or may
not have investments or positions in any assets or derivatives cited above.

         Communications from the author are intended solely for informational purposes. Statements made by various
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be construed as an endorsement by the author, either expressed or implied. The author is not responsible for typographic
errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable.
However, errors may occasionally occur. Therefore, all information and materials are provided “AS IS” without any warranty
of any kind. Past results are not indicative of future results.


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