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					Market Notes by Chris Belchamber Investment Management LLC

      Growth – smoke and mirrors?
        The media heralds 7.2% as the fastest quarterly growth rate since 1984, yet at
roughly the same time the central bank sounds far more cautious. On October 28, 2003,
the Federal Reserve said “The Committee perceives that the upside and downside risks to
the attainment of sustainable growth for the next few quarters are roughly equal. In
contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a
rise in inflation from its already low level.”

       Something doesn’t quite add up. If the economy is so strong why is the central
bank is so cautious? In recent years record levels of stimulus have been applied to the US
economy as never before - tax cuts, government spending, record low interest rates,
remarkable expansion of the money supply and dollar devaluation. And now Q3 growth is
at record levels, but still the central bank is worried.

       The key issue is the strength of the current up cycle in the economy versus the
structural weakness of the US economy. Has the enormous boost to the economy set off a
vigorous and sustainable recovery or is it just a sugar shot that will soon wear off and
leave the US economy stranded with its record structural imbalances?

       It is clearly time to shed some light on this puzzle. We need to understand why it is
getting harder and harder to sustainably boost the US economy. Has the US economy
developed a debilitating structural weakness that now acts as a constant headwind
against a normal cyclical recovery? Or is the reality of the new global labor market
creating an additional constraint both on jobs and incomes in the US as well as genuine
wealth creation?

      Lastly, there are some rather disturbing patterns repeating themselves when you
look at economic and profit growth, mutual fund flows and insider activity. Also both
Warren Buffet and Sir John Templeton, who have both made more money than anyone
else out of US equities in the last half century, are now doing something they have not
done before.

      Politics versus economic reality
        Politics is currently winning. Demand is being created artificially by asset inflation.
Decreasing the cost of capital and increasing paper wealth make people and businesses
spend more. This artificial demand allows high cost producers to stay in business for a
little bit longer, although in the end the market ensures that the low cost, best organized
producer wins. Conventional stimulus can not repair the problem of high costs and excess
capacity, but it can create bubbles to alleviate the situation temporarily, while creating a
bigger and bigger balance sheet problem down the road.

       The main structural imbalances the world now faces is excessive high cost capacity,
particularly in Japan and Germany, and chronic deficit spending in the US. More savings in
the US and less production in Europe and Japan is what market forces demand. However,

Market Notes by Chris Belchamber Investment Management LLC
political imperatives resist an equilibrium that involves shrinking major economies.
Politically this must be avoided at all costs. The outcome is that the authorities continue to
stimulate excessively, causing the global economy to move from one bubble to another.

       Yes, the economy receives another boost which gives the appearance of economic
growth. But if it is built on debt and apparent wealth, yet spending remains out of line
with income how long can it last? In the end recessions have been needed to downsize
balance sheets and discipline us all to live within our income. Suspending this part of the
cycle just stores up bigger trouble in the future.

      This creates a highly unstable macro-economic background which becomes
increasingly volatile. Until finally the adjustment that has to happen happens anyway, but
more painfully as the debts and distortions have become larger than they otherwise would
have been.

      Unprecedented stimulus leads to ……?
       In recent years interest rates have been cut from 6.5% to 1%. As we have
described in previous notes the budget deficit has deteriorated at the fastest rate in
history. The US tax cuts boosted disposable income (not gross income) by 7.2% in Q3 and
there is probably still some residual spending power left over from the massive burst of
mortgage refinancing in the first half of the year. And this has occurred while the money
supply, as judged by MZM, has grown faster in the last 4 ½ years than in the previous 13
years. On top of all this the dollar trade-weighted index has fallen 27% from its recent
high just over 2 years ago.

      Given the scale of this stimulus we really should expect some response. So far we
have had some strong quarters from time to time but each time further steps have still
been needed to keep the ball rolling. Also one would have expected that inflation should
be picking up given the strong medicine, but look at the chart below.

Market Notes by Chris Belchamber Investment Management LLC
        The job market is also providing a mixed picture. The red line below shows that at
least layoffs are slowing down, but the blue line shows that there is very still very little job
creation. Although the last months payroll report at last showed an increase in jobs for
the first time in many months, average hourly earnings fell for the first time since 1989.

      The weak outlook for job creation is confirmed by the help wanted index which has
not been this low since the 1960s.

       The theory is that low rates and tax cuts will somehow lead to job growth. But here
is the problem - “hours worked” are actually falling, and incomes “excluding tax cuts and
home refinancings” are in high reverse. Without these temporary factors personal income
has fallen by around 2%. What will happen to the economy once the one-off factors and
policy stimulus have passed?

Market Notes by Chris Belchamber Investment Management LLC

      Three Possible Outcomes
      It seems that normal responses to stimulus, as regards jobs and inflation, are just
not occurring. There may be many reasons for this, but three main possible outcomes
seem to dominate:

     1. We just need to keep the stimulus going and be patient for the self-sustained
economic recovery to arrive,

      2. We need to come to the realization that the US economy is seriously impaired
and without surgery and a period of extended convalescence it cannot sustain any vigor,

       3. The realities of the new global labor market have radically changed the prospects
for the US labor market.

      It is the latter 2 possible outcomes that seem to be worth investigating further.

      Economic Surgery?
      Before we get out the scalpel we should probably diagnose the patient. We’ve
talked about the structural imbalances before. The ballooning fiscal and trade deficits
which, when combined with a net national savings rate that fell to a new low of 0.5% of
GNP in 2Q03, create a debilitating cocktail for the US economy.

       America’s economic behavior is driving debt expansion and dependence on foreign
finance as never before. Such reliance on a debt-funded growth paradigm is symptomatic
of a US consumer that clings to the wealth driven growth model that became so popular
during the late 1990s.

       As the equity bubble morphed into other assets bubbles – property, credit, and
bonds – newfound wealth effects gained the upper hand over classic income effects in
driving consumer demand. In a job-constrained and income-short recovery, wealth driven
demand – and the increased dependence on debt it entails, generates a key source of
structural vulnerability to the US economy.

       At some point the surgery that may become necessary is to revert to spending
based on income -- a quaint old-fashioned notion perhaps, but one that has stood the test
of time and does make sense from the standpoint of sustainability. But this will now have
to be achieved while carrying high levels of debt and could become painful if assets do not
oblige with endless price appreciation and this could mean an extended period of
convalescence and low interest rates.

Market Notes by Chris Belchamber Investment Management LLC
      The new global labor market
       “I’m here to be the skunk at your garden party” says Any Grove, chairman and co-
founder of Intel. Grove was referring to the software and services industries -- strong
drivers of US economic growth for nearly two decades. He says that although the US
economy is improving, tech employment is not. Technology jobs as well as many others
are increasingly being exported to take advantage of radically lower costs. India, for
example, could surpass the US in software and tech service jobs by 2010.

       Recent estimates from financial consulting firms show that by “offshoring”,
companies can cut costs to between one-sixth and one-third. The Gartner Group, a
market research firm, estimates that 10% of jobs at US information technology vendors
will move offshore by next year.

       Courtesy of profound changes in IT-enabled globalization, there has been a
meaningful breakdown in the time-honored relationship between aggregate demand and
employment growth in high wage developed nations like the US. Outsourcing platforms in
goods (i.e. China) and services (i.e. India) present multinational corporations with
alternative input and cost structures that have never before been available with the scope
and scale that is the case today. At the same time the internet offers a new connectivity
to offshore outsourcing options that never existed in business cycles of the past.

       Little wonder that fully 22 months after the economy supposedly hit bottom in
November 2001, the private sector US hiring curve is running fully 4.3 million workers
below the norm of the past six recoveries according to Morgan Stanley. Little wonder also
that in such a climate American consumers have turned to wealth and debt as the
sustenance of aggregate demand growth. The shortfall of domestic income generation is
also key to America’s savings deficiency and the lethal current-account and fiscal policy
dynamics that have subsequently been unleashed.

      If the cycle does not lead to sustained growth and rising inflation, the US will be
faced with a weak economy and limited choices. It will become much harder to boost the
economy. Interest rates cannot be reduced much further, and fiscal policy will already be
severely stretched. A weak dollar and money supply growth will be the main options –
hardly attractive for foreign investors.

      Not great for domestic investors either. In the last few weeks both Warren Buffet
and Sir John Templeton have declared that they are investing in overseas currencies as
never before. These two investors have probably made more money out of US equities
over the last half century than anyone else. Now they are not only avoiding US equities,
but they have both decided to get out of the US dollar.

Market Notes by Chris Belchamber Investment Management LLC
      Domestic investors need also to consider some other parallels. In the Q1 2000
there was strong economic growth and strong profit growth and this encouraged record
mutual fund purchases that reached $35bn in February 2000 alone. At the time there was
also massive insider selling. As we all know now the S&P 500 peaked in March 2000 and
then halved in value.

      Scroll forward to 2003, and it looks like mutual fund purchases in October were in
the region of $30bn and once again there has been record insider selling, strong growth
and profits. Perhaps Warren Buffet and Sir John Templeton are giving us a good tip.


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