Yearly Forecast

  Introduction

This is the time of the year when it is traditional for market commentators to pen their annual forecasts. We always follow this tradition and have included, below, our 2007 forecasts for the US dollar, bonds, commodities, gold, and the US stock market.

When reading these or anyone else's forecasts you should keep in mind, though, that successful investing/speculating is about being able to manage money and do real-time analyses of risk versus reward; it is not about being able to accurately forecast.

A theme that runs through our various market outlooks for the coming year is that there will be a significant slowdown in global economic growth during the second and third quarters. A significant growth slowdown seems like a reasonable expectation given that:

a) Credit spreads are near all-time lows and are therefore more likely to increase than decrease.

b) Profit margins are near all-time highs and are therefore likely to contract.

c) Inflation expectations are presently near their lows of the past three years, which is the optimum place for them to be because a further reduction would require a deflation scare while an increase would put downward pressure on stock and bond valuations. That is, any change from here -- and some form of change is likely -- will move inflation expectations away from their optimum level.

d) The inverted yield curves in the US and elsewhere indicate that liquidity growth is still strong, but they also indicate that the liquidity trend is very mature and vulnerable to a reversal.

e) The popular view seems to be that the downturn in the US housing market has run its course, but the historical record points to a high risk of this view being overly optimistic.

In other words, right now things appear to be as good as they are going to get, and when things can't get any better there's a good chance they will get worse. As discussed in many previous commentaries, an upward reversal in the US yield-spread should prove to be one of the clearest signals that things are about to get worse.

  The US Dollar

The Current Account Diversion

Before we get to our US$ forecast we thought we'd weigh-in on a debate between Peter Schiff and Robert Murphy regarding the implications of the US's large and seemingly ever-expanding current account deficit (and corresponding capital account surplus since a deficit on the current account must be offset by an equivalent surplus on the capital account). Mr Schiff argues that the current account deficit is a major problem that virtually guarantees a much lower US$, whereas Mr Murphy argues that today's balance of payments situation is not necessarily a bad thing and does not point towards a weaker US$.

On this topic our views are much closer to those of Mr Murphy than those of Mr Schiff. A large current account deficit does not, in and of itself, constitute a problem. The fact is that it can be advantageous for some countries to run current account deficits and, at the same time, advantageous for other countries to run current account surpluses, just as it can be advantageous for two individuals to engage in a transaction whereby one individual provides goods or services to the other in exchange for the promise of a future return (an IOU or a stake in a business venture, for instance). Actually, the simplest way to see that neither a current account deficit nor a current account surplus is necessarily problematical is to reduce the issue to the individual level. After all, no country decides to run a current account deficit or surplus; rather, the balance of payments situation for any country is the net result of millions upon millions of individual transactions.

To make the point that neither a deficit nor a surplus on the current account is necessarily a bad thing Mr Murphy describes the hypothetical example of an American entrepreneur who can't afford to purchase the office equipment (computers, photocopiers, phone system, etc.) needed to get a new business off the ground. In exchange for a stake in the business, some Japanese investors send the American entrepreneur the required office equipment thus allowing him to begin the wealth creation process. If the business succeeds then both parties to the transaction -- the American entrepreneur and his Japanese investors -- will benefit. The US economy as a whole also stands to benefit despite the fact that the transaction adds to America's current account deficit.

Further to the above and as we've noted many times in previous commentaries, the US current account deficit is not a good reason, in itself, to be bearish on the US dollar. A large current account deficit can sometimes, however, be symptomatic of an inflation (money-supply growth) problem in that a relatively high inflation rate in a country will lead to a relatively large rise in the costs of doing business within that country, thus increasing the incentive to import goods rather than manufacture them locally. And a relatively high inflation rate IS a very good reason to be long-term bearish on a currency. In fact, a relatively high inflation rate is the ONLY good reason to be long-term bearish on a currency.

In general terms, what happens is that if the supply of Currency A consistently grows at a faster rate than the supply of Currency B then Currency A will end up losing its purchasing power at a quicker rate than Currency B; and if this happens then the A/B exchange rate will trend lower over the long-term. Under such circumstances Country A will most likely end up running a greater current account deficit than would otherwise have been the case, but it's critically important to realise that the problem lies in the inflation, not in the current account.

Which leads us to the question: Has the large US current account deficit stemmed from a relatively high US inflation rate?

We think the answer is yes; inflation has, over the past several years, been an important contributor to the widening of America's current account deficit. There are two reasons for thinking this way. First, the supply of US dollars increased at a relatively high rate during 1998-2002 and this inflation, like all inflations, undoubtedly resulted in misdirected investment and higher costs. Second, a substantial portion of the external demand for US dollars over the past 5 years has come from foreign central banks.

Expanding on the second of the aforementioned reasons, it seems that over the past 5 years private foreign investors, as a group, have not been overly impressed by the potential real investment returns on offer in the US. As a result, foreign central banks -- institutions that often have as their primary motivation something other than achieving a reasonable real return on investment -- have had to 'take up the slack'. As opposed to being comprised almost entirely of transactions of a similar nature to the one in the above-described hypothetical example, over the past 5 years a big chunk of the foreign investment demand for US dollars has been associated with the currency-management programs of foreign central banks. Specifically, foreign central banks have bought-up huge quantities of US dollars and funneled these dollars into the US bond market with the primary goal of preventing their own currencies from appreciating. Such dollar-support operations would never have been necessary had the large current account deficit not been an effect of rampant US$ inflation.

But that was then and this is now. Over the most recent 3-year period the US dollar's inflation rate has generally been lower than the inflation rates of its major fiat currency counterparts. Therefore, whereas it was an obvious choice for us to be long-term bearish on the Dollar Index back in 2000-2004, it is no longer a cinch that the US dollar's foreign exchange value will ultimately trade at much lower levels. This is not because the US dollar's fundamentals have improved, but because other currencies' fundamentals have worsened. (As an aside, the rapid simultaneous devaluation of all fiat currencies via inflation improves the long-term investment case for gold. Gold will eventually become widely recognised for what it already is: the only viable alternative to the dollar.)

In conclusion, the US$ bears whose bearish outlooks are primarily based on the current account deficit might end up being right about the dollar, but if so they will be right for the wrong reason. Specifically, they will only be right if the US$ inflation rate once again becomes relatively high. On the other hand, making a long-term bet against the US$ via currencies such as the euro, the British Pound and the Canadian Dollar -- a tactic that worked very well during 2002-2004 -- will result in losses if the relative inflation-rate trends of the past three years continue.

2007 Forecast

Interest rate differentials and inflation expectations are the most important determinants of intermediate-term currency market trends.

Although the US dollar's interest rate advantage has diminished over the past 6 months, an advantage still exists. Furthermore, changes in interest rate differentials tend to affect currency exchange rates with a lag of at least 2 quarters, so even if the dollar's interest rate advantage were to completely disappear by the middle of this year the interest rate backdrop would probably remain supportive for the dollar through to year-end.

Inflation expectations are always a wildcard in that they can change quickly and unpredictably. For example, when New Orleans was devastated by Hurricane Katrina the expected rate of dollar depreciation increased due to the surge in US government spending that was expected to result from the massive re-building effort.

As things currently stand, the differences between the yields on inflation-protected and non-inflation-protected securities tell us that inflation expectations are near their lows of the past three years. This means that in the absence of a deflationary shock, inflation expectations are more likely to rise than fall over the next few months. Rising inflation expectations usually result in downward pressure on the dollar.

Our expectation is that 2007 will be a good year for the Dollar Index, but if inflation expectations rise over the next few months in parallel with rebounds in commodity prices then most of the dollar's gains will probably occur during the second half.

  Bonds

Our view is that bonds are in the process of completing a major topping pattern. However, although such a pattern is readily apparent in the first of the following charts (a long-term monthly chart of Japanese Government Bond futures), the second of the following charts (a long-term monthly chart of US T-Bond futures) is more ambiguous. We interpret everything that's happened in the US bond market over the past 5 years as a topping process with the ultimate top having been put in place in June of 2003, but more bullish interpretations will retain some plausibility until the bond price breaks decisively below its August-2003 and May-2004 lows.

We suspect that the T-Bond's price action remains ambiguous due to the massive demand for bonds stemming from foreign central banks. During 2003-2004 the bulk of this demand came from the central banks of China and Japan, but over the past two years the central banks of the world's major oil-producing countries have taken the lead thanks to the huge quantities of oil-related dollars that have flowed into their coffers. What we find interesting, as well as encouraging as far as our long-term bearish view on bonds is concerned, is that the hundreds of billions of dollars of additional central-bank-generated demand for US debt securities over the past three years has only managed to prevent bonds from breaking-out to the downside. In other words, the huge additional demand from the official sector has enabled bonds to do no better than 'tread water'.

We remain long-term bearish on bonds due to our expectation that the weaknesses inherent in today's monetary system will become more widely recognised over the coming years, but are "neutral" as far as this year is concerned. We are anticipating a slowdown in global growth, weakness in stock markets and additional weakness in industrial commodities during the second and third quarters of this year, a backdrop that would likely create a bid for high quality bonds such as 30-year US Treasuries. However, such a backdrop would also be likely to prompt the world's major central banks to abandon any inflation fighting pretense and begin overtly promoting inflation, thus setting the stage for a far more bond-bearish backdrop during 2008 and beyond.

Our 2007 forecast, therefore, is that high-quality government bonds will make their lows during the first 5 months of the year and then rally enough to end the year roughly flat. Lower-quality (higher-risk) bonds are, however, expected to perform very poorly during 2007; in other words, we expect credit spreads to widen (we expect that yields on low-quality bonds will rise relative to yields on high-quality bonds). This, in turn, should coincide with strength in gold relative to industrial metals.

  Commodities

Oil

Our view is that oil commenced a cyclical bear market (a 1-2 year downward trend within the context of a secular bull market) last July. We expect that this cyclical bear market will bottom in the $40-$50 range some time this year.

We aren't believers in the theory that the world is going to experience an oil shortage within the foreseeable future, but there is clearly a lot of evidence to support the idea that there is an emerging shortage in low-cost conventional oil. A much higher oil price is therefore necessary to make the huge reserves of high-cost non-conventional oil -- first and foremost, the oil contained within Canada's vast tar sands -- economically feasible.

We don't think there's much chance of oil making a sustained move below $40 ever again, not just because of the emerging shortage of low-cost conventional oil but also because of currency depreciation. However, if there's a substantial slowing of global growth during 2007 then long-term support in the low-$40s will probably be tested.

If there is not a significant slowing of global growth during 2007 then the oil price probably won't move far below the low reached earlier this month.

Our forecast is that in the absence of a major Mid-East-related supply shock the oil market will be uninteresting during 2007, with the oil price spending 90% of its time between $45 and $65.

Natural Gas

Our view has been that the natural gas (NG) market would test its September-2006 continuous contract bottom ($4) during the first two months of 2007, following which a major upward trend would begin. As previously noted, we would consider a drop to the low-to-mid $5 area to constitute such a test.

As illustrated by the first of the following charts, the February NG futures contract has rebounded strongly over the past week. However, unless it is able to achieve a daily close above $8 we will assume that the aforementioned test of the September-2006 bottom is still on the cards.

A test of the low still appears to be the most likely bet because: a) as evidenced by the second of the following charts, the amount of NG in storage remains much higher than normal for this time of year, b) the NG market has followed its seasonal/cyclical pattern very closely over the past year and this pattern projects a January-February -- more likely now to be February -- test of the September low, and c) the NG price has just reversed lower from a confluence of resistance in the $7.50-$8.00 range.

We expect NG to trend higher from whatever low it makes during the first 2 months of the year, but a move up to near the 2005 high probably won't occur until at least 2008.

Industrial Metals

The copper market led a sharp sell-off in the industrial metals during December and the first half of January, but prices within the sector have recently firmed-up and a couple of metals (nickel and tin) have even moved to new all-time highs.

Due to the large divergences in the price performances of different industrial metals over the past several months it is difficult to come up with a sector-wide outlook. However, when there's a disparity between what's happening in the copper market and what's happening in markets for the more thinly traded metals we will generally go with the copper market. We therefore take the breakdown in the copper price as evidence that a major peak was put in place last May.

Our 2007 forecast is that industrial metals prices will be stable or firm during the first few months of the year and weak during the remainder of the year in parallel with a global growth slowdown.

Grains

Our outlook for grain prices was discussed in the 15th January Weekly Market Update, at which time we said:

"...the cyclical advance in the grain markets that began in early 2005 is very much intact..."

and:

"...we can look forward to a continuation of the massive ethanol subsidies and all their adverse ramifications [including upward pressure on grain prices]. Furthermore, there is a chance that later this year the increased demand for gains stemming from the burgeoning ethanol industry could meet a supply disruption caused by El Nino."

As far as the coming 12 months are concerned we think the grain sector has the most upside potential and, with the possible exception of gold, the best risk/reward ratio in the commodity universe.

  Gold

The chart of the US$ gold price included below shows that gold trended higher at a steady pace from the first quarter of 2001 through to the third quarter of 2005, and then accelerated upward to a peak in May of 2006. Upward acceleration of this nature is something that usually only happens during the final phase of a multi-year rally and in this case it might have ushered-in a correction that will last 1-2 years. The first of our two most probable scenarios, therefore, is that the correction that began in May of 2006 will continue until at least the final quarter of this year. The next multi-year advance in the gold price would then get underway.

Given that the short-term (1-3 month) outlook for gold is bullish, this first scenario would likely involve a test of the May-2006 peak at some point during the first few months of the year followed by a drop to re-test the June-2006 bottom (around $550) during the second half of the year. A breach of the June-2006 low would pave the way for a test of long-term support in the low-$500s, a support area we wouldn't expect to see violated under this or any other realistic scenario.

The second scenario worthy of consideration is that the post-May-2006 correction ended in October and the next multi-year advance is already underway. In this case we'd expect a test of the May-2006 peak within the next few months; followed by a pullback to around the current level (630-650); followed by a rally that ultimately takes the gold price well beyond its May-2006 peak.

The second scenario has the advantage of being consistent with long-term charts of the gold stock indices. Unlike the US$ gold price, which is yet to experience its first major correction, the gold stock indices consolidated for about 20 months beginning in December of 2003. This consolidation contained two peak-to-trough declines of around 40% and can reasonably be given the "cyclical bear market" label (in this case the term "cyclical bear market" means a 1-2 year bearish trend within a secular bullish trend). It would be unusual for a new cyclical bear market to begin less than a year after the previous one ended, meaning that the post-May-2006 downturn in the gold sector is more likely to be a correction within an on-going cyclical bull market than the start of a new cyclical bear market; and if this is the right interpretation then it is not reasonable to expect gold bullion to trade anywhere near its June-2006 low over the coming 12 months.

The key, we think, is what happens to yield and credit spreads. If yield and credit spreads become significantly wider during the first half of the year -- something that probably won't happen unless there's a large enough decline in confidence to prompt a substantial (10-20%) downturn in global stock markets -- it will mean that the financial/economic backdrop is becoming more conducive to a major advance in the gold price (our second scenario). On the other hand, if yield and credit spreads remain near their current low levels over the coming 6 months then any up-move in gold will probably be capped at the May-2006 peak and there will be a significant risk of a break below the June-2006 bottom during the second half of this year (our first scenario).

Just to be clear, we think the more bullish (for gold) intermediate-term scenario would go something like this:

1) Stock markets begin to weaken and interest rate spreads (the differences between long-term and short-term interest rates and the differences between the yields on low and high quality debt securities) begin to widen.

2) The gold price initially declines along with the prices of cyclical assets such as stock markets and industrial commodities, but holds up better than these other assets.

3) The markets begin to anticipate the traditional central bank response to declines in cyclical asset prices and evidence of slowing growth: looser monetary policy. This results in greater investment demand for gold and a rise in the gold price in terms of almost everything.

At this stage we favour the second (more bullish) scenario because it is consistent with our stock market and economic outlooks. We've therefore upgraded our intermediate-term outlooks for gold and gold stocks to "bullish", thus putting ourselves in the uncomfortable position of being intermediate-term bullish on gold and the US$ at the same time. The position is uncomfortable from an inter-market relationship perspective because gold and the Dollar Index usually trend in opposite directions and the inverse correlation has been particularly strong over the past 12 months. Note, though, that it's not an uncomfortable position from a fundamental perspective because gold's fundamentals are clearly superior to those of the dollar whereas the dollar's fundamentals are arguably superior to those of the euro.

The decision to upgrade our intermediate-term view on the US$ gold price was also influenced by gold's recent price action in terms of currencies other than the US$. Specifically, the long-term charts included below of gold in A$ terms, gold in terms of the British Pound and gold in terms of the South African Rand reveal a pattern that can be described as: a multi-year consolidation ending in 2005; followed by an almost straight-up surge culminating around the middle of last year; followed by what currently appears to be a smaller-degree consolidation. Charts of gold in euro, Yen and Swiss Franc terms have a similar look and in every case the consolidation that began in mid-2006 appears to be either breaking-out to the upside or about to breakout to the upside.

As with the gold stock indices, in non-US$ terms gold completed a lengthy mid-cycle correction within the past 18 months and is therefore unlikely to embark on another correction of this magnitude in the near future.

The last thing we'll mention before leaving our 2007 gold forecast is the potential for the IMF to adopt an accounting change that requires central banks to exclude, when reporting their gold reserves, the gold that has been swapped or loaned out. If implemented this accounting change will reveal the quantity of the metal that has been swapped/loaned into the market by the central banking community. Refer to http://www.resourceinvestor.com/pebble.asp?relid=28416 for additional info.

The aforementioned accounting change is a wildcard in that: a) only senior central-bank insiders currently know the real numbers with regard to gold loans/swaps, b) it is not certain that the change will ever actually be implemented, and c) if the change is made official there's no telling when it will come into effect.

With so many unknowns surrounding this issue it should not form the basis of any forecast or investment decision. Our guess, though, is that it won't prove to be a major event in the gold market because it will only get implemented if the amount of gold involved is either lower than or roughly in line with mainstream views (no more than a few thousand tonnes). Putting it another way, it's very unlikely that the IMF will require central banks to implement an accounting change that causes great embarrassment to the central banking community. In any case, even if this mooted accounting change is destined to eventually become important it won't become important this year because such things generally get implemented with glacier-like speed.

  The US Stock Market

If the total supply of US dollars grows at a quick pace during 2007 then the US stock market will probably have an 'up' year in nominal dollar terms IF there's only a modest increase in labour compensation and IF the bond market fails to react in a meaningful way to the on-going currency depreciation. These are, however, big 'ifs' because with bond yields so low the bond market is acutely vulnerable to a significant rise in inflation expectations and, as mentioned above, it looks like labour compensation is about to begin increasing at a faster rate.

In any case, if inflation (money supply growth) proves to be the main driver of stock market gains during 2007 then our gold stocks should still do OK and the best-performing sector -- one in which we also have significant exposure -- would probably be base metals. Therefore, although it would make our intermediate-term stock market outlook wrong we don't view the possibility of inflation-related stock market gains as a risk to our overall position.

In conclusion, then, we are expecting 2007 to be a 'down year' for the US stock market due to a combination of contracting liquidity and falling profit margins, but are effectively hedged against the possibility of liquidity remaining abundant by virtue of our core long-term position in the industrial metals sector.

    *According to the NBER (the institution that determines the official start and end dates for US recessions), the recession ended in November of 2001. However, it didn't actually end until at least the middle of 2003. Discrepancies between official and actual often occur due to the gross misreporting of the effects of inflation.