Hobson's choice economically speaking...

Thesis: Expect contiuned weakness in the market, the Fed is left with a single sided choice of maintaining loose credit standards until housing regains footing. Oil continued to fall even though fundamentals remain in tact.

The single most concerning piece of information this week was the Federal Reserve’s quarterly Senior Loan Officer Survey of Bank Lending Practices. Respondents to the July survey revealed that their banks ratcheted credit conditions yet tighter in recent months, suggesting more “stag” ahead. The credit crunch has now spread into all areas of lending, with more than 80% of banks reporting a tightening in lending standards for mortgage loans, and more than 60% for consumer and business loans--levels far above those seen in the 2001 recession and even in the 1990-91 recession (graph below). Lending officers asked about their willingness to make consumer installment loans reported the biggest negative shift in attitudes towards lending to households since early 1980.


Also very disappointing were weekly data on jobless claims. New claims edged down slightly to 450,000, but remain well above levels just a few weeks ago, while the total number of claimants topped 3.4 million for the first time since 2003. With credit conditions tightening, the labor market weakening, asset prices down substantially, and fiscal stimulus now a thing of the past, households are likely to cut back on spending over the next several months. Consistent with this gloomy outlook, core retail sales in July--excluding autos, building materials, and gasoline were up only 0.3%, the third consecutive month of slowing. This suggests that the impetus from fiscal stimulus is rapidly fading.

The “flation” half of the stagflationary data came with the monthly reports on import prices and the Consumer Price Index. Import prices continued their climb in July, accelerating to a 21.7% year-over-year increase overall, 8% excluding petroleum products (the highest inflation rate since the depreciation of the dollar in the late 1980s following the Plaza Accord). For those of us who aren’t business history buffs, The Plaza Accord or Plaza Agreement was an agreement signed on September 22, 1985 at the Plaza Hotel in New York City (hence the name, I know politicians are really creative). The agreement was signed by 5 nations - France, West Germany, Japan, the United States, and the United Kingdom. The focus of the agreement was to depreciate the US dollar in relation to the Japanese yen and German Deutsche Mark (remember what was going on in West Germany right now) by intervening in currency markets. The exchange rate value of the dollar versus the yen declined 51% over the two years after this agreement took place. Most of this devaluation was due to the $10 billion spent by the participating central banks. The reason for the dollar's devaluation was twofold: to reduce the US current account deficit, which had reached 3.5% of the GDP (FYI as of 2007 it was at 5.3%), and to help the US economy to emerge from a serious recession that began in the early 1980s. The U.S. Federal Reserve System under Paul Volcker had overvalued the dollar enough to make industry in the US (particularly the automobile industry) less competitive in the global market. Devaluing the dollar made US exports cheaper to its trading partners, which in turn meant that other countries bought more American-made goods and services (sound familiar?). The Plaza Accord was successful in reducing the US trade deficit with Western European nations but largely failed to fulfill its primary objective of alleviating the trade deficit with Japan because this deficit was due to structural rather than monetary conditions. US manufactured goods became more competitive in the exports market but were still largely unable to succeed in the Japanese domestic market due to Japan's structural restrictions on imports. The recessionary effects of the strengthened yen in Japan's export-dependent economy created an incentive for the expansionary monetary policies that led to the Japanese asset price bubble of the late 1980s. But I digress….

Consumer prices leapt higher yet again, with headline inflation accelerating to 5.6% year-over-year on sharp increases in energy and food prices. Perhaps more concerning, core inflation rose 0.33% on a plethora of upside surprises strewn throughout the index, e.g. apparel +1.2% (likely related to the acceleration in import prices), tobacco +1.2%, public transportation +1.1% (probably driven by higher energy costs), lodging away from home +0.7%, education +0.5%.

The main bright spot of the US economy isn’t in the United States it’s the rest of the world, which is increasingly turning to US manufacturers given their steady productivity gains and more favorable exchange rate. In volume terms, the trade deficit has been narrowing since early 2007 (wait, this seems eerily familiar!).

Beyond the fundamental drivers of a weak dollar and weak US domestic demand, high commodity prices have been a factor behind this dramatic improvement. They encourage conservation by commodity-consuming countries like the United States (hence fewer imports) and stimulate more spending by commodity producing nations (including spending on US exports). Essentially all of the acceleration in real exports in recent months has been in commodity related goods.

Mortgage deterioration has spread beyond subprime. Early policy efforts e.g. modification of adjustable rate loans and a government-backed refinancing program generally focused on subprime borrowers, but defaults are accelerating in Alt-A and prime mortgages as well. Even among the government-sponsored enterprises (GSEs), recent mortgage vintages appear to be deteriorating at a faster pace. Thus, programs targeted to a more limited subprime population may be less effective as defaults broaden.

The federal government is likely to bear an increasing share of losses going forward. Financial institutions have now announced over $500 billion in losses over the last year, but have managed to raise $367 billion in capital, largely through issuance of common and preferred stock. However, as some institutions find it difficult to raise capital, additional exposure is likely to fall on the government (can someone say higher taxes?). Also, because a substantial portion of the early losses was related to securitized products, institutions with the most direct link to the government deposit-taking banks and the GSEs did not face immediate risk. This has now changed, as a result of widening losses and government action. As the federal government bears a greater fiscal burden, there is the potential for increasing conflict between policy objectives and political realities. Individual lenders have an incentive to reduce risk to limit losses and preserve capital. While policymakers aim to maintain credit availability, there is pressure on politicians to resolve financial disruptions in the least costly manner possible, as well as a desire to take incremental steps in the hope that more aggressive action will not be necessary.

Apart from the initial steps taken to date, what more can policymakers do? Congress plans to return for one month in September and then adjourn until early 2009. The Bush Administration may take additional action before next January, but without further legislation this would be limited to working within the existing authority that Congress recently granted. The incoming administration and the next Congress face three important questions: first, will the federal government devote more money to cleaning up the mortgage mess? Second, will lawmakers compel greater participation from lenders? Third, how will policymakers balance longer term reform against medium term stability?

So what does all this mean with regards to potential trades? The recent emergence of wider corporate credit and commercial mortgage spreads, GSE worries, and the potential contagion to the rest of the financial sector all do not bode well for the market. Getting above 1,300 required a great deal of inflation worry to be resolved, painfully so for the supposed “growth” areas, but having wrung out that fear and facing the specter of another wave of seemingly imminent financials damage, a pullback to previous lows is far easier to envisage than any break back to the tops of the recent range. The most proximate upside catalyst might very well be government intervention in the GSE space. Over the last year the market has come to respect the power of government action to spark short-lived market rallies, but it may take more damage from here to get that to happen.

A GSE bailout is certainly damaging for equity holders in that space. But as we have seen in the recent past, government intervention may be a market and sector positive, at least in the short term. Getting there may entail some serious pain and, while the nearly explicit GSE put may limit broader contagion in the financials space, it is worth remembering that a capital injection that just repairs balance sheet damage does not mean that GSEs will be open for “business as usual,” and mortgage activity will likely continue to be impaired.

Against this backdrop, though GSEs themselves face the most direct pressures and the entire financial sector is likely close second, housing equities look vulnerable too, with housing activity meaningfully related to GSE fortunes. Mortgage rates are rising despite a bond market rally, pushing mortgage spreads up even more sharply, and bank de-leveraging means further constraints on consumer credit and mortgage lending.

The XHB has outperformed the market by more than 20% since mid-July, as some tentative signs of firming in the data emerged (An uptick in permits, a slowing in the pace of house price declines, and some sequential improvements in the inventory of new homes relative to sales). But there has been little data follow through in the form of continued stabilization, and mortgage centered concerns ought to be the dominant force here, at least for now, with significant room for housing equities to run lower.

One of the symptoms of the weakening economic growth outlook (at least in the market’s estimation) has been the sharp pullback in oil prices. This has led to some significant sector rotations. Consumer areas of the market have been supported, while the energy sector has been damaged. As previously written, I view this rotation as extreme on both counts: Consumer discretionary stocks have taken too much credit for the potential boost to spending from a pullback in oil prices, and energy equities have taken on too much damage. Relative to the market, the broad consumer discretionary sector (XLY) and the retail space (RTH) have rallied; the underlying indices are both up around 5% relative to the SPX since mid-July. With oil price relief the likely catalyst, the magnitude of these rallies looks overdone, exceeding historical “betas” to the oil price move, and in the face of still significant underlying consumer headwinds. The weekly unemployment insurance data point to further labor market damage commensurate with an unemployment rate well into the 6% range, confidence remains at recessionary levels, and consumer balance sheets continue to be de-leveraged as banks cut back on lending.

On the oil side, even if oil prices only stabilize here, energy equities, which have looked inexpensive relative to crude oil all summer long, ought to benefit too. Even after taking into account the sharp pullback in oil prices themselves, the energy sector (relative to the market) looks undervalued.

Given all this data it would appear as if the choice is simple, we are left with only one option (hence the title, A Hobson's choice is a free choice in which only one option is offered, and one may refuse to take that option. The choice is therefore between taking the option or not taking it, colloquially formulated as "take it or leave it.") Expect equities to continue turbulent times and seek safety in wide moat companies, energy specifically is looking appealing given the recent pull back, avoid consumer stocks until future spending looks more promising.

From contango back to backwardation...

Summary: Oil may continue to trade in a range bound fashion, but don't expect it to drop too much further, in the medium to long-term fundamentals are nothing but bullish.

To the average American, the US economy is clearly in recession. This is because, in most people’s eyes, a recession is what a recession does: it snuffs out jobs as companies cut output to accommodate a weakening in demand, thus reducing real income. However, the data on GDP have yet to meet what many call the “technical” definition of recession--two consecutive quarters of .negative growth, an oxymoron that only economists could love. In fact, the National Bureau of Economic Research (NBER) the arbiter of business cycles in the United States does not use this definition. In its words: “a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

The four monthly indicators on this list that the NBER specifically tracks are consistent with the common view that a recession started late last year. The conclusions today are the same as they were then, strengthened a bit by revisions that have steepened the declines in the interim. In particular:

1. The US economy probably hit a cyclical peak last November.

2. The recession has been exceedingly mild, at least so far.

Although the rise in unemployment that most people take as telltale of recession has been anything but mild, all four indicators have held up better than the median for the cycles since 1953. All but real sales have also fallen less quickly than in 2001, when the US economy experienced the mildest recession on record as measured by GDP the only one that shows no year-to-year decline in real GDP. Given this backdrop, it should not be surprising that the lack of a significant drop in real GDP has held up the NBER’s recession call. Even after last month’s annual revision, which produced a tiny 0.2% annualized drop in the fourth quarter, some members of the NBER committee charged with this august responsibility seem hesitant, pointing out that real GDP subsequently rose during the first half of 2008. Conceptually, Gross Domestic Income (GDI) and GDP are equivalent, as sales of goods produced in the United States (GDP) generate income for someone (GDI). Observed differences are statistical in nature. According to a Fed staff study, real GDI often gives a more reliable signal than GDP around turning points.

That being said, we can’t help but wonder if lower energy prices will lead to economic salvation. However, as is usually the case that form of syllogistic reasoning is flawed. Although lower energy prices will assist the consumer it only takes care of one of our “four horsemen of the recession” (the others being: housing malaise, credit freeze, and the indebtedness of the U.S. and its citizens).

Now I shall shift the focus more onto this “correction” in energy. The tug of war between fundamentals tightness and concerns over demand weakness continues to dictate oil price movements, with the latter in the spotlight over the past few weeks. The explosion in the BTC pipeline and the recent hostilities between Russia and Georgia have not only materially disrupted a significant portion of Azeri exports, but have also underscored the vulnerability of oil supplies from the region, which accounts for a good part of the expected year-end supply growth. However, oil prices have continued to sell off to below US$115/bbl regardless.

Although concerns over demand weakness have outweighed fundamentals tightness in the past few weeks, recent data releases confirm that constrained supply and supportive non-OECD demand continue to more than offset weak OECD demand. Declining supplies in mature producing regions and strong non-OECD demand more than countered the 1.1% price-induced decline in OECD demand in 2Q08, leaving total OECD inventories flat in 2Q08 against a seasonal 900 kb/d build, remaining below 10-year average levels for the end of July. The 9.5% annual increase in Chinese demand in July exemplifies that non-OECD countries continue to absorb oil supplies and keep fundamentals tight even in an increasing price environment. Further, last week’s US Department of Energy (DOE) statistics have confirmed a decline in refined product inventories prompted by refinery run cuts, against a backdrop of continued low crude inventories.

While near-term fundamentals remain tight, since the beginning of the year and specifically over the past few weeks’ expectations regarding long-term fundamentals have been center stage. Long-dated oil prices have been driving the rally since the end of last year, accelerating dramatically in May and June, and are now leading the downwards correction. While the 20% sell-off over the past four weeks has been a record decline for long-dated oil prices, it comes on the heels of a record acceleration that had brought backend prices above the trend in price changes that had characterized the market since the end of last year and in the 2004-2005 structural rally. In particular, five-year forward prices had soared to over US$140/bbl at the beginning of July. Despite tight near-term fundamentals, bearish sentiments over future demand destruction have driven the back-end sell-off. Indeed, remarkably, the recent sell-off has been accompanied by signs of strengthening physical fundamentals as prompt WTI timespreads have strengthened over the past few weeks moving into a front-month backwardation. Further, while the price acceleration in May and June weighed on 2Q08 US demand and more modestly on European demand, overall the impact on global demand has likely been modest as is suggested by the unseasonably flat OECD inventories in 2Q08.

The long-term drivers in the market remain intact –trend supply growth has declined and cannot continue to accommodate stable trend demand growth on the back of supportive global economic growth fuelled by emerging markets. Therefore, on a long-term basis, higher prices are necessary to promote a structural demand adjustment and to continue to incentivize investments in production capacity enhancements. While weakening economic conditions in G3 countries coupled with the recent acceleration in oil prices have restrained demand, especially in the US and more modestly in Europe, the necessary structural adjustment required to bring demand in line with production capacity will likely take many years of high prices to promote a meaningful increase in energy efficiency.

While concerns over demand weakness continue to permeate market sentiment, recent data releases confirm that supportive non-OECD demand and restrained supply have more than offset OECD demand weakness, leaving total OECD inventories unseasonably flat in 2Q08 against a seasonal 900 kb/d build. Further, preliminary industry data for July indicates a 28 million barrels increase in total OECD stocks in July, which while slightly higher than the 19 million barrel seasonal build for July, continues to leave inventories below 10-year average levels.

The lack of inventory builds in 2Q08 despite softer price-induced OECD demand and the 400 kb/d increase in Saudi production in May and June underscores extremely tight crude balances suggesting that non-OECD demand has continued to be exceptionally strong and, possibly, that supply growth could be lower than currently estimated. It should be noted that given the 90% yoy surge in oil prices in 2Q08, the 1.1% yoy decline in total OECD demand over the same period has not been surprisingly strong but, if anything, has been lower than would be suggested by standard demand elasticity estimates, likely on the back of supportive power-related demand in Japan. Further, while US oil demand has born the brunt of the oil price surge, given its higher price sensitivity, weaker economic environment and distressed credit conditions, the decline in total US oil demand has not been stronger than in previous economic slowdowns.

More importantly, US gasoline demand growth continues to show a strong correlation with price changes instead of with price levels, underscoring that as oil price inflation moderates in the second half of the year, some pressure on demand will likely be alleviated.

The necessary expansion in oil production capacity remains constrained by escalating resource protectionism at the same time that alternative fuels are proving to have limited scalability. As these constraints are slowing trend oil supply growth against a backdrop of higher world GDP growth, long-dated oil prices need to increase steadily to slow oil demand growth in line with supply on a long-term basis. While the need to curtail demand growth on a long-term basis will likely keep long-dated prices above marginal cost of production, industry costs are re-accelerating at the same pace as they did in the 2005/2006 period.

This indicates that the floor below which long-dated prices are unlikely to fall for a sustained period of time is rising. In particular the historical relationship between industry cost indicators such as the US Oil and Gas Field Equipment and Machinery PPI and long-dated oil prices suggests that the cost-based floor to long-dated oil prices was US$105/bbl in June and is likely continuing to increase.

In other words, don’t bet the farm on oil falling too much further.

From Russia with Love?

Thanks to some reader suggested input, I will now place the thesis of each post at the very top. Thesis: Long Russia/Long LNG.

For those of you who have read my prior posts you might have realized that I am relatively bullish on certain foreign economies, with Russia being one of them. The Russian thesis in a nutshell is: they have an immense amount of natural resources which should drive their domestic economy allowing the government (via heavy export levies) to invest substantial amount of domestic infrastructure which should help spur development in non-natural resource based industries, this coupled with the fact that I believe their currency is currently undervalued should provide a U.S. investor an interesting return spectrum. The risks to this thesis are obvious: inflation, Dutch Disease, government risk (think recent events with Mechel or Yukos), and most recently war with Georgia.

As you probably have heard Russian tanks crossed into South Ossetia Friday after Georgia launched a major military offensive to recapture control of the separatist province on Thursday night. In Moscow, Russian equities tumbled, as investors turned nervous following news of the escalating situation. The benchmark RTS stock index fell 6.5%. The index has declined 24.8% this year (this decline is due to three things: 1. Putin’s recent move against Mechel, 2. Falling natural resource price and 3. Conflict with Georgia. The Russian currency, the ruble, fell more than 1% against its dual currency basket Friday. South Ossetia has a population of 70,000, most of whom are not ethnically Georgian, but close to the Ossetians in Russia's province of North Ossetia. A destitute region, South Ossetia has received two-thirds of its $30 million budget from Russia and the majority of its population holds Russian passports, according to Global Insight. Russian state-controlled gas giant Gazprom is building a pipeline to the region as well as infrastructure. For Russia, South Ossetia is a useful means to undermine and cause inconvenience to the unfriendly Georgian government, which sees itself as the U.S. outpost in the post-Soviet space and seeks to join NATO, which is very annoying to Russia. Politics aside one can’t help but wonder what could be the end result financially speaking. The likely result is that the fighting will continue until Russia is allowed to either remove the people or claim the territory; I view the former as the most likely scenario. Although Georgia does control reasonably important pipeline territory Russia has already been finding ways to build around it. I think the recent sell-off in both the equities and currency is overdone.

Demographically speaking Russia does face certain challenges. Russia stands out for its high levels of educational and scientific achievement. But the fiscal crisis of the 1990s caused a ‘brain drain’ of many of its top researchers and difficulties in recruiting new teachers. The country still needs to go some way to restoring the quality of its schools and universities, while adapting them to the demands of a knowledge-based economy. Demographics pose one of the most serious challenges to Russia’s long-run growth potential, and have a direct, negative impact on the future size of the economy. The US census bureau forecasts that Russia’s population will shrink from the current 142mn to under 110mn by 2050, with the workforce contracting after 2009. So far, the government has offered incentives to mothers to have more children, has begun to invest more in health care, and has promised to promote a healthier lifestyle. As the government begins to invest more domestic infrastructure that will drive job growth which will spur immigration from surrounding countries. Just as in the other BRIC nations, Russia needs to improve its infrastructure significantly. Because Russia is already reasonably urbanized, its need is not in the same league as China’s or India’s. Nonetheless, Russia has plenty of scope to improve its transport systems, linked to the rapidly rising wealth of Russians. The airline/airport infrastructure need appears to be especially strong, and it represents both a challenge and a significant business opportunity.

The question then remains will commodities remain high enough to fund the backbone of the Russian economy? The conflict in Georgia might act to disrupt Russian oil & gas supplies to Europe (they could also tighten the spigot as a form of political pressure for EU neutrality or support). Speaking on a more macro level, there has been a substantially negative shift in sentiment owing largely to concerns about commodity “demand destruction” in the context of both slowing global economic growth and substantial commodity price increases this year. Concerns about increased supply availability owing to OPEC production increases and substantial improvement in US crop conditions and development post the slow start to the U.S. planting/growing season and the Midwest flooding have also contributed to recent sharp price declines. Although US and broader OECD demand for oil has weakened substantially over the prior six months in response to rising prices, this weakness has been necessitated by extremely disappointing non-OPEC crude oil supply growth –down 650 thousand b/d year over year in June – in the context of still strong emerging market demand. The US in particular has borne the brunt of the demand declines relative to the rest of the world because lower taxes, a weaker economic environment and tighter credit conditions have left US consumers most sensitive to rising prices. Despite substantial US demand weakness, US total product inventories have failed to build meaningfully and US crude oil inventories actually remain at critically low levels, providing further evidence that any supplies made available by US demand weakness are being consumed by emerging economies. This lack of an inventory build also underscores that recent increases in OPEC production have only served to offset substantially larger-than-expected production declines in places such as Mexico, Venezuela, Russia and the North Sea. As the rise in prices earlier this year is very consistent with the magnitude of the resulting demand weakness based on historical relationships, it is likely that the demand weakness has simply been induced by the rising prices and is therefore temporary rather than more permanent demand destruction.

I will now spend some time focusing in on a few key commodities.

Black Gold:
Oil prices declined by almost 15% in July and another 4% so far in August primarily as concerns over global economic growth and weakening oil demand have triggered a sharp financial liquidation. WTI crude oil open interest has plummeted to the lowest levels since the beginning of 2007 and speculative length has declined to lows reached at the beginning of the year when oil prices declined by 13% - similar to the recent sell-off. As a result, prices have declined to levels where large open interest in put options is concentrated, underscoring the risk of further selling pressure as financial traders who sold the puts need to sell further contracts to delta hedge their portfolio – traders call this the “negative gamma effect”. Recently, the U.S. consumer has borne the brunt of the necessary demand adjustment because lower taxes, the weak U.S. dollar, a soft economic environment and tighter credit conditions relative to the rest of the world have left the U.S. consumer most sensitive to price. Accordingly, U.S. oil demand has been exceptionally weak. However, the magnitude of weakness has been consistent with the rise in price, suggesting that this weakness is likely transient rather than more permanent demand destruction and could reverse on stabilization or decline in prices. Importantly, this demand weakness on top of recent increases in OPEC production is not leading to meaningful inventory builds as emerging markets are consuming the available supplies, and as OPEC production increases have largely served to offset non-OPEC production disappointments. Since the beginning of May, total US and OECD oil inventories have built less than seasonal norms and have declined below 10-year-average levels while US crude oil inventories remain at critically low levels. A strong rise in Chinese refinery runs - up 7.2 % year over year in June despite the 20% increase in controlled domestic prices announced on June 20 – underscores the emerging market demand strength. Overall, while spare oil production capacity is extremely low, inventories remain below 10-year average levels, underscoring that global demand for oil is not falling significantly below supply. Goldman Sachs recently reaffirmed their year-end price target of $149 which is a full 29% above Friday’s close. In my opinion I think this forecast might be slightly high, given the negative demand dynamics associated with EU and US consumers I am leaning more towards a year-end price target of around $130 which is about 13% higher than today’s prices.

Natural Gas:
NYMEX Natural Gas closed at $8.248 with WTI Crude closing at $115.20. Historically, crude oil has traded at about a 6-8 multiple to natural gas, currently the ratio is 13.96x. Natural gas was the worst performing commodity in July, as prices declined 46% in the period (vs. a 15% decline in Oil), disconnecting from international natural gas prices and widening their discount to the oil complex, largely on the back of economic concerns that have generated downward pressure across the commodities complex as well as a meaningful softening of the US natural gas balance. Specifically, despite modestly hotter-than-normal weather in July, natural gas inventory builds over the last few weeks have been substantially above average, leaving inventory levels only 6 Bcf below 5-year average levels from a peak deficit of -78 Bcf in the week of July 4, 2008. On the supply side, US pipeline imports from Canada, although still down year-on-year, have reduced their differential to 2007 levels by more than 400 mmcf/d or 38% in July relative to June. Going forward, expect no meaningful recovery from Canadian exports to the United
States due to still low Canadian gas rig counts and no significant displacements of natural gas-fired generation, now that the excess water supply has been depleted and natural gas/coal differentials are at near record-low levels. Goldman Sachs recently came out with an October price target of $13 which is 57% above current levels. I think this forecast is a little overly bullish. It relies significantly on a strong hurricane season and a large amount of cold weather in both September and October. I think a fairer price estimate would be in the $11.50 range which is still 39% higher than current prices.

On the equity side, even after accounting for the pull back in commodities, the consumer and energy shifts look extreme. The equity damage in the energy sector has outpaced the commodities themselves. In fact, the recent disconnect between equities and commodities are on the high end of their historical relationship. Part of the equity drag has been a reflection of the underperformance of large cap refiners, with margins under extreme pressure. In fact, refiners look more like industrial oil users than parts of the energy sector. But even when looking at an equal-weighted version of the energy sector, the gap to commodities is at the top end of the range.

Given the recent pull back in commodity prices the risk/return dynamics have been favorably skewed. It would be wise to re-adjust your portfolio allocation to this specific sector. Given that Russia is the largest producer and exporter of LNG it might also be wise to take a look at it. The short-term risks with Russia are over blown; the real worries lie in inflation and long-term growth (i.e. bulking up non-natural resource dependent sectors of the economy).

Interesting Opportunity

Fear of inflation is back. Consumers and investors alike are concerned that higher commodity prices, a weak US dollar, and easy monetary policy are generating a self-reinforcing inflationary spiral. This confluence of events reminds many of the 1970s, and we.ve heard so many references to that era in recent weeks that we.re half-expecting bellbottoms and the Bee Gees to make a comeback. The evidence of inflationary angst is everywhere. News reports including the word inflation are up substantially in the last few months. The median household expects 5.2% inflation over the next year and a 3.4% rate over the next five to ten years, according to the latest University of Michigan survey the highest inflation expectations in more than a decade. In the markets, the spread between nominal and inflation-indexed Treasury yields remains over 2.5%, quite high by recent standards. These inflation fears are understandable. Year-over year consumer price inflation is running just under 4%, and has been below 2% for only three months out of the last four years. Gasoline prices and commodity prices more broadly have soared to new records, and the last time that the United States experienced increases of this magnitude in the 1970s they were associated with a decade of rampant inflation and dismal growth.

Several unpleasant similarities between now and 1970 rightfully prompt concern about the inflation outlook. First, inflation was unpleasantly high despite a mild recession both then and now. Second, monetary policy was simulative both then and now, with the real funds rate below zero. Third, productivity slowed from the 3%-4% rates through most of the 1960s to 1½%-2% around the turn of the decade, and has followed a similar pattern over the last few years. Fourth, the dollar has depreciated sharply in the last few years, as it did following the breakdown of the Bretton Woods system in 1971. Finally, and perhaps most concerning, inflation expectations have jumped: the University of Michigan survey showed that households’ average expectation for inflation over the following year rose from about 2½% in 1963-65 to over 6% in early 1970; the same measure shot up to 7% in the May 2008 survey a 27-year high. Although each of these factors suggests that inflation risk is elevated, the differences between 1970 and the present situation are more important:

Capacity was much tighter. The economy had been running hot for several years, with the unemployment rate still 3.9% at the beginning of 1970, near an all-time low.

Wages had accelerated substantially. Average hourly earnings rose at about a 4% pace during 1966, 5% during 1967, and then more than 6% in 1968-69. Then, over the entire decade of the 1970s, wage growth never dipped much below 6%. Currently, average hourly earnings are up only 3.5% over the past year, a deceleration from the pace over the prior two years. The contrast between unit labor cost growth then and now is even greater.

Inflation was broad-based. Inflation was not confined to one or a few parts of the major price indexes; core and headline inflation were both far above desirable levels.

Credit conditions were less of a drag. Although monetary policy is quite accommodative now, it is being offset to a significant degree by tighter credit conditions. In other words, broad financial conditions are not as loose as the funds rate implies in isolation. In contrast, credit conditions were relatively stable in the late 1960s and early 1970s (with the notable exception of the Penn Central bankruptcy in June 1970 and its fallout on the commercial paper market).

Policy choices favored low unemployment over low inflation. Ultimately, price stability is the Fed’s responsibility. Although the Fed did tighten to slow the economy and contributed to recessions in 1969-1970 and 1973-74, it never kept rates high enough for long enough to bring inflation, inflation expectations, or wage growth down to acceptable levels. It took more than a decade of unacceptably high inflation before the Fed, under Paul Volcker’s chairmanship, took the bitter medicine and pushed the economy into the double-dip recession of 1980-82.

Given the number of differences between now and the 1970s, I am not sold on the 1970s being a viable analogy. Although I do believe our economy is in and will remain choppy waters for some time I think the logical trading strategies will be distinctly different from the 1970s. That being said I do believe the recent pull back in commodity prices particularly natural gas may offer the investor an interesting risk/return spectrum. Although the current environment may not be perfectly comparable to the 1970s I do believe that as historically was the case, commodities will outperform in high inflationary environments.

According to Goldman Sachs equity research, energy equities have rallied and corrected 10 times since 2004. Surges averaged 24% and pullbacks averaged 13%. At $129, crude oil trades at the same price as on May 20th, but Energy shares have dropped 14%. Energy earnings season kicks off this week, with 81% of the Energy market capitalization reporting over the next two weeks. Schlumberger (SLB), in the first significant Energy earnings report of the 2Q season, reported above-consensus earnings resulting from better than expected international revenues and in spite of weak results in North America. SLB has served as a bellwether for the sector in past quarters and I expect this quarter to be no different. Emerging market demand for energy, exhaustion of refining capacity, limited sources of new supply, and modest availability of alternative sources should continue to provide support for energy prices. That being said, I personally believe that recent pull back in Exploration & Production E&P natural gas companies offers investors a particularly attractive opportunity. With the E&P group off 28% from its 52-week highs and down 22% month-to-date, the E&Ps are now trading at a 5% discount to gas at $8.00 which is 12% below Friday’s closing prices.

There are a number of reasons I am particularly interested in natural gas. We have a lot of it, it trades at a discount domestically to its UK equivalent, and it is much cleaner than other fossil fuel offerings. In addition to this, T. Boone Pickens recently announced his “plan” which is basically an attempt to wean our country off of oil and onto natural gas and wind energy (both of which T. Boone is heavily long on). Pickens said the plan could cut the amount the country spends annually on foreign oil from $700 billion to $400 billion." He proposed the following steps:

1. Using the United States' wind corridor, private industry will fund the installation of thousands of wind turbines in the wind belt, generating enough power to provide 20 percent or more of the country's electricity supply.

2. Again funded by the private sector, electric power transmission lines will be built, connecting these wind power generating sites with the power grid, providing energy to the population centers in the Midwest, South and Western regions of the country.

3. With the energy from wind now available to serve the large population centers in key areas of the country, the natural gas that was historically used to fuel natural gas fired power plants can be redirected and used as a fuel for private cars and thousands of vehicles in the transportation system. This reduces the need for imported gasoline and diesel fuels.

I like many others am very intrigued by the idea of weaning ourselves off the black gold from the middle-east. As good as this plan sounds; it will likely not pass in anything near its original form. It requires a capital outlay of $1-$1.5 trillion which is too large an amount for our short-sided government to approve. As optimistic as I am, I am also skeptical that private companies will be willing to foot the bill. That being said, I am quite bullish on the long-term prospects of natural gas. The natural gas value chain looks similar to value chains for many other fossil fuels, consisting of exploration & production, transportation, marketing/distribution, and ultimately, delivery to end users. Historically, the natural gas industry has looked a lot like the electricity industry-- a natural monopoly industry (due to the high capital costs of natural gas pipelines and difficulty in storing natural gas), heavily regulated at both the wholesale and retail levels. However, unlike the electricity industry, deregulation has been a boon to the natural gas industry, encouraging innovation and reliability of supply.

The key drivers of the end-user price of natural gas are two-fold. (1) The raw fuel costs account for about 60% of final costs, while (2) the transmission and distribution costs account for the remaining 40%. The raw fuel price is market determined, but is driven by a combination of market demand and both current and future supply of natural gas. Natural gas is unique in that it is challenging both to transport and to store, limiting the short-term flexibility of supply in response to demand shocks.

There are typically two methods of transporting natural gas, both requiring significant investment. The predominant method of transportation in North America is via natural gas pipelines. An increasingly popular method of transport, and one likely to continue to gain traction as the U.S. finds itself importing more natural gas from sources outside Canada, is Liquefied Natural Gas (LNG), which enables gas to be shipped overseas in tankers. LNG requires major investment in both deep-water, sheltered ports to harbor LNG tankers and in liquefaction and gasification plants on both ends of the transport route-- the U.S. only has 5 LNG terminals currently, but plans to nearly double capacity over the next 3-5 years. However this expansion has been met with significant resistance as no one (NYC included) wants to have the new LNG terminals in their city due to noise, pollution, etc.

Gas storage also offers an opportunity to reduce the cost of natural gas. Natural gas prices are typically seasonal, peaking in the winter months and hitting lows in the summer months, when heating needs are least. Though storing gas is challenging, given that it is lighter than air and therefore prone to dissipation, solutions have been found. Typically, gas is stored in depleted natural gas and oil fields or underground aquifers. In times of abundance (i.e., summer) gas can be injected into storage facilities, only to be withdrawn again during times of scarcity. The state of storage capacity and technology has a significant impact on natural gas prices in both the short-term (as stocks of stored natural gas represent the most readily available supply in case of increased demand for natural gas) and the long-term (as increased storage capacity offers the opportunity to build up more substantial reserves of easily accessible natural gas). Natural gas demand observably fluctuates on a seasonal basis, falling in summer months (like it has) and rising in winter months (like it will). The need for heat during the winter and lack thereof during the summer are the primary factors responsible for these fluctuations. Seasonal anomalies, like cooler summers or warmer winters, can dampen this effect and change the amount of gas demanded on a large scale, thereby affecting natural gas prices, revenues, and profits. Utilities that purchase gas when prices are lower during the summer months, in order to keep inventories ready for the winter, also have a muting effect on natural gas seasonality. Now that we have covered a good primer to natural gas, we should look at which companies stand to benefit the most.

As you can see the top four companies are true diversified Oil & Gas giants, although they in themselves might offer an interesting investment opportunity we are primarily interested in pure-play natural gas companies. I have yet to do the heavy lifting needed to identify the best of breed but I should post on it shortly. As always, input would be greatly appreciated.

Looking into the crystal ball....

To say that the first half of 2008 was a volatile environment for investors is somewhat of an understatement. Looking forward we can’t help but wonder what the future may hold. In the second half of 2008, global growth is likely to slow further, although inflationary pressures may remain elevated for a while longer before trending lower. There are several key macro themes that could be critical to market performance in the next six months: renewed pressure on the US consumer; continuing cycles of losses and injections in the banking sector; clearer signs of slower growth in Europe; global inflation to be less of a concern, although commodities remain an upside risk; and softer growth and lower inflation in China (this will caused by a combination of slower and a strengthening currency). While global growth is expected to slow over the forecasting horizon, inflationary pressures are likely to be slower to recede. As such, the next few months will likely remain a challenging environment for policymakers and there is a risk that some EM central banks remain behind the curve.

Now I shall delve further into the six macro themes for the second half of 2008.

Renewed pressure on the US consumer. Despite strong headwinds, including plummeting consumer confidence,
US consumers in the first half of the year continued to spend and overall growth has been stronger than expected. This consumer resilience is evident in the very strong retail sales report for May. This most likely reflects the impact of tax rebates, which have boosted spending a bit sooner than previously expected. But, the fiscal stimulus would only be a temporary boost to consumer incomes and the headwinds facing the consumer would re-impose themselves later this year. Besides higher energy prices and tightening financial conditions, US consumers are faced with the ongoing deterioration in the housing market, weaker jobs and income growth, falling equity wealth and a US banking sector that is increasingly hesitant in extending any form of lending. Unless the recent drop in oil prices continues and/or there are additional tax cuts, expect the consumer spending data to slow meaningfully over the next few months. Although the trade sector continues to provide a boost to the economy, this profile for consumer spending is likely to experience a double-dip, with GDP growth likely to be anemic towards the end of this year and the first half of 2009. Expect further USD weakness and a steeper yield curve. Equity market consumer views appear rich relative to macro benchmarks, and with the economic data set to worsen further, the fundamental story here still has plenty of room to play out.

Continuing cycles of losses and injections in the banking sector. The fear of a systemic collapse of the US financial sector has been at the top of the market’s and policymakers’ list of concerns since last summer. With many US and European financial sector companies entering the current housing and economic downturn with highly leveraged balance sheets, the overriding concern of investors since last summer has been the fear of further write-downs and falling earnings expectations. So far banks have been successful in raising additional capital but their ability is arguably likely to become impaired given the recent price action, which has seen financial stocks shed 14.2% over the past two weeks (and down 40.7% year to date). Moreover, it is reasonable to expect policymakers to remain alert to the need for additional liquidity and capital injections as confidence in the financial system continues to come under pressure. Last week’s equity meltdown of the US housing agencies Fannie Mae and Freddie Mac was reminiscent of the suddenness of the Bear Stearns demise in March, and highlighted the precarious position of those institutions that are directly exposed to the dynamics of the US housing market at the current juncture. The latest episode led to the US Treasury and Fed announcing measures to extend credit to, and buy equity in, Fannie Mae and Freddie Mac, if requested by the two GSEs, thus allowing them to remain active in the troubled mortgage market. This cycle of losses in financial institutions, and associated swings in confidence and liquidity injections from the authorities, could remain a feature of the outlook in the second half of 2008—especially if the US housing market continues to deteriorate.

Clearer signs of slower growth in Europe. As the US economy continues to slow over the next few months, growth in the BRICs and the EM universe should moderate only gradually, and their resilience should help to keep global growth reasonably strong. But it might become clearer in the second half that growth in the advanced economies is slowing. The latest Euro land industrial production data (-1.9%mom in May) and PMI surveys suggest that growth is slowing from the very strong first quarter. Indeed, tighter financial conditions (mainly due to the stronger Euro and higher interest rates) and rising oil prices pose meaningful downside risks to Euro land growth in H2. One area that looks particularly vulnerable is the Euro land consumer. Consumer confidence has fallen to its lowest levels since 2003. Consumer-related data in France is weakening, similar to Spain, reflecting to some extent a slowing housing market. Signs of economic weakness are also emerging in other English-speaking economies. The most striking signs of economic trouble are in the UK where falling house prices, tighter credit conditions, weaker global demand and a squeeze on household disposable incomes all suggest mounting risk of a recession. Tightening financial conditions are also slowing growth momentum in Australia, while the main driver of the New Zealand slowdown is an entrenched capitulation in the residential property market.

Global inflation to be less of a worry, but commodities are a wild-card. Global inflation could still rise further, but it could begin to fall off later this year as growth slows and base effects from food and energy prices start to kick in (assuming that the prices of food and energy stabilize). The recent drop in oil prices will be important to monitor in this regard. The rise in inflation has been more evident in the EM space relative to the developed world (where rising inflation expectations are perhaps more concerning). EM inflation has risen from a low of 4.8% in late 2006 to current levels of 9.1%. There is a chance that EM inflation peaked in 2008Q2 and one could expect the downward trend to continue until end-2009. The main driver of this forecast is the view that commodity price inflation (both food and energy) is likely to slow from current levels, leading to favorable base effects. The main risk to this view is if commodity and energy prices continue to accelerate, and this in turn keeps upward pressure on headline inflation intact in various countries. Physical shortages for many commodities, together with strong emerging market demand, suggests the risk still lies to further upside price risk in the near term. In addition, the risk of second-round effects materializing also rises significantly if near-term headline inflation continues to rise.

China: Softer growth, lower inflation. China will experience a moderate slowing in growth (but with consumption remaining strong) and a marked fall in inflation. This will primarily be due to the global slowdown and a strengthening Yuan. In its pursuit of lower inflation, China’s currency adjustments will take on a larger role in tightening monetary conditions this year The expected fall in Chinese inflation would obviously relieve current global and EM inflation fears, and likely be a boon to investor sentiment and Asian equity markets in particular.

Global central banks walking a tightrope—the risk is that some are behind the curve. Global central banks will have to tread carefully over the next few months in their attempt to keep inflation (and inflation expectations) under control. Applying too much pressure on the brakes would risk growth prospects. But not doing enough would fuel inflation concerns. The ECB did not seem to be overly concerned about braking too hard when it raised rates 25bp this month. But, judging by the accompanying statement following this hike, ECB will likely remain on hold during H2. In the absence of inflation expectations becoming unanchored, the Fed is also unlikely to raise rates either. The market has certainly moved in this direction, with just a 13.5bp hike now priced in by the end of the year compared with nearly 72bp in mid-June. The higher than expected +1.1% and +0.3% rise in June headline and core CPI respectively is a timely reminder of the inflation risks. Given the macro headwinds the UK economy is currently facing, there is some chance of further UK rates, the market is currently pricing in a 40% chance of a rate hike by year-end. Turning to the emerging markets, some EM central banks have been more proactive in counteracting rising inflation expectations than others. Among the major EMs, Brazil and Mexico have generally taken a fairly aggressive stance and even in those countries, where the central banks initially appeared to be behind the curve, interest rates are now being lifted. For instance, last week, the Russian central bank raised rates by 25bp and also allowed the currency to appreciate. Moreover, the Reserve Bank of India has responded to soaring WPI inflation by recently raising rates and the cash reserve ratio. In contrast, in other EMs, such as the Philippines, Taiwan, Hong Kong and some Middle-Eastern economies, inflation appears to be turning into a broad based problem and central banks are still behind the curve. Of course, in NJA, countries with large BboP surpluses and undervalued currencies (such as the MYR, CNY, TWD or SGD) are still able to use their exchange rate in order to fight inflation. From an equity standpoint, countries with positive exposure to the near-term upside risk to commodity prices (such as Brazil, Russia, and Mexico) will remain at a relative advantage compared with markets such as India and Turkey, which have negative exposure to commodities and are also experiencing macro headwinds generated by policy tightening.

Ramblings on currencies

Given the current less than stellar state of the U.S. economy I felt it was time to revisit the thesis behind investing abroad. From a macro perspective when investing abroad there are principally two components which drive returns: asset appreciation (stock, bond, index, etc.) and currency appreciation. I shall first address the latter.

The USD no longer offers the investor an appealing risk/reward trade off, with U.S and consumer debt ballooning the USD will in all likelihood continue its decent. Over the past few years, we have seen a couple of important shifts in currency regimes. The de-pegging of the Chinese Yuan from the Dollar in 2005 was the most important single event. But smaller countries have also moved away from Dollar pegs. Malaysia moved away from its Dollar peg at the same time as China, and we saw Kuwait abandon its Dollar peg in 2007. These developments have raised the question of whether other Dollar pegs are also likely to break. In particular, many investors have been focused on the durability of Dollar pegs in Hong Kong and in the Middle East.

This is particularly interesting due to the recent run of inflation that these countries are experiencing. The reason these countries are experiencing inflation is due to the increased capital inflow from increased exports to the U.S. and the rest of the world, this inflow is then compounded by the effects of a declining dollar, creating a run of inflation. Although an appreciating currency might help ease inflation it also runs the risk of contracting the ever feared "dutch disease" (Dutch disease is an economic concept that tries to explain the apparent relationship between the exploitation of natural resources and a decline in the manufacturing sector combined with moral fallout. The theory is that an increase in revenues from natural resources will deindustrialise a nation’s economy by raising the exchange rate, which makes the manufacturing sector less competitive and public services entangled with business interests).

Determining the optimal currency regime for a given country is a complex matter. But, ultimately, a large part of the choice is about weighing up the costs and the benefits. On the one hand, a fixed exchange rate regime brings benefits in terms of increased stability and lower transaction costs. On the other hand, it also entails a cost, in terms of relinquishing control over domestic interest rates. This is because monetary policy cannot be used to manage the business cycle and/or deal with external shocks when the exchange rate is fixed.

Goldman Sachs recently outlined four parameters to properly analyze the cost/benefit analysis:

Parameter #1 is the Strength of Trade Links: If trade is heavily skewed towards one country, or skewed towards a group of countries using the same currency, then there will be the advantage of having currency stability versus this reference currency. Having a fixed exchange rate versus a currency that accounts for a large share of trade will secure a relatively stable effective exchange rate (trade-weighted exchange rate).

Parameter #2 is the Size Effect: Trade will matter relatively more for small economies, which are typically also more open. Transaction costs related to exchange rate fluctuations will tend to be more important in smaller economies. Size also matters in relation to the efficiency of the currency market. Small countries will have a harder time building efficient currency and capital markets. All told, the cost of exchange rate volatility is likely to be bigger for small countries.

Parameter #3 is the Synchronization of Cycles: If the business cycle is closely correlated (synchronized) to the reference country’s cycle, then there will be less benefit from using the exchange rate to adjust to cyclical shocks. That is, the cost of relinquishing monetary independence—by fixing the currency to a reference currency—is smaller when the domestic cycle is closely synchronized with the cycle in the reference country. On the contrary, a lack of monetary independence may be problematic if an economy faces very different shocks (including terms-of-trade shocks) to the reference country.

Parameter #4 is Policy Credibility: If domestic policy credibility is low, then there is a more compelling argument for ‘importing’ policy credibility from the reference country and anchoring inflation expectations in that way. On the other hand, if the domestic policy framework is credible and domestic institutions enjoy a good reputation relative to the reference country, then the benefit of ‘outsourcing’ monetary policy will be smaller.

I shall now address each one of these four parameters with country specific examples.

Parameter #1:
A key argument in favor of a fixed exchange rate regime is that a fixed exchange rate reduces transaction costs and exchange rate risk, which can potentially discourage trade and investment. But a peg to a specific anchor currency (typically the Dollar or the Euro) will not eliminate exchange rate volatility entirely. Pegged currencies may experience significant exchange rate volatility on a trade-weighted (also called effective) basis, if the anchor currency moves significantly versus other major currencies. This has been an issue in the Middle East in recent years, where currencies have been pegged to the Dollar. As a result of the USD weakness observed since 2002, Middle-Eastern currencies have depreciated notably versus most currencies, especially versus the Euro. This is important because the Middle East has strong trade links with the Euro-zone. The bottom line is that Middle-Eastern currencies have seen significant volatility on a trade-weighted basis despite their fixed exchange rate regimes, and currency depreciation versus key trading partners has placed upward pressure on import prices.

Parameter #2:
A second key parameter in the choice of exchange rate regime is linked to country size. Small countries will typically see bigger benefits from a fixed exchange rate regime than larger countries, for a number of reasons. First, small countries are typically very open, which means that a large proportion of the economy is exposed to exchange rate fluctuations and related adjustment costs. Second, small countries are typically closely integrated with large anchor countries/regions, which means that the business cycle tends to be closely linked to the cycle in the anchor country/region. Third, small countries will have a harder time building efficient local currency and capital markets. This means that transaction costs (both in foreign exchange markets and capital markets more generally), related to a flexible/independent exchange rate regime, are higher. This issue is particularly important for countries that are vulnerable to swings in investor sentiment, and related currency fluctuations. Hence, the smaller the country is, the bigger the benefit of a fixed exchange rate regime, all else equal. On the other hand, the benefit of a fixed exchange rate regime will be more moderate for larger countries. More specifically, the cost of exchange rate variability is likely to be lower for larger countries. The countries that benefit most from this are places like Estonia.

Parameter #3:
The cost of relinquishing monetary independence—by fixing the currency to a reference currency—will be smaller when the domestic cycle is closely synchronized with the cycle in the reference country. More specifically, the intuition is that if business cycle shocks are similar across partner countries, then the need for policy independence is reduced and the net benefits from adopting a currency peg might be higher. This parameter was the logic behind establishing the Euro. In my opinion sometime in the future we will likely see a similar agreement is reached with the U.S., Canada, and Mexico. It is one of the logical solutions to the declining USD that no politician has yet to broach (plus it would be a way to solidify the NAFTA agreement thus appeasing the fears of our neighbors down south).

Parameter #4:
Historically, exchange rate pegs have often been used to ‘import’ monetary policy credibility. That is, countries without a good track-record in maintaining low inflation have often resorted to a fixed exchange rate regime in an attempt to anchor inflation expectations to the level in a reference country.
The basic idea behind this decision is that in the absence of domestic institutions with credibility as ‘inflation fighters’ it is preferable to link the exchange rate to a reference country, which already has institutions with a high degree of credibility in terms of inflation control. For this reason, a move to a fixed exchange rate regime has often been a part of economic stabilization programs in emerging markets. For example, when Poland experienced high inflation rates in the early 1990s, the economic stabilization program involved an exchange rate peg for a period. From this perspective, the credibility of domestic institutions is an important parameter in the cost-benefit analysis of the exchange rate regime choice. Basically, the lower the credibility of domestic institutions in terms of managing inflation, the higher the cost of a floating exchange rate, and the lower the benefit of monetary independence. This is the cornerstone behind my thesis that all of Africa should unite behind the South African Rand. It is especially logical for South Africa’s neighbor Zimbabwe who is currently experiencing hyperinflation to yield to this argument.

What are the ultimate conclusions that we have learned? Investor focus on currency regime issues has increased significantly following the changes in the Chinese currency regime in 2005. In addition, following accelerated USD weakness over the past year, investors have increasingly started to question the sustainability of the remaining USD pegs. For Eastern European EU members the arguments in favor of EUR pegs or adoption of the Euro are very strong across the board. The Eastern European economies have become increasingly integrated in the overall European economy; and most countries in the region, perhaps with the exception of Poland, are too small to build fully efficient domestic capital markets. We conclude that the Eastern European EU members are all suitable for some type of EUR peg within the foreseeable future. It will always be a challenge to pick the right fixing rate, but the end-goal seems very clear. For the Gulf Cooperation Council countries in our sample (Saudi Arabia, Qatar, and United Arab Emirates) the conclusions are also clear. From an economic perspective, the current USD pegs do not look optimal. In the short term, a peg to a basket of both USD and EUR would help reduce the impact of volatility in major currencies. But it would not address the region’s need for greater monetary independence. Such independence may not be technically feasible at this juncture, given that domestic capital markets are not sufficiently developed. But over time, increased flexibility seems highly desirable. This is especially the case since energy shocks are likely to continue to impact the region in the opposite direction to most other countries. Greater monetary independence would provide a better framework for dealing with cyclical dynamics which are likely to run asynchronously with both the US and the Eurozone. Domestic institutions and capital markets should be developed to facilitate gradually more monetary independence and exchange rate flexibility. A GCC monetary union would help to engineer the economies of scale needed to boost efficiency in local capital markets. From this perspective, a single GCC currency is a sensible longer-term goal, albeit perhaps a tricky one to achieve by 2010. For Hong Kong o the USD peg is no longer the optimal arrangement from an economic perspective. This is especially the case now that China, which accounts for a large share of Hong Kong’s trade, is itself allowing more currency flexibility. That said, one big concern for monetary authorities in Hong Kong is that the exit from the current peg itself could generate too much volatility in domestic financial markets broadly. Given the importance of the financial sector in the Hong Kong economy, this potential ‘exit cost’ remains an important consideration.

State of Affairs

This blog, more than anything else is meant to be an exercise in idea creation. In an effort to further solidify the theses behind my various investments, I will from time to time post ideas that lay out my investment framework. Hopefully meaningful feedback will be received. We'll see....