Yearly Forecast

  Random Thoughts

 *Our view at the beginning of 2008 was that economic weakness would result in a deflation scare (widespread fear that deflation is a threat, as opposed to actual deflation (money supply contraction)) during the first half of the year. What actually happened was that inflation fears remained elevated during the first half thanks largely to incredible strength in the oil market, prompting us to change course and to speculate, during May through August, that a deflation scare would commence in the second half of the year and probably extend into 2009. As things turned out, the fear of deflation ramped up more quickly than anticipated. Importantly, however, up until now it has been a classic 'scare', as opposed to the genuine article (monetary contraction), in that the fear of deflation has become rampant even though the rate of monetary INFLATION has increased dramatically.

The deflation scare will extend through 2009, with a respite during the first half of the year. In particular, the fear of deflation will likely become more prevalent after the stock market's rebound runs out of steam.

  *The spread between long-term and short-term US interest rates will remain unusually wide because the Fed will keep overnight interest rates pegged near zero while long-term (30-year and 10-year) interest rates establish an upward bias. Also, credit spreads (spreads between the yields on relatively high-risk and relatively low-risk bonds of the same duration) will generally remain wide, although they should contract while the stock market rallies. Wide/widening yield and credit spreads will ensure that the interest-rate backdrop remains bullish for gold relative to other commodities and investments.

  *Gold will weaken against industrial commodities (including silver) during the first half of the year in response to an economic 'false dawn', and then recapture its relative strength during the second half.

  *In our 2008 Yearly Forecast we wrote: "In a desperate effort to revive the economy...the US Federal Government will become the primary engine of debt/money expansion (inflation)... 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." This comment is also applicable for 2009.

  The US Stock Market

We began 2008 expecting the S&P500 to end the year with a small loss, meaning that our outlook at the beginning of last year was nowhere near bearish enough.

As far as 2009 is concerned, we think the first few months will be characterised by hope of recovery and the remainder by disappointment. In particular, it looks like the stock market has been building a base capable of supporting a 2-4 month rally from whatever low is made in January.

There is very little prospect of a new bull market beginning anytime soon, but this is not because the economic backdrop is dismal and likely to remain so (the beginnings of new bull markets always coincide with dismal economic news); it's because valuations are not yet low enough.

  The US Dollar

In our 2008 forecast we wrote:

"...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."

Last year a number of important trends began a few months later than expected, and when they did finally begin they moved much more quickly than expected. Last year's US$ rally is a good example.

As far as 2009 is concerned we think the US$ will have a negative bias for a few months beginning in late January and a positive bias thereafter. The negative bias in the US dollar's exchange value will be due to the temporary waning of deflation fears and the emergence of recovery hopes, whereas the ensuing positive bias will be due to the renewed desire to avoid risk after it becomes apparent that a sustainable recovery will not begin this year.

In addition to rejuvenated fears about deflation and economic weakness, the US$ could be given a boost later in 2009 by the growing realisation that Europe's monetary union may not survive.

Note that a rise in the US dollar's foreign exchange value in response to fears about the stability of the European Monetary Union would constitute euro weakness rather than genuine US$ strength. This is the sort of situation in which a rise in the Dollar Index would likely coincide with a rise in the US$ gold price.

  T-Bonds

Bonds are currently in a short-term downward trend and this trend should continue while the stock market rebounds, but we don't have a firm opinion on what bonds will do beyond that. On the negative side of the ledger, there will be a veritable deluge of additional bond supply during the course of the year and in all likelihood there will be reduced demand for T-Bonds from China and the Middle East. On the positive side of the ledger, deflation fear will probably move back to centre stage during the second half of the year and the Fed has intimated that it will buy T-Bonds to suppress long-term interest rates.

  Gold and Gold Stocks