By Yiannis G. Mostrous

MYKONOS, Greece–I’m currently tucked away on a small but vibrant island in the Aegean Sea. Markets, wars and the other chaos that make up our daily lives seem quite distant.

I hope you found the last issue of SRI, a Geopolitics & Investing Special Report, as interesting to read as it was to research (and I owe my colleague Elliott Gue a special thanks for his able assistance).

Our lives and our investment decisions are increasingly affected by geopolitical developments. Hence, although it’s long, I recommend that you take the time to read Still Playing The Great Game: Business, Investments And Politics In Central Asia.

That said, the US Federal Reserve was unable to walk the walk. The latest decision of its Federal Open Market Committee (FOMC) proved once again that the “transparency” new Chairman Ben Bernanke aimed for when he assumed his lofty perch is still a long way off from becoming reality.

If there’s one thing to take from the FOMC’s most recent statement, it’s that the Fed has been unable to gauge the growth outlook of the US economy; it’s had to turn phrases like “inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand” to justify not raising rates again.

Here’s what I had to say about the now-paused rate hiking cycle a month ago (see SRI, 5 July 2006, Still Leading):

Turning to the US, a recent Bloomberg/Los Angeles Times poll showed that the American public has turned against the Federal Reserve’s two-year campaign of interest-rate increases, concerned it may hurt the economy by slowing growth.

That sentiment should come as no surprise, as the preferred ways for increasing wealth–namely borrowing and real estate–might not fare very well as the Fed continues to drain liquidity.

It’s immaterial at this point whether the Fed stops or not. The long-term consequence is becoming not only more visible, but also more worrisome: The great American economic machine is hooked on cheap money and, consequently, an asset-based virtual wealth effect. At the same time, the threshold for economic pain is moving lower and lower.

From a global perspective, the main problem with this picture is that the world’s leading economy–a big contributor to Asia’s good fortune–is preparing to land, hopefully softly.

Serious investors should contemplate the probability that the US economy will prove unable to handle the shock, lose steam and trigger a recessionary 2007. In that case, expect Japan and the EU to outperform, on an economic basis, the US next year.

The real problem the Fed has had from day one of this tightening cycle wasn’t–as most commentators argued–one of inflation and growth. Rather, it had to do with a red-hot housing market and, more important, the positive role that market played in wealth creation for the average American. Now that the housing market is showing signs of slowing and the pace of economic growth has faded, the big talk of a strong economy has disappeared overnight.

Now the Fed is effectively saying that economic growth will drop below its long-term potential rate, especially now that productivity numbers aren’t looking as strong as a many believed them to be. Consequently, the Fed dropped its usual productivity reference from its latest statement.

At the same time, Japan’s economic numbers continue to improve. Long-term readers know Japan is one of my favorite markets. As I recently wrote (see SRI, 14 June 2006, T-Minus Two Days):

Short-term market volatility aside, for long-term bulls on the nation’s economy, Japan’s confidence and its exit from deflation is all that matters. Normalization of rates increases the alternatives available to the Japanese to use their huge bank deposits in more productive and profitable ways. And as I’ve written previously, investors who don’t think Japan’s deflation years are over shouldn’t own Japanese stocks.

That said, the latest data showed prices rising. Utilities, food, transport, clothing and footwear led the increase.



Source: Bloomberg LP

Note that core inflation has also been rising; this is a positive development, as it represents another step toward the return of normalcy to the Japanese economy.



Source: Bloomberg LP

Industrial production is also very strong in Japan, as exports and increasing domestic demand have been the main drivers. In addition, recently published private machinery orders showed an increase of 8.5 percent month-over-month. The same measure was up 17.7 percent year-over-year, the fastest pace in three years and significantly stronger than expected.

Given the generally encouraging signs coming from the Japanese economy, the Bank of Japan will probably continue its tightening. I still expect the Japanese economy to surprise to the upside during the second half of 2006 and into 2007.



Source: Bloomberg LP

Asset Allocation And Hedges

As the investment climate is changing, the hedges I recommended in previous issues are starting to help performance.

In early March (see SRI, 8 March 2006, Hedge Your Bets), I recommended that you start building positions in government bonds:

This is the time to take a position in bonds. Use the iShares Lehman 7-10 Year Treasury Bond Fund (AMEX: IEF). Even if there is short-term risk, now is the time to gain exposure to the Treasury market.

Treat this as a more permanent hedge for the Portfolio because, later in the year, this hedge will become important to achieve positive returns. As previously explained hedges will be monitored separately since the Portfolio is a long-only portfolio.

The recommendation was flat until recently, but is now in positive territory. The iShares Lehman 7-10 Year Treasury Bond Fund is still a buy.

I introduced another permanent Portfolio hedge at the end of March (see SRI, 29 March 2006, Right You Are#), noting:

[I]t’s becoming increasingly obvious that the majority of investors aren’t certain as to what will be the final outcome of the Fed’s moves and the probable 2007 slowdown of the US economy. The debate between deflationists and inflationists remains animated.

I anticipate a deflationary outcome (i.e., a deleveraging of the consumer), and the only hedge able to cover both is gold.

Gold has been the object of ardor and the target of scorn throughout the centuries, but has never been refused as means of payment. The reason is that gold has no substitutes.

Gold is one of our permanent hedges because it’s expected to preserve its purchasing power in deflationary and inflationary economic environments. And given the demand for the yellow metal we’ve seen during the past three years (from central bank buying to new gold exchanges and liberalization of trade around the world), gold has become the world’s fourth currency.

In today’s world of massive deficit spending and financial imbalances, expect demand for gold to continue to increase. Since my original recommendation, this hedge is up 14 percent and is a solid contributor to our strategic goals.