9 November 2007

The Decline of the West, Act II

Truth and Beauty (… and Russian Finance)

Global Macros and Mayhem 2 Global Markets How to Trade ‘em 13 Acceleration of Economic Change - A Short -The Amazing Shrinking Dollar 15 History of Time 4 -Asian Markets One man’s bubble 16 Asia’s New Asian Millennium 5 -EMEA Catch-up time 16 George Bush and the Fall of the West -G7 Equity Markets 17 Economics 6 Commodities Revenge of the Old Economy 18 Fear and loathing in the Capital Markets 7 Agricultural Prices 18 -Against Economic Calvinism 8 Russian equities Bloodied by not bowed 19 Global Turbulence Blowback for the Empire 11 The Easy Money Rouble Bonds 19

Write Fast then Run like Hell!

Verily, we live in interesting times. Strategists in particular feel a bit like rabbits on the first day of the hunt. As the volatility in markets continues, we live in constant fear of issuing a brave call hitting the “send” button then promptly being made total fools of as the market spins back into crisis mode. Perhaps we should learn to live with it any given call will almost certainly be “right” at some time over the next 30 days (and stopped clocks tell the right time far more frequently than do most strategists at global investment banks)! Credit Markets the Fire THIS Time Quite extraordinarily, a clutch of sober, senior and very, very serious Wall Street bankers has been allowed to create a Frankenstein’s monster which now threatens the global financial market with massive destruction. This monster was built upon a foundation which any school child should have known to be hopelessly unstable extention of unlimited, inadequately collateralized credit to individuals clearly unable to repay. The US credit market is in even worse shape than is commonly acknowledged. Large segments of it are now broadly insolvent. There is a single theme underlying the entire debacle the US mortgage market, both Prime and Sub-Prime. Forgive the colourful language, but the “cancer of bad housing loans” has infiltrated itself so widely throughout the financial body as to imperil not just the housing market itself, but also the corporate high-yield debt market (via CLOs), the vitally important municipal bonds market (thanks to the near-bankrupt monoline bond insurers) and the banking system itself. The bank regulators have been badly discredited the rating agencies shown to be criminally negligent. We will almost certainly see the failure of one or more major financial institutions before the carnage abates. A series of bailout operations by the Federal Reserve is now both vitally necessary and very much to be expected. $$$ - Once Fooled Twice Shy Rather than actually doing something to support its currency, the US Treasury Department has long reassured itself that global investors would continue to throw good money after bad, thanks to their “deep faith in US debt markets the world’s deepest and most liquid; if so, this faith has been ill-rewarded as a wave of CDO defaults blows dozens of European and Japanese institutions out of the water; presumably, they shall henceforth take a slightly more jaundiced view. Yes, liquidity is cool, but fundamentals still count! Similarly, while the UST is not yet pricing in any default risk, the currency in which it is denominated has proved a bad bet. Ironically, the undoubtedly shallow and illiquid Russian bond markets have proved a far, far safer bet…while recently, there was a brief bout of mark-to-market damage, there have been no credit events; and investors face the comforting prospect of receiving both full interest and principal in fine.

Global Macros and Mayhem Those who cling to the memory of the economic primacy of Atlantic Alliance have taken to reminding us of the Japanese Bubble predicting that history shall repeat itself and China’s secular rise will prove equally unsustainable... “Bollocks!” we say. Like China, Japan grew fast based upon an authoritarian, export-driven politico-economic model with massive, state-sponsored investment in Capex. Beyond that, both countries are Asian, and Westerners can easily confuse Chinese and Japanese tour groups -the similarity ends there. Vitally, Japan was a fairly old country with a modestly-sized population, at least relative to that of China. Thus, as Japan’s GDP per capita reached the levels of the industrialized West, the rate of growth naturally levelled off. Undoubtedly, this same phenomenon would occur in China, the day its 1.5 billion people attained a European standard of living. Needless to say, by that (very hypothetical) point, its economy would dwarf that of Europe and America combined! We do not expect to see this happen due to the limited global resources available to subtend industrial growth, and expect to see an increasingly brutal competition for resources develop first. That, fortunately, is for a subsequent issue, and in the near term, we expect to see China reshape the post-war global politico-economic montage far faster than would have seemed conceivable ten years ago.

The Dollar Regime Change Our safest trading call remains our long-standing dollar short the EUR has just broken our first target $1.45, first suggested in 2004 -with patience, all things come. Disturbingly, the devaluation is occurring much faster than we had thought possible the USD has weakened by almost 4 big figures, from 1.415 to 1.4540, in the week since we started drafting this issue. Whilst a gradual, orderly decline in the dollar is in everyone’s interest (the Americans’ most of all), a sudden collapse could be calamitous. Everyone in particular, every central bank has some skin in this game, and presumably, will wish to ensure at worst an orderly demise of the world’s erstwhile reserve currency.

Mistakes, however, can happen and powerful, poorly understood forces are at work; a disorderly unwind with a panicked sale of US assets, soaring US treasury yields, disruption of trade flows and possibly, of dollar-based commodities markets would not be a happy event for anyone involved. As owners of dollar assets take an increasingly devastating hit to their net worth, we are seeing panicked sellers foreign private entities are net sellers, as are an increasing number of sovereigns. The Bank of America estimated this week that the US outflows of funds into foreign bonds and equities are likely to reach $290bn this year. Are currency controls next? As an interesting corollary, according to Chris Granville’s Trusted Sources, the G7 finance ministers spent an inordinate amount of time agonizing about the new sovereign wealth funds. It is quite extraordinary that the deficit countries expect the rising economic powers to continue accumulating constantly depreciating currency, simply to help support the deficit spending of the governments in question spending often directly inimical to their own interests. Instead, they are now planning to actually do something with their money - in a striking reversion of the classical roles, buying productive assets in the industrialized world.

The King is Dead! We live in troubled times. “Faith-based” economic mismanagement, with its convenient belief in the ultimate sustainability of a model whereby the world at large will forever finance the mushrooming US trade and budgetary deficits, has effectively killed the dollar as a store of value this, coupled while the secular rise of Asia and the newly industrialized economies, has sharply decreased at least the relative weight of the US economy. Fundamentally, we are facing not just another bout of financial volatility we are experiencing the economic equivalent of “regime change”. The fundamental tenets of the post-war global economy are quickly becoming obsolete: both the US dollar as the ultimate anchor against which all other assets are valued, and the overwhelming primacy of the American economy (indeed, of the West, as a bloc) have been fatally tainted. Those who chose to ignore these shifts do so at their own peril. Accelerate me up, Scotty! What we find truly extraordinary is the accelerating rate at which this shift is occurring. T&B is on the record predicting a dollar at 1.45/Euro and $100 oil but certainly, at the beginning of this year, we would never have foreseen either event occurring in 20071. Thus, as the world accelerates into the vortex of a generalized global catastrophe the contours of which we can only vaguely apprehend (see appendix II The Fire THIS Time) not only is the rate of change accelerating, but the rate of acceleration is itself accelerating second and third derivatives come into play.

A Bull in a Candy Store Global markets are currently both frightening and elating. Given the self-organizing nature of market economies, as the old system crumbles, a new meta-stable system will certainly emerge what is less clear is whether this will be a smooth, continuous process. We can only guess at the contours of this new system. Certainly, it will be multipolar, probably with a strong regional flavour. Given the absence of any obvious substitute for the US dollar, there will likely be a series of systems built around various stores of value: an Asian currency system, the Euro, perhaps systems anchored by the value of ounces of gold, even bushels of wheat and barrels of oil. Bridges will quickly form between the various components of this balkanized system. Now, more than ever before in living memory, investors must remain intellectually flexible, ready to abandon long-held preferences and practices at a moment’s notice. Old reflexes can be dangerously maladaptive in a new world as just one example, international investors who retreated to the perceived safety of US treasury bills at the beginning of this year (much less, to “high-grade” US debt securities) have suffered a substantial erosion of their wealth. Russian rouble bonds widely seen as high-risk assets have proved to be infinitely safer than Investment-grade CDOs. More controversially, Russian bank debt may turn out to be far safer than the paper of some of the major Western Investment banks. 1 Oil prices are now driven by a combination of fundamental supply/demand factors and financial drivers in particular, long-only US investment funds which have recently been buying protection against $100 oil leading the investment banks to hedge their exposure by going long the underlying commodity ed: thanks to W.A!

Acceleration of Economic Change

- A Short History of Time A man born in 1700 would have likely died in a world which had seen only very limited change. Economic relationships were fixed and regulated by long tradition, society was stable and predictable, the majority of men lived on the land, worked as their fathers had, and expected their children to inherit a world largely unchanged from the one they knew. Likewise politics: empires rose and fell slowly, over centuries. France had risen to become the preeminent European state by the early 18th Century; she remained so for some two hundred years. The seeds for the rise of what was to become National Germany were planted during the Napoleonic wars; the resultant tree grew disruptively into the middle of the 20th century. The Turkish Empire declined for some 250 years before finally giving up the ghost, playing its part in the bloody onset to the century just ended. The old Europe was inwards-looking. Given the huge costs and relative uncertainty of transportation, until the middle of the 19th century the impact of trade was very limited primarily based upon the importation of luxury goods from Asia and precious metals from the Americas. The agrarian societies of Asia and the Americas were tradition-bound, intellectually immobile, and inward-looking; they were little affected by the technological change which was transforming the West. Europe’s undisputed pre-eminence was due as much to a pragmatic and positivist intellectual approach as to her superior technology. The conquest of Mexico by a handful of Spanish adventurers was repeated throughout the Americas, resulting in a continent divided into a series of agrarian, hierarchical Catholic societies with deeply inflexible class structures, a conservative outlook, and widespread poverty Following the classic colonialist model, these countries were exploited for their commodities and kept as captive markets for excess industrial production, first by Spain, later by the United States (The Monroe Doctrine) The first experiments with left-wing revolution failed, both due to external pressure and to the maladaptive nature of the classical Marxist model; most Latam economies thus remained essentially feudal until recently, when a fundamental shift in global trading patterns allowed new experiments in alternative growth models . Likewise Asia, where despite a rich and complex high culture and substantial scientific achievement, Asian societies were loath to embrace technology i.e. the pragmatic application of knowledge. Having invented gunpowder and early artillery, the Chinese themselves had no workable guns to fend off European raiders. With the obvious exception of Japan, the first non-European nation to defeat a major world power in 1905, and despite brief moments in the sun for the likes of Argentina and Brazil as one or another commodity came into demand, this situation remained essentially unchanged until the 1960s. Trade in vital commodities, in particular oil, was almost entirely controlled by companies domiciled in the industrialized West; the commodity exporters - mined for their resources - were essentially passive price-takers. Indeed, seen from Europe, the emerging world seemed primitive and comical lazy, happy natives lying in the sun eating fruit - impoverished, tradition-bound societies obviously inferior to the civilized and prosperous industrial world of Europe and its English-speaking offshoots.

The Dragons Resume Smoking This seemingly immutable divide between the industrialized nations and the third world began to erode with the rise of the Asian Dragons. First a resurgent Japan, rising from the ashes to undergo radical modernization and industrialization, transformed itself from a primarily-agrarian backwater into a first world country. By the 1970s, Korea, Taiwan and Singapore authoritarian, centralized states hell-bent upon transformation in a single generation, became serious players. Other Asian states sought to emulate their more successful neighbours. Yet the true tipping point was the rise of China growth has been extraordinarily fast for the past two decades, but given the extremely low baseline, it is only in the past few years that it has belatedly been recognized as being one of the world’s most important economies (number one in terms of the gross volume of GDP growth, impact on global prices for consumer goods, as well as effects upon commodity prices).

The sheer size of the Chinese economy is by now daunting. A decade ago, China was strictly the appanage of Asian strategists no one else much cared. It is now inconceivable that a global strategy piece should be drafted without giving pride of place to China! Equally, as a working hypothesis, the limited effect of the subprime crisis on global markets can be explained by the resilience of the Chinese and Indian markets. If this decoupling can be sustained, it will accelerate the Eastward shift in the global centre of economic gravity. Future Shock 220V History does not repeat itself…Historians repeat themselves! The single greatest danger to the investor is to indulge his apparently inborn tendency towards intellectual conservatism the belief that things will always be as they are today. Perhaps a useful trait in a stable, predictable world, it becomes a crippling impediment to adaptation during times of rapid change. Even for those at least vaguely cognizant of the major events surrounding them, there is a huge resistance to accepting the implications of these events i.e. the disruption of tried-and-true traditional models. One of the best examples was the behaviour of the oil analysts. From 1998 until about a year ago, thanks to their highly sophisticated (if increasingly-irrelevant) supply/demand models, almost to a man they warned of the impending collapse of crude prices back to its “long-term average” of, say, $25. In the meantime, oil prices have surged some 900% intellectual conservatism in action! It is not that the analysts are fools simply, their finely-honed mathematical models, which had proved so useful in the past, offered a comfortably “scientific” means of extrapolating present trends into the future. The hugely inconvenient fact that an elephant China had entered into the elevator was simply ignored; in fact, this single factor has itself outweighed all of the other changes measured by the models. More recently, commodities analysts have fallen victim to the same fallacy, predicting a collapse in commodities prices due to an incipient US recession the fact that Chindia has replaced the US as the primary source of incremental commodities demand has apparently been missed. .

In Summary T&B believes that the current financial crisis and shift in global growth patterns is not merely a fluctuation within a relative continuum nor even a cyclical function; instead, it falls within a fundamental discontinuum; our basic assumptions are now that: - The centre of economic gravity is shifting away from the G7 it will not return in our lifetimes. As a result of the economic shift, the global political/diplomatic context will see a radical change. - For the first time in modern history, the world will be deprived of a single reference currency against which all others can fluctuate. A multi-currency system including not just classical currencies but also ounces of gold and perhaps bushels of wheat/barrels of oil will have to fill the gap. - Increasing prosperity may prove to be not a factor for peace, but rather, for a dangerous exacerbation of conflict, as increasingly-wealthy emerging nations compete with the old G7 countries for scarce resources…

Asia’s New Asian Millennium As we have noted previously, one of the most interesting aspects of the current crisis is that it will test our fundamental financial thesis that growth in the emergings is now self-sustaining, and that the centre of economic gravity has shifted from New York/London to Beijing/Bombay. While it is too early to arrive at any final judgments, T&B has clearly won the first round. While the short-term volatility in financial markets remains primarily driven by events on Wall Street, the real economies of Emerging Asia have not yet suffered any damage. Thus, as G7 equities have stagnated, Asian indices have boomed, both on surging liquidity as well as on signs of accelerating economic growth. As of this writing, the economic fundamentals have been decoupling smartly. As the US faces a housing recession, Japan is threatened with a renewal of deflation, and Europe struggles to avoid being sucked into the credit-withdrawal vortex. Chinese GDP has just printed at 11.5%. Singapore, India, Korea, even the Philippines and Indonesia are showing unexpectedly rapid growth. Russia is likely to come in well above 7.5%. Selected commodity prices are on a rampage - prices for oil, iron ore, as well as fertilizers, agriculturals, shipping (Baltic Dry Index) and most base metals suggest a continuation of rapid demand growth.

Again, whilst US imports of consumer goods are trending down, the real test is what will happen when US demand is hit by recession. As the value of the dollar plunges, and the credit squeeze hits, US consumers will be obliged to begin saving, thus decreasing the demand for imports. We continue to expect this to primarily affect those countries most dependent upon sale of high value goods Japan, Korea, and Taiwan, rather than those who fill up the shelves of the Wal-Marts of this world China, Vietnam, Thailand, etc. Nevertheless, to some extent, all will be faced with the need to find alternative markets in the Asia-Pacific region, and especially, to stimulate their own internal demand. If they succeed, then a new era will be upon us; if not, then the transformation will be delayed until the next cyclical trough. In any event, financial markets are increasingly discounting a decoupling. For the first time, average P/E ratios in the emerging markets are higher than those in the Atlantic countries…not surprising, given that emerging GDP growth rates are three times those in the G7, while fiscal policy has been far more virtuous in the major emerging markets than in their developed peers.

George Bush and the Fall of the West - Economics There are those who view history as a purely mechanistic process, with the rise and fall of great empires pre-ordained. In this view, statesmen are seen as mere actors, playing their roles in a tragedy not of their own conception. A contrary view, one espoused by our favourite modern historian, AJP Taylor, is that much of history is due to blind chance the stumblings of men across an unlit stage. Whether or not the relative decline of the American Empire became a certainty on the day after its greatest triumph the fall of the Berlin Wall is purely speculative, but unipolar global political systems have reliably proved labile, providing a compelling target for all of those outside the charmed circle. Diplomacy aside, simple economic determinism the secular rise of China and the other Asian powers is now inexorably diluting out the economic primacy of the West. What should be clear is that the election of George Bush in a rigged Florida election (albeit, confirmed 4 years later in a poll widely viewed as relatively free and fair) sharply accelerated this process. The election of what is now widely seen as the worst US administration in living memory, as well as the catastrophic failure of a finely-honed system of checks and balances to restrain the Presidential ability to make mischief, has a price. As was briefly the case during the late Reagan presidency, great empires may well fly for some time on autopilot they do not fly well with a chimp at the controls! It would have been extraordinary had a Bush regime which has proved so extravagantly incompetent in its foreign and domestic policies failed to do its bit to cripple the US economy. From the purely domestic standpoint, crony capitalism has flourished, while the increasing propensity to live beyond one’s means has masked a precipitous decline in social mobility once the mainstay of the American credo. Relatively unconcerned with US domestic issues, T&B will focus instead upon the international implications. The dangerous combination of gross incompetence and extraordinary arrogance characterizing Bush’ international diplomacy has also marked US economic policy: “deficits don’t matter” was the credo ‘faith-based’ economics the theology. Early in the Bush presidency, so as to brush away the inconvenient strictures imposed by economic reality, the new administration deliberately appointed compliant and ideologically pure non-economists to key economic policy positions. O’Neill and Snow could be reliably counted upon to countenance whatever policies suited the Neocon ideologues. Thus, in a grotesque expansion of Reagonomics, they convinced themselves that military spending could be driven to levels reminiscent of the late USSR, while taxes (at least for the wealthy) could be slashed; this would result not in massive deficits, but in a balanced Federal budget because they wished it to be thus. This childlike faith extended to the general populace which briefly enjoyed the delights of cheap credit, disavings, and home equity extraction. The laws of gravity are now extracting their brutal revenge.

The Kindness of Strangers The US budget balance, briefly in surplus under Clinton (an almost unheard of feat for the old, industrialized democracies),has swung into deep structural deficit; whilst the extent of this shift was temporarily masked by the enhanced tax revenues generated by a burst of credit-fuelled economic growth, it will be seriously exacerbated by the coming downturn, and will require substantial, pro-cyclical tax hikes in a recessionary environment (in turn, requiring the Fed to run an extremely accommodative monetary policy).

A recent study by the US Congress put the potential cost of the wars in Iraq and Afghanistan at as much as $2.7 trillion (under a moderately pessimistic scenario, and including compounded interest). The fundamental problem is not the deficit per se (other countries run larger ones as a proportion of their GDP) but rather the fact that, given US disavings - unlike Japan, France or Italy (but very much like Turkey and Estonia) the deficit must be financed entirely by foreigners. Those foreigners who have rushed to do so are now taking a nasty hit on their dollar holdings presumably, they will now be increasingly disinclined to provide further financing. Funding the US deficit could thus prove to be a far stickier undertaking than in the past. Again, gross incompetence and the conscious decision to see the world as it should be, rather than as it is, has a price. Payback time is at hand. While there is reason to hope that the coming US recession will be relatively mild, it is also likely to be prolonged, and to provide a convenient historic milestone marking the secular decline in US economic preponderance, at least in relative terms. This will be accompanied by a substantial decline in living standards as wealth is destroyed and the dollar loses much of its value. Eventually, the weak dollar will lead to a rebalancing of the trade deficit, consumers will be compelled to save enough to fund the US deficit, and (after an overshoot) the dollar will find a floor. The US may well avoid slipping into absolute decline, but in economics, as in politics, the era of absolute American pre-eminence is over. It is not coming back.

Fear and loathing in the Capital Markets Given the boom in Asian markets, the collapsing dollar, and the resultant run-up in commodity prices any half-competent international asset manager should currently be shooting the lights out if he had the courage to short credit indices, then he is an absolute hero. And yet speaking to our peers in Europe and Asia T&B has encountered a generous dose of fear, mixed in with the greed. Investment Banking Always Darkest…just before it goes Pitch Black Each time someone suddenly turns on the light switch in the financial kitchen and the market begins to take a closer look at the doings of the major investment banks, we encounter not just an almost inconceivable measure of greed but also, of raw stupidity. Thus, the bluest of the blue-blooded have been grievously mauled, and it is to be expected that at least one major financial institution will go bankrupt (or at least, be acquired under distressed circumstances) before this is over. Most extraordinarily, Merrill Lynch may be looking at a $30 billion dollar writedown (an achievement for which Stan O’Neal, Merrill’s outgoing president, is to be paid a modest $161M…) in a subprime crisis which any adult economist should have seen coming (this is not back-trading T&B warned of it repeatedly, as did, in far greater detail, a host of independent global strategists, notably Marc Faber). As of this writing, the list grows longer by the day: Bear Sterns, UBS, Citigroup, Bank of America, and predictably a host of Japanese banks. The Europeans also took a hit, stupidly competing with the American banks for a piece of the latest bubble. Typically reminiscent of its heroic role in the Russian financial crisis only Goldmans looks to come out relatively unscathed. Although they created some of the most egregious structured products (one of them nominated as the Worst Deal of the Year in what is proving to be a veritable kennel club a leveraged, collateralized structure based upon second mortgages with virtually zero homeowner equity, it was truly innovative given the almost complete absence of any recourse!) At least Goldmans had the good sense to then go massively short the entire CDO market! The systematic optimism of the economic commentators is heart-warming but misguided. Each time three days go by without another implosion of a bank/hedge fund/investment vehicle we hear that old chorus of “Thank Heavens, the worst is past!” Though T&B is certainly not predicting the apocalypse, equally, the worst is nowhere near past. The US/UK housing markets have a wretched 18 months ahead of them, promising a continual flood of defaults on the mortgage loans which provide the vital biomass which feeds almost the entire leveraged financial montage. Defaulting mortgages will mean massive losses for holders of the CDOs and SIVs. These, in turn, have been incorporated into a wide variety of other financial products, all of which are going to lose money. As the underlying loans go bad, they will continue to turn up in the most unexpected places. With a bit of luck, and a very proactive central bank, the financial system will have the time to absorb these losses, growing its way out of the problem; but anyone who imagines the losses will just go away is delusional.

Likewise the investment banks - do not be fooled by their carefully cultivated images nor by all those reassuring 4-colour press advertisements. They are large carnivores predators driven by a combination of greed and survival instinct in a viciously competitive environment to extract increasingly huge sums of money (“create value”) from the underlying economy; in recent years, as corporate profitability has grown faster than GDP, an increasingly large share of economic activity has been captured by the financial system much of the “growth” in the international economies has occurred in a fundamentally parasitic sector essentially specialized in the moving of money from one pocket to the other.2 Darwin has been at work here with the disintermediation of lending, as well as the commoditization of bond and share trading, the banks have been obliged to forage far-and-wide to feed their copious appetites. Recently, they thought to find their salvation in structured finance a wonderful example of the ability to extract substance from nothingness. Note that these are the same banks which essentially lost more than their entire combined profits for the previous hundred years in the emerging markets debt crisis of the 1980s. Having bought into the convenient fiction sovereigns could never default, they built a nice franchise recycling the huge mass of petrodollars created in the aftermath of the oil embargo into Latin America. When starting with Mexico these hopelessly over-indebted and recession-struck borrowers began defaulting, the entire US banking system became insolvent. They were saved by the regulators, who allowed them to continue to mark their non-performing loans at 100%. It took them a decade to grow out of the problem. The resulting “moral hazard” was an irrelevance. They will never 2 The author acknowledges his own membership in this fundamentally-parasitic clan it certainly beats working for a living! repeat the same stupid mistakes though their ability to find new ones never ceases to amaze! Under the circumstances, and given the nature of the beasts essentially pass-through structures where the top producers take home most of the profits it would have been miraculous had they failed to leverage up their new investment vehicles to the point where they endangered their very survival. No miracle was forthcoming, and verily the bluest of the blue-blooded have been bloodied to the extent that their independence is threatened. And thus, we encounter: The Dumbest Headline of the Month : “Fed May Be Done Cutting as Inflation Risk Increases” T&B is willing to make a largish bet that the Fed is nowhere near finished with the rate cuts. They are understandably doing their best to manage expectations, but in the absence of hard evidence of increasing core inflation, their first priority will be to avoid a meltdown of the financial and housing sectors. Rate cuts and a steepening of the curve can do wonders for a wounded banking system, whilst lower rates will have an immediate pass-through effect on borrowers having floating rate mortgages. We continue to believe that we will see a 3­handle on Fed rates before this is done, and that the Fed will remain in rate-cutting mode through end-2008.

-Against Economic Calvinism Von Sacher-Masoch : The Greatest of the “Austrian” Economists? Each day it seems, T&B reads yet another tirade demanding that terrible punishment be visited upon those who got caught in compromising positions under the influence of copious liquidity. The saintly Greenspan has been revealed as nothing more than the Devil’s accomplice, and his host of followers soft, pink and fat are to be scourged and shrived to save their immortal souls. One indignant columnist demands that “millionaire investors” who took advantage of the leverage on offer should be made to pay the Fed should tighten rates to support the currency (shades of 1929…), the US Treasury should allow the commercial paper market to implode, the ECB should let banks go bankrupt, SIVs collapse, financial markets should fail, all so that a chastened human race should turn away from sin, living according to the words of the gospel sober, frugal…and very, very poor.

Some of T&B’s favourite macroeconomic pundits aside, the current crisis sweeping through global capital markets is not the end of the world as we know it. Properly managed it will not bring the global (or even the US-) economy to a screeching, grinding halt; it will not cause a collapse in all asset prices, nor create global hyperinflation sending gold prices into the 5 digits. The dollar will not lose all (perhaps most…but not “all”) of its value. For once, the central banks, both European and American, have done precisely what they should have done maintaining an adequate level of liquidity to prevent the seizing up of credit markets. Even the much-maligned ‘super SIV plan’ if successful is an absolute godsend. The total meltdown in a one-trillion dollar market for commercial paper is a recipe for disaster not for recession, but rather, for outright depression. Central banks were not designed as vehicles for divine retribution, but rather, as institutions devoted to maintaining the viability of their financial systems, without which the real economy fails, disrupting the lives of millions of ordinary people. Markets have no magic. They make mistakes. They blow bubbles which collapse, and the collapse can cause huge and durable destruction of value. The economic masochism which demands that the culpable pay for their misdeeds is somewhere between misguided and insane. It is akin to suggesting that no one should have tried to extinguish the fires at Chernobyl after the operator’s intellectual curiosity led to a loss of control over the reactor. In fact, the guilt parties had already been irradiated. It was the neighbours who were at risk. The moral hazard argument is vacuous for the simple reason that no one is ever going to do the same awesomely stupid things again they will do other equally stupid things -but not the same ones. No amount of punishment for the culpable will prevent future folly. Future bubbles will be blown in new and unexpected places like dictators, successful bankers will always imagine themselves immune from the punishments meted out to their predecessors3. After the debt crisis of the 1980s, the global banks stopped sovereign lending, never to resume. The US S&L crisis put an end to the S&Ls. Following the tech wreck the problem shifted elsewhere internet IPOs ceased to be a problem. CDOs were invented. 3 Mr. O’Neals $161. golden handshake suggests that they are correct…. Letting the financial system collapse to warn bankers against doing silly things is like shooting fallen dictators to make sure that no one does it again. The nature of man is that he sees death all around him, yet does not believe that he himself shall die. An endless supply of dictators will always be available…and of risk-tolerant bankers too. Each feels sure that he will be the exception to every rule. By all means shoot a few of each, pour encourager les autres, but never believe that this will prevent future mistakes. Thus the era of the adjustable subprime loan with a teaser rate, of commercial paper based on worthless assets supposedly rendered viable by their short term-structure and of collateralized debt obligations of dubious provenance etc. is gone. Dead as the dodo. They are not coming back. The banks which engaged in ill-advised lending are taking massive write-downs Merrill’s initially reported $8bn loss was impressive even by recent standards it now it looks like that may have been just the tip of the iceberg. Hundreds of smaller mortgage lenders now sleep in a watery grave. Some two million Americans will lose their homes, and somewhere between 2-7 trillion (yes, that’s trillion) will be wiped off the US real estate market. Guillotines are being set up in the lobbys of US investment banks, with their presidents the first to step onto the escalator…ergo, punishment is not in short supply.

Who Said Investment Banks Lacked a Sense of Humour? Leafing through a recent back issue of The Economist strategically placed in our bathroom, T&B found the most delightful advert by Merrill Lynch

If we allow Merrills the benefit of the doubt by assuming that they did not know what the hell they were buying when they stuffed their own book full of hugely-complex toxic waste, we must assume that not only did the investors not understand what it was they were buying, but that Mother Merrills was equally at sea. As for whom one would want in the room we leave it to the readers` imagination personally, we think a priest would be a good idea, probably a model (you are going to end up marking your new product to her), perhaps someone from the bomb squad…and a whole bunch of attorneys!

Global Turbulence Blowback for the Empire Iran Mohammad Mosaddeq Or why do they hate us so? Amazingly, Condoleezza Rice, perhaps the most incompetent Secretary of State in American history, has just declared that Iran is the “greatest security threat facing the United States.” While the reasons for this obsession perhaps nothing more than an attempt to deflect domestic attention from their hugely successful efforts to “liberate” Afghanistan and Iraq are not entirely clear, the statement itself is obvious nonsense. As we have remarked previously, the greatest threat is Pakistan and the sorcerer’s apprentices in Washington have predictably succeeded in fouling up the single most dangerous foreign policy dossier on the planet. By putting all of their chips on Musharraf, the Bush regime repeated the US errors in the runup to the eminently-predictable overthrow of the Shah of Iran finding themselves totally cut off from the moderate opposition, and thus, from any of the potential successors. As a result, they were unable to switch mounts, and when a new leader swept aside the Shah’s rotten edifice, it was of course the one most inimical to their interests the Ayatollah Khomeini. Predictably, the US foreign policy establishment cajoled, bribed and prodded Musharraf into initiating a suicidal policy a hugely unpopular war against the radical, Taliban-aligned tribes in Pakistan’s border regions. Given the unmitigated hatred with which the US is viewed in most of the Islamic world, not excluding Pakistan (according to the Pew Survey, only Palestine and Turkey are more anti-American), an alliance with Washington was the kiss of death. Having failed in a desperate, last minute attempt to slip in a more compliant politician in Musharraf’s steed, Washington is now reduced to watching passively as Musharraf ignores his erstwhile masters, declaring martial law, and throwing his country into something looking dangerously like civil war. In Eastern Pakistan, military units are reportedly defecting to the rebels; elsewhere, a political free-for-all is underway. Most terrifyingly, the world at large is now faced with a high-cost, if low-likelihood danger of a Taliban-style state armed to the teeth with REAL nuclear-tipped missiles, not with the Iranian variety potential, hypothetical, some­day nuclear weapons but real ones, fully tested and ready to fire. Those 40 Virgins awaiting martyrs in Heaven should be getting ready for some heavy traffic there’s likely to be something of a virgin shortage soon….

Meanwhile, back in Teheran The Pakistan story aside, to everyone except perhaps the folk in Washington, it should be obvious that, rather than being the threatened party, in recent years it has been the United States to have posed the greatest threat to Iran’s security, first planning and supporting a coup that replaced the populist government of Mosaddeq with a puppet dictator beholden to the US4, then sponsoring the slaughter of millions of Iranians in the Iraq-Iran war. Regarding the first, in cahoots with a United Kingdom irate that the Iranians should presume to exert ownership over the massive oil deposits conveniently situated beneath their soil, the CIA engineered the 1953 coup against Mohammad Mosaddeq, installing a corrupt, brutal and widely hated puppet regime under a tame Shah. When this regime was finally overthrown in a popular uprising led by the Ayatollah Khomeini (an uprising which included not only the religious fundamentalists, but also virtually that entire segment of the Iranian bourgeoisie not personally related to the corrupt and brutal Rezi family i.e. the bazaris) it was only to be expected that they vented their spleen on the erstwhile (neo-) colonial power the United States. The US embassy was occupied and its staff held hostage in a major humiliation which spelled the death-knell for the Carter presidency. 4 Before rolling their eyes, readers who suspect T&B lacks in balance would do well to run a Google search on “Iran, Mosaddeq, 1953” the CIA management of the coup, and the participation of the UK, has been amply documented, including by US academic sources based upon documents released by the CIA under the Freedom of Information act

No self-respecting imperial powers can Washington Foreign Minister Bernard countenance slights of this sort, and the US Kouchner, a political amateur more at ease in extracted terrible revenge by encouraging a the heady world of NGOs than at the Quai proxy war Iraq’s decade-long war against d’Orsay, made a fool of himself by appearing Iran. This sponsorship included substantial to threaten military intervention in Iran, before technical assistance in the manufacture of being silenced by an irate Sarkozy. chemical warfare agents, used with terrible effect against Iranian civilian populations. Before ending in stalemate, this war left Big wind, loud Thunder No rain? millions dead on both sides. Iranian foreign Despite almost weekly warnings of the policy, perhaps including the development of imminence of an American attack on Iran, nuclear capabilities, is generally backed up by presumably aimed at preventing any repeat of these calamities. When When all Else Fails try Diplomacy! The limitations on America’s international reach are being laid bare by the Iranian Arroz Sin Leche Rice in Moscow Miss Rice’ trip to Moscow was a predictable debacle. Along with US Defense Secretary Gates, Rice had been dispatched to attempt gain Russian cooperation on the Iraq dossier. In a wonderful example of the anachronistic nature of American diplomacy, no sooner had she landed than she was gratuitously antagonizing her hosts by publicly interfering in Russian domestic affairs, meeting with a gathering of anti-Putin dissidents. some intelligence regarding one or more US carrier groups cruising about in the Gulf, T&B has long predicted that the US would limit itself to bellicose language, empty sanctions, and moral outrage refraining from an actual military strike situation. With the Iraq Tacit any discussions of the advisability of against Iran. This was debacle, the US has gratuitously antagonizing your hosts when on based upon the become belatedly a visit to plead for diplomatic assistance, the assumption that, after aware of the need to meeting provided at least one delightful an almost unbroken work via international moment. A St. Petersburg woman got up to series of foreign policy institutions. Alas for tell Rice that, given the fact that America had failures, the Bush Washington, the UN lost the moral high-ground, rather than regime would be loath Security Council seeking to act alone, the US should join to start yet another includes Russia and forces with the European Union in bringing unwinnable war one China, both of whom pressure on Russian administration. having potential have important ties with Rice was predictably furious, snapping back consequences far Iran; whilst neither is that the United States has not forfeited one bit greater even than those comfortable with the of its moral standing! The funny part is that of its current Eastern notion of a nuclear- she was undoubtedly sincere in her stalemates. armed Iran, they are even more concerned with maintaining their ability to protect their own interests and to cluelessness. Surely, she must be one of the very few passport-holding Americans to be unaware of their extraordinary loss of international prestige over the past 7 years. And What if we’re Wrong? We could be wrong. Perhaps a fatally

retain an independent foreign policy neither wounded but still-dangerous hard-core is willing to become a tail wagged by the Neocon faction centred around Cheney its NATO dog. Likewise the other Caspian dreams of empire shattered and faced with states, which will have to live with Iran as a imminent political oblivion will lash out, major regional power. Even India, despite counting on a wartime patriotic reflex to save maximum pressure from Washington, has its fortunes… one last roll of the dice. More announced its intentions to go ahead with the sinister yet, perhaps not content to saddle the building of a pipeline to bring Iranian gas next U.S. administration with unwinnable wars across Pakistan; new sources of energy are in Iraq and Afghanistan, they would simply like indispensable for the continuation of the to add one more to the pile. Given the Indian economic miracle. progressive shift towards an imperial presidency and the utter failure of legislative Britain, already mired in both Afghanistan and oversight, they could just conceivably get Iraq thanks to a childlike faith in Bush, seems away with it. disinclined to open up a third front. Only France has surprised by aligning itself with The diplomatic implications of such insanity would fall outside of our remit. It could certainly destabilize the Middle East, paving the way for an unstoppable fundamentalist wave indeed, it could, just conceivably, provide the spark for a true war of civilizations

Islam vs. the West5.

Clearly, Iran would strike back against US and other Western interests throughout the region, and the survival of pro-Western Arab governments would be more a matter of luck than of planning. It seems unlikely that Russia

the major power in the Caspian or China, dangerously dependent upon oil imports, would stand by passively. Although an armed confrontation falls within the realm of political fantasy, Russia and China would be driven further into a hard, anti-Western military alliance. Iraq and Lebanon would explode. Iran - damaged but not occupied would dig in and race to build a bomb as a matter vital to national survival. Turkey already furious at the Americans for having ignored their warnings of what would happen if they invaded Iraq would find itself with another war zone along its sensitive Eastern border. Their patience could snap.

Oil and Money For financial markets, given the importance of Iran and the region for the global petroleum trade, this would be a catastrophe scenario. It is difficult to predict the reaction of erstwhile friendly Arab governments, and especially, of the Arab street, to yet another invasion of an Islamic country by Western Crusaders, with the perceived backing of Israel. Certainly, there is a real danger of a repeat of the 1973 oil embargo which plunged the world into a deep recession (at a time when dependency on imported oil was far lower than today). Even if one or more Middle Eastern states did not halt its oil exports and OPEC refrained from slashing quotas out of solidarity, and further assuming that the Iranians could not successfully imperil Gulf oil shipments (now that the Revolutionary Guard is armed with supersonic torpedoes, this is a risky assumption) the withdrawal of 3.5M bbd of Iranian oil, along with the perceived threat of a disruption of Middle Eastern supplies, would send an already tightly balanced oil market into panic mode oil prices would 5 Those who would scoff at our typically alarmist commentary are referred back to our predictions of the possible consequences of the Iraq invasion, including the fatal destabilization of Iraq, the export of fundamentalism and terrorism, as well as radicalization of Turkey likely surge above $200/bbl, tipping an already fragile global economy into meltdown mode.

How to trade it, if it happens: Massive longs in oil and gold, spot and futures. Initially, long USD and Yen, then quick reversal to short USD, Yen. Short equities. Long G7 treasuries. Long Russian Roubles and commodity currencies. Extreme case portfolio long canned food, firearms, land in New Zealand.

Global Markets How to Trade ‘em

The ultimate binary Trade Short-term trends in financial markets are driven not by rational expectations, but rather, by the alternation between fear and greed. Ordinarily, market participants oscillate back and forth between these two fundamental emotions, most unusually, we are now encountering an unprecedented combination of the two, with the savviest investors simultaneously elated and terrified. Whilst, over the longer run, markets are remarkably rational, the amount of short-term idiocy one must endure to get a piece of the “long-run” is really quite extraordinary. At present, global markets are almost totally binary. On any given day, depending in particular upon whether or not yet another global investment bank has just announced that some new horror has been found lurking in its basement, our screens are either blood red or the emerald of a well-tended lawn financial risk either gets put on or taken off, wholesale and indiscriminately. The prices of all risk assets move together in lockstep: Asian currencies, carry trades, metals precious and otherwise, Asian indices, credit spreads and emerging markets debt, are almost perfectly correlated, as the hedge funds scurry about, each trying to keep one jump ahead of the others. Events in the US markets continue to set the tone for the short-term volatility. Whilst the global economy is increasingly decoupling from the US (vide Chinese and Indian GDP growth), short-term market trends very clearly have not. This is to be expected old reflexes die hard, and preferring the comforts of the herd, traders are not the most adventurous of beast.

In the short term markets are voting machines in the long term weighing machines. If the economic centre of gravity continues to shift in the way we believe it shall, markets will eventually take their lead from Shanghai, Delhi and perhaps, even Moscow. We are not there yet, and the last shoe has not fallen, so Beware the Bear!

Fearful Greed/Greedy Fear T&B is gratified to find the majority of our trading recommendations from a massive and reiterated short on the US dollar, to our long Russian rouble debt, equity indices in China, India, Vietnam (and latterly, Indonesia), crude oil and industrial commodities shooting the lights out6. Equally, we are in self-congratulatory mode as regards our underweights Japan, the US, and to a lesser extent, European equities. Only our recommended overweight of the sole asset class for which we can claim some true, in-depth expertise Russian equities has proved a tad disappointing; after several years of massive outperformance Russia (and Eastern Europe in general) have been lagging the other emergings. We now see an inflection point, and expect Russian equities to close the year with a powerful rally. Whilst we have made similar predictions several times already this year, only to be left bewildered by the sogginess of the subsequent rallies, with oil nearing our $100 target faster than anyone imagined possible, and Russia awash in liquidity, we think it only a matter of time before she elbows her way back to the front of the pack.

Do you Really want to be Rich? As emotions go, fear is far stronger than greed. Risk is asymmetric, and men fear losing what they have far more than they hunger after new acquisitions. Thus, in times of rapid change and stress, like generals constantly fighting the last war, investors retreat back into the familiar; as often as not, this proves to be a fatal error. In 1999, when T&B was hawking Russian sovereign bonds for a major European bank, prudent investors gave us short shrift. One German institution listened politely before showing us the door - they were not going to risk their investor’s hard-earned money on 6 To forestall the temptation of back-trading, all past issues of T&B are available on our website speculative Russian assets, and instead, were building carefully hedged positions in safe, high-grade US securities with attractive spreads. We have just learned that this same institution is faced with imminent bankruptcy if a buyer cannot be found. As always at times of fundamental change, the psychological adaptation is lagging the reality analogous to the situation at the beginning of Russia’s extraordinary resurgence from 1999, relatively simple and hugely lucrative investment opportunities are available to those possessed of the requisite psychological flexibility needed to jettison tried and true reflexes and to adapt to the new reality. As the centre of global growth shifts towards the emerging economies and away from the old industrialized countries at a rate unprecedented in human history, the economic equivalent of “regime change” is sending the emerging markets ballistic. Meanwhile, the world’s erstwhile reference currency is plunging, while defaults in that ultimate store of value US investment-grade credit have triggered an avalanche of downgrades and defaults, posing a real threat to financial stability. Investors who withdrew into the safety of safe, predictable assets, the US dollar and high-grade credit, are facing severe losses. Those who invested in blue-chip equities have fared only a bit better; while, in dollar terms, US equity indices are holding up very decently given the carnage in the debt markets, expressed in terms of Euros (or, as Mark Faber likes to repeat, in ounces of gold, or bushels of wheat) they are once again underperforming their global peers.

-The Amazing Shrinking Dollar: Ay Dolores You are such a pain7.

Trade-weighted US Dollar 1985 Present. To hell in a handbag? In the few days between the time we began to draft the current issue, and the present, the US dollar has fallen by nearly four figures. In parallel, oil prices have surged to within spiting distance of our target at $100. Clearly, anyone wishing to make predictions had best move fast! It has long appeared obvious to T&B that the “Kindness of Strangers” model of US deficit funding was not sustainable, and that foreign entities would sooner or later grow weary of trading valuable goods for the hypothetical safety of US debt securities. Our long-term dollar short is playing out very nicely, indeed. While some patience has been required, investors who took our advice and maintained short-dollar forward positions against EUR, NOK, GBP, AUD, NZD or CAD have made out like bandits. While shorts on the USD by now the mother of all “crowded trades” are indeed getting long in the tooth, we do not believe that the slide is anywhere near over yet; at most, for caution’s sake, we might begin to diversify into the Asian currencies which have thus far traded closer to the dollar: TWD, SGD, KRW, etc. We reiterate our recommended Yen short with side bets on the INR, PHP, and even the Indonesian Rupiah. 7 T&B has been recycling the above title for the past 5 years. It is loosely borrowed from Swinburn’s extravagantly bad poem “Dolores Our Lady of Pain”, http://www.victorianweb.org/authors/swinburne/dolo res.html as well as playing on the homonyms dolores (Latin for pains), and Dollars (presumably also a source of pain for international investors, given its plunge by 50% in recent years) it caused some short-term discomfort during the August turbulence, but is once again providing much joy; there is simply no way that the Bank of Japan can hike rates into a deflationary, recessionary environment. The Yen will thus continue to provide the basis for a number of lucrative carry trades our personal favourite being leveraged Russian rouble bonds funded with borrowed Yen. The carry is about 8.5% p.a., with a nice currency kicker.

Anyone seen my bottom? During our days as Chief Strategist at Sovlink, T&B was repeatedly asked to predict how far the US dollar could fall. Our prediction was that there would be a first stop at 1.45, at which point the Europeans would make a forlorn attempt to intervene. Lying down in front of a freight train is generally futile, and following a period of consolidation, the Euro could easily go to 1.60 or more; we expected this long cycle to terminate in a blow out and a substantial overshoot. Our first targets may well be hit before we can release this issue we have no reason to change our assumptions. Despite Sarkozy’s squeals, the strong Euro is actually a decidedly mixed curse for Europe. While exporters are penalized by a rising currency, in recent years countries such as Switzerland, Germany and Japan saw a rapid increase in competitiveness, driven by their exorably appreciating currencies. Instead, it was the perennial laggards, in particular the Latin swath, who suffered the most from revaluation. Furthermore, Europe is being largely sheltered from the explosive growth in commodity prices by a strong Euro, which has also reduced the need for the ECB to raise rates to keep inflation in check. Thus, while Sarkozy blusters, the Deutsche Bundesbank sighs contentedly. In any event, intervention is futile without US participation and the Americans are delighted to see a continued, orderly sell-off in the dollar to help rebalance their unsustainable deficit. Not only is the European Central Bank opposed to intervention, the only way it could slow the sell-off would be to accumulate dollars massively, ultimately resulting in a huge mark-to-market loss as the dollar crashes further. At some point, of course, the cheapness of the dollar will start to price out imports, while exports are already providing substantial support to US GDP. Americans will once again produce what they consume. Living standards will decline until the trade gap is rebalanced. The dollar will overshoot, find support, and eventually strengthen to an equilibrium level but given the long lag-time (the J-curve) that is still well in the future, and one would be foolhardy indeed to trade it today.

-Asian Markets One man’s bubble… Some months ago we wrote that the crush of newspaper stories warning of the impending implosion of the Chinese “A-shares bubble” virtually guaranteed that nothing of the sort was about to happen. Journalists writing about economic issues for the non-specialist press tend to be superb contrarian indicators. T&B shares the view of our friend, CLSA’s oracle Chris Wood, that the reaction of the Fed to the risk of recession in the US will force money into the emerging markets, leading to an Asian equity bubble. We remind our readers that, despite the negative connotations of the term “bubble” the early and middle stages are a delight for the investor. We would now reduce our overweight on China, moving into the laggards Asia, ex-Japan, selected EMEA (short Baltics, neutral Central Europe, long Russia and Balkans a substantial long Middle-East) and perhaps Brazil.. The current crowded trade par excellence is Hong Kong, in particular the H-shares (Chinese shares listed on the Hong Kong exchange, which trade at a discount of around 50% to the same shares, listed on the mainland…) Although we would be wary of near-term volatility -and predicting the actions of the Chinese government poses a serious challenge - we think it still compelling, and least in the medium term. India has been our other favourite, and despite some well-intended, badly communicated attempts to limit the inflow of hot money, we think the Bombay market should remain a one-way bet. Rates have probably risen far enough to strangle inflation (at least, ex-food) and the Capex cycle has a long way to run. The Central Bank is currently tightening bank reserve requirements to slow the rate of liquidity growth, but that starts to smack of desperation. Our other overweight is in most emerging of the Asain emergings, Indonesia. It is very cheap by Asian standards, enjoying rapid disinflation, and finally embarking on much needed infrastructure build-out. Vietnam had a brilliant 2006, and is currently consolidating it will certainly enjoy another leg up in coming years. Brazil we missed finding the gapping income disparities unsustainable - thus far, it is doing rather better than we had expected, despite a dangerously overvalued currency. Although Thailand looks temptingly cheap, we cannot quite bring ourselves to jump in; perhaps we scare too easily, but the political situation is parlous at best, there is a murderous insurgency going on in the South, and we have great faith in the ability of Thai political establishment to shoot itself in the foot. In brief, despite a massive run-up, we are not convinced that the upside potential for BRICs/Asia is exhausted. Provided (a major proviso) that the US does not crash outright instead, gliding into a soft landing, and that the Fed continues to pump in liquidity which promptly flows offshore, then Asian growth should remain strong. Although inflation poses an increasing threat, thus far, it remains relatively tame. While some pundits have angrily asserted that food inflation is a major problem, in particular for the poor, what they miss is the fact that, like for oil prices, there is no way (at least, short of intentionally engineering a deep recession) that monetary policy can address this type of inflation, caused not by monetary factors but by growing demand for commodities in limited supply.

-EMEA Catch-up time The entire concept of EMEA is faintly ludicrous any asset class which includes Nigeria, Israel, and Russia in the same basket is pretty much useless. The impressive momentum in Asia may have distracted some of the attention in which the EMEA basked last year. As discussed elsewhere, we have been slightly bewildered by the lagging performance of Russian market, up a modest 18% this year. The Baltics, on the other hand, are due to get crushed. They are running the sort of unsustainable current account deficits associated with Thailand and Korea just prior to Asia crisis 17% for Estonia, 14% for Lithuania, and an amazing 25% for Latvia.

Any interruption of their ability to fund would be catastrophic. One can short these indices via ETFs. Eastern Europe is also overextended, but less dramatically so; C.A. defits are running about 4%, possibly sustainable for EU states. Poland is once again governed by adults, but the macros are precarious. We would exercise caution. Turkey we get consistently wrong. We have no further advice. Its continued appreciation in the face of dangerous macros, political turbulence, and the effective demise of the myth of Turkish EU ascension remains a mystery to us- perhaps it always will. Kazakhstan provides a cautionary tale of what can happen to investors who blissfully ignore macroeconomic imbalances. The sudden withdrawal of the global liquidity lifeline feeding Kazakh banking system has revealed the fragility of the entire montage. Like Georgia, Kazakhstan a vicious and corrupt dictatorship has become a poster child for the US Neocon faction which finds only good things to say of Nazarbayev. Unfortunately, this adulation does not extend to the provision of cash. We add one EMEA global trading idea this month. The Gulf markets. A relatively homogenous group including Dubai, Kuwait, Saudi, UAE, Oman etc. Ex-Saudi, still recovering from the leveraged bubble of 2005, these markets have already performed well this year, but given the huge amount of oil-infused liquidity in the region, we think that their revaluation is still in its early stages. Sooner or later all of them will be compelled to abandon their dollar peg, giving a further kicker to the dollar-term indices. -G7 Equity Markets Stay Neutral/Short

(or, not with MY bargepole) We reiterate our previously expressed view that there is no compelling reason for absolute-return investors to own the senior equity markets. Although we do not foresee any apocalyptic events in the global markets, US macros are clearly unsustainable, while the European markets are overly dependent upon Wall Street, as well as being weighed down by restrictive credit and a substantial currency effect. The risk/reward ratio is simply not compelling; we would rather take our Euro exposure via forwards. Expressed in anything but devalued dollars, the US has seriously underperformed its European peer group (and hugely underperformed Canada, Australia, etc. only Japan has lagged, and we reiterate our short on Japanese markets). By way of example, expressed in Euro terms, the S&P is down 3.61% on the year, the broad Dow Jones European Index is up 6.51%, with Germany’s DAX up 18.51%. On the other hand, we would be cautious about shorting the US indices. The weakening US dollar is itself the primary reason for the modestly positive performance of blue-chip US equity indices this year, providing support both via the monetary effect (like commodities, equities constitute “real assets,” the falling value of each dollar means it takes more of them to buy one share) and because foreign profits repatriated to the US buy more dollars thus, the large-cap companies with substantial international exposure are outperforming the broader market.

Can you spot the difference?

Commodities Revenge of the Old Economy Even that damned fool Jim Rogers cannot be wrong about everything (though he remains psychologically unable to acknowledge that he was totally wrong about Russia; had anyone been insane enough to follow his advice, his apocalyptic predictions and implicit recommendation to go short Russia at the beginning of this decade would have provided a fast track to bankruptcy…) - as regards commodities (as well as for the continued decline of the dollar and of the Baltic markets) he happens to be right. Alongside the emerging Asian markets trade, the commodities trades and their offshoots are perhaps the fundamental opportunities of our new century. As industrialization spreads, and hundreds of millions of people are drawn into the consumer sector, the demand for energy, base metals and food will increase inexorably; as they run into hard supply constraints, economic and diplomatic relations will be profoundly disrupted (as will the fundamental survivability of planet Earth). While the latter half of the twentieth century was characterized by a seemingly inexorable fall in commodity prices with a shift towards the service economy and economic growth based on the production of intangibles. Now, thanks to the emergence of Asia, the “Old Economy” has reclaimed pride of place. The fact that a trade is “fundamental” does NOT, of course, mean that it is unidirectional; given the weight of speculative money, fierce corrections are to be expected. In the near-term, except for specialized commodities futures players, we would steer clear of the S&P Index, In Euros futures markets; in particular, almost all are now in contango rather than backwardation,

i.e. forward premia cause a negative carry at each rollover (perhaps precious metals are the exception; long-dated gold futures have acceptable volatility, and as long as the dollar continues to tank, gold is an excellent hedge.)

Agricultural Prices - Malthus, Come Home Dinner’s On the Table! In a wonderfully ironic inversion of the classic roles, the “developed” countries are now major suppliers of agricultural commodities to the “emergings”, upon whom they are in turn increasingly dependent for imports of manufactured goods!

The explosive growth in energy prices has been squeezing the global economy for most of the decade - food prices are now joining the party. As the Asian countries get richer, they are enjoying a huge increase in their consumption of foodstuffs, moving up the value chain towards higher protein diets. Unfortunately, this comes in parallel with declining local food production due to the paving over of agricultural land, desertification, inadequate water supplies, pollution, and damage due to poor land management practices. This is already providing a boon for the agricultural exporters, Brazil and Argentina, but also for the old industrialized countries Europe, Canada, Australia/NZ, and the United States. Already, the EU is winding down the set-aside program which formerly paid farmers to not grow crops.

Alas, it is not easy to get exposure to food inflation as a pure play. Fertilizer companies provide one good alternative, infrastructure another. In terms of geopolitics, in the absence of sudden disruptions, it is just possible that price action will allow a gradual accommodation, while better agricultural technology helps to avoid severe deficits. If, on the other hand, there is a serious disruption to current production, e.g. a severe drought caused by the rapid loss of the Himalayan glacier flow which irrigates both India and China, then expect a free-for-all as the Asian tigers forage the world over for desperately needed food…at best, this will play havoc with pricing at worst,… Extreme case portfolio canned food, firearms and land on Jupiter…

-Russian equities Bloodied by not bowed Having initially predicted yet another strong year for Russian equities, T&B spent much of the year trying to explain the relative underperformance of the RTS vis-à-vis the emerging indices. Our explanations included the flood of egregiously mispriced IPOs, bad press, and a (justifiable) discount due to the fact that virtually all traded companies are controlled by a reference investor private or public rendering shareholder value somewhat concept. On the other hand, we had discounted political risk, given that we saw it as obvious - that a smooth presidential transition would be engineered. All of these explanations are now open to debate and perhaps a simpler one is justified: -While the IPO market has clearly been a case of naked greed and short-termism, a similar flood in 2006 was easily digested. Russia is increasingly part of the European sectorial plays: when Uralkaliy went public in London, it was bought as a global fertilizer play, not as a specifically Russian stock. Current IPO supply in China is being snapped up at extravagant valuations. The world is not yet short of liquidity… -Over the past 7 years, bad press has been a constant feature of the Russian economy. As we have noted previously, subscriptions to The Economist may have cost investors tens of millions of dollars per annum, i.e. the price paid for allowing oneself to be shoed-away from the world’s top performing debt and equity market. -Anyone attempting a hostile takeover in China had best be heavily armed this has not prevented the Chinese share market from going ballistic. -Finally, this year’s performance has not been as weak as suggested by the RTS. Indeed, some sectors retail, steel, and non-ferrous metals have been very strong oil has been the laggard, and oil is a disproportionately large component of the RTS. After spectacular performance in 2005/2006, the Russian market has slowed down this year. Perhaps the primary driver is simply a loss of momentum given the strong competition from Asian, Latin and even African markets. In particular, everyone we know has been shooting the lights out in Chindia this year, and Russia has slipped from being the flavour of the month. Not the most satisfying explanation, but certainly the simplest! As we go to press, we are enjoying a long-delayed rally. Absent anything truly ugly in the global markets, T&B continues to expect a substantial rally going into the year end. Please see our upcoming T&B Decline of the West Part II the Eternal Russia, for further detail.

-The Easy Money Rouble Bonds Finally, we reiterate our slightly contrarian view that the single best place for your safe money is Russian rouble bonds! Even during the worst of the recent bout of global financial carnage, the rouble declined by no more than a couple of percentage points, before clawing its way back to a post-crisis high. Similarly, while selected third/fourth-tier bonds, in particular the banks, weakened during August, we saw this as an excellent buying opportunity. Certainly, the likelihood of the CBR allowing any Russian bank to go under is nil. In the event that any got into trouble, the CBR would bail them out, impose a shot-gun wedding, or at worst, allow in a foreign buyer.

In particular, we like the Russkiy Standart and the URSA rouble bonds. This extends to the foreign currency instruments - the Euro-denominated URSA 8.3s of 2011 currently yields 10.5% or some 650 over bunds it is one of the most compelling mispricings we’ve seen since the Russia 28s traded at 25 cents on the dollar!

URSAP 8.3% 11/11 € Market 93.2205/93.8244 (yield graph)

Happy Trading…and Good Luck we’ll all need it! This message is provided for informational purposes and neither the information nor any opinion expressed herein constitutes an offer, or an invitation to make an offer, to buy or sell any investment funds, securities or any options, futures or other derivatives related to such securities. Investment in emerging markets bears a high degree of risk, and is not suitable for all investors. This report is based upon information we believe to be reliable, however it is provided solely as an intellectual exercise, and no investment decisions whatsoever should be based upon it, in full or in part. In particular, investing in securities, including Emerging Markets securities involves a great deal of risk and investors should perform their own due diligence before investing. Past performance is not necessarily a guide to future performance. Some investments may be subject to sudden and large falls in value and on realization customers may receive less than they invested or may be required to pay more. Changes in foreign exchange rates, interest rates, or other financial parameters may have an adverse effect on the price, value or needs of customers. We would recommend that investors take financial advice as to the implications, including taxation, of investing in any financial product. Some investments may not be readily realizable and valuing the investment and identifying the risk to which customers are exposed may be difficult to quantify. It should be assumed that the author and/or the funds he advises will from time to time have long or short positions in any of the assets discussed, or derivatives thereof. These positions may at times be contrary to the views expressed. Although the Nikitsky Fund is a sponsor of T&B, its trading policy is totally independent of this publication, and it should not be assumed that it is positioned in a fashion in keeping with the market views expressed herein. Like cats and horses, markets whether emerging or emerged, are apt to do as they damned-well choose, and a considerable measure of luck is required to come out in one piece. Exercise caution in all things. Good Luck! © Eric Kraus, Nikitsky Russia/CIS Opportunities Fund www.nikitskyfund.com 7 November 2007 -20 -

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