Yearly Forecast

  Random speculations about the year ahead

  *The US stock market's upside will be limited by falling corporate profits (and profit margins), continued pressure on the financial sector, political uncertainty, inflation fears, and a lack of growth in consumer spending.

  *The stock market's downside will be mitigated by the beating already dished out to housing-related and financial stocks, as well as by the fact that the investing public is already very pessimistic.

  *The upward trend in the US yield-spread that began in 2007 will persist through 2008, due initially to long-term interest rates falling less than short-term rates and then, later in the year, to long-term interest rates rising faster than short-term interest rates. This will create a generally positive environment for gold, although gold's bull market will be interrupted by a substantial 2-4 month correction that begins during the first two months of the year.

  *Gold's H1-2008 correction will be driven by a strong US$ rally as currency speculators belatedly come to the realisation that the dollar's large purchasing-power discount to the euro is unwarranted.

  *In a desperate effort to revive the economy and the electoral chances of the Republican Party, the US Federal Government will become the primary engine of debt/money expansion (inflation) during 2008. As a result, the people who doubt the ability of the powers-that-be to maintain a high level of monetary expansion in the face of a 'tapped out' consumer will receive an "Inflation 101" course. They will learn that there is no limit to the amount of bonds that the US government can issue to the Fed in exchange for newly-created currency.

Note: The "pushing on a string" analogy often cited in discussions about the inflationary abilities of governments and central banks is based on the patently false assumption that every increase in money supply will be met by an equivalent increase in money demand with no change in the price (purchasing power) of money. This assumption goes against basic economic law. Until the law of supply and demand is repealed there will be no question that an entity with the power to expand the supply of money ad infinitum will also have the power to reduce the purchasing power of the money (bring about a general increase in prices, that is). The challenge facing the monetary authorities isn't to maintain a high level of inflation; it's to do so whilst keeping inflation FEARS in check.

  *Weakness in the economy will result in a deflation scare during the first half of 2008 (a "deflation scare" involves widespread fear that deflation is a threat, as opposed to something resembling actual deflation), but the nature of the current monetary system and political environment will ensure that the weaker the economy the greater the INFLATION.

  The US Dollar

In the 11th January edition of his "Thoughts From The Frontline" letter, John Mauldin makes the point that forcing China to upwardly re-value its currency cannot possibly make a significant dent in the US trade imbalance. The reason is that the large US trade deficit has been caused by the combination of increased US consumer spending and reduced US saving, not by the incorrect pricing of currencies in the foreign exchange market. As he puts it:

"Want to see the real problem at the root cause of the trade deficit? The one that candidates absolutely cannot mention from the debate podiums? Look at the next chart:

No, the simple answer is that the trade deficit is not going to come down until the US starts to save more and spend less. In 1992, consumer spending was a little over 65% of GDP. It is now closer to 72%. Savings are down from 8% in that time, to barely above zero. If US consumers simply saved 5%, as we did 10 years ago, the trade deficit would come down by a lot."

Unfortunately, Mr. Mauldin stops short of identifying the "real problem at the root cause of the trade deficit". To identify the real problem you have to go a step further and ask the question: Why has there been a long-term trend towards more spending and less saving? After all, the average American didn't set out, in 1992, with the goal of whittling down his/her savings to zero over the ensuing 15 years. The reduction in savings has, instead, been a RATIONAL response to the economic stimuli of the times.

All you have to do is dig a small distance beneath the surface to discover that the reduction in the savings rate has been a natural reaction to inflation. The crux of the matter is that it makes no sense to keep much of one's wealth in the form of monetary savings if one is very confident that money will be worth a lot less in the future than it is today.

As we've explained in many previous commentaries, a trade deficit is not, in and of itself, a problem. It can, however, be a symptom of an inflation problem. In the US case, the large slide in the savings rate that has occurred alongside the large increase in the trade deficit strongly suggests that the trade deficit is, indeed, symptomatic of such a problem.

An inflation problem caused the bear market in the Dollar Index, but the bear market might either be over or about to go into hibernation for an extended period. This is not because the US no longer has an inflation problem; it's because the market has taken the US$ too low relative to other currencies, most notably the euro, that have major problems of their own. The euro now trades at a 20-30% purchasing-power premium to the US$, and yet: a) the euro-zone has developed its own inflation problem thanks to double-digit growth in money supply, b) the unfunded government liabilities of countries such as Germany and France are every bit as problematical as those of the US, and c) there is a significant risk that the European Monetary Union (EMU) will start coming apart at the seams due to economic distress in countries such as Italy and Spain.

Which brings us to our 2008 outlook for the Dollar Index:

Our view is that the Dollar Index commenced a bottoming process last November -- a process that will probably entail at least one test of the November low and be complete by March of this year. We expect that an intermediate-term US$ rally, driven initially by the realisation that the ECB will have to cut interest rates almost as much as the Fed, will then begin.

  Bonds

Preamble

Conventional wisdom has it that slower economic growth will reduce inflationary pressures, thus creating a bullish environment for Treasury Bonds. But slower economic growth means a slowdown in the rate at which 'stuff' is being produced, so if all else remains the same then slower economic growth will lead to less 'stuff' being chased by more money. That is, it will INCREASE inflationary pressures, thus creating a BEARISH environment for T-Bonds.

It could be argued that as the economy slows, the rate at which new money gets borrowed into existence will fall faster than the rate at which 'stuff' is being produced. And if so then inflationary pressures will decline.

The above argument will sometimes be true, but under the current monetary system it will more often than not prove to be false due to counter-cyclical monetary and fiscal measures. To be more specific, the way things typically work these days is that the central bank and the government take steps to counter the reduction in private-sector borrowing that occurs in response to an economic downturn. For its part, the central bank reduces short-term borrowing costs, injects money into the banking system, and, if necessary, monetises government debt. The government possibly plays an even greater role in that it attempts to replace private-sector borrowing and spending with its own borrowing and spending. And since there is no rigid limit to the amount of its own currency that a government can borrow it will always be possible for a government to more than offset any reduction in private sector borrowing and spending, if that's what it chooses to do. Of course, the government's spending will be far less productive than the private sector spending it replaces, but that's not an issue if the overriding goal is to create the illusion of prosperity in the present. 

Further to the above discussion it should not be surprising that the most severe recession in the US over the past 50 years -- the 1973-1975 recession -- occurred in parallel with the quickest rise in the general price level. This was the inevitable outcome when a Fed/government-generated monetary tidal wave came up against slowed production of goods and services.

Outlook for T-Bonds

Treasury Bonds are currently benefiting from the general shift away from higher-risk bonds and from the belief that a weakening US economy will bring about reduced inflationary pressures. For the reason discussed above, we think this belief is mistaken. Based on the historical record and, in particular, on the record of the current US administration there is a very high probability that economic weakness over the coming months will prompt a massive increase in US Government spending, which will, in turn, be monetised by the Fed and thus lead to greater inflationary pressures. A weaker economy should therefore make the outlook for government bonds more bearish, although US government bonds should continue to fare better than higher-risk bonds.

Having said that, there could well be at least 3-6 months between when the government begins to cobble together an "economic stimulus package" and when the bond market begins to discount the inflationary effects of the package. During this period the T-Bond price will probably maintain an upward bias. This leads to the following bond market outlook for 2008:

The bond market is likely to show modest strength during the first half of the year. Specifically and with reference to the following weekly chart, there is a reasonable chance that T-Bond futures will breach resistance defined by their 2005 peak and rise to test their 2003 peak during H1-2008. However, we expect that modest strength during the first half on the back of economic weakness will be followed by a very negative second half as the market begins to discount the effects on currency purchasing power of a massive increase in government borrowing/spending.

  Gold and Gold Stocks

Gold

We are presently short-term bullish on both gold and the US$, but this does not mean that we expect gold and the Dollar Index to rally together over the next few months. Rather, it means that we think the upside potential outweighs the downside risk in both markets. In the case of the Dollar Index we think that a bottoming process is underway and that while this process continues the downside risk will be limited to a test of the November low (74-75). In gold's case, the potential will exist for significant additional gains until the dollar's bottoming process is almost complete, following which a sizeable gold-market correction is likely to begin.

If the dollar's current bottoming process follows the typical historical pattern then it will take 3-4 months to complete, after which a strong multi-month rebound should begin. This suggests to us that an intermediate-term US$ rally will start before the end of March and that gold will reach an intermediate-term peak during the first two months of the year (since turning points in the gold market usually lead turning points in the currency market).

We expect that yield and credit spreads will continue to widen during 2008; that real interest rates will remain low; and that financial market volatility will increase. If so then the backdrop will remain 'gold bullish' and a US$-inspired 2-4 month downturn in the gold market during the first half of the year will be followed by another powerful advance. Our guess is that gold will end 2008 above $1000, but will trade below $750 at some point during the first half of the year.

Gold's upward trend relative to the base metals should continue during 2008. Also, we expect that gold will move sharply higher relative to oil.

Gold Stocks

With one exception (Gold Fields Ltd), we perceive considerably more downside risk in the major gold stocks than in gold bullion and only slightly more upside potential. As a result, we don't see a good reason to take long-term investment positions in the majors. This has, in fact, been our view for at least four years. These stocks periodically become oversold relative to gold bullion and at such times they make good trading vehicles, but on a longer-term basis they are not worth the hassle. There are simply too many things that can go wrong with them compared to the amount of additional upside potential they offer. In our opinion, if you are risk-tolerant and looking for ways to leverage gains in the price of gold bullion then you should own a portfolio comprising mid-tier and junior gold mining equities, but if you are risk averse you should focus on gold bullion or gold bullion surrogates such as GLD.

The gold-stock indices can be expected to track gold bullion during 2008, falling further during gold-market corrections and rebounding faster thereafter. However, if the broad stock market were to become very weak then we could encounter a period during which the gold sector falls while gold bullion rises. 

We expect to see an increase in takeover activity in the gold sector during 2008, with mid-tier miners seeking to acquire juniors and majors seeking to acquire mid-tiers.

Possible surprises:

1) Barrick Gold makes a takeover bid for Kinross Gold

2) A large diversified miner (BHP, Rio Tinto, Xstrata, etc.) decides to increase its exposure to gold by making a takeover bid for a large gold mining company

  The US Stock Market