Message in a Bottle

• Africa
• Alternative Investments
• Asia
• Commodities
• Inflation/Deflation Watch
• Election Watch
• Europe
• Junk Bonds
• Latin America
• Mergers and Acquisitions
• Middle East
• Munis
• North America
• Real Estate
• Short Selling
• Technically Speaking

Africa

Ghana received the latest in a string of Chinese investments in Africa. The loans highlight China’s strong interest in resource-rich African countries, such as Ghana. Ghana is preparing to tap massive oil fields that are expected to turn it into one of Africa’s biggest energy producers. Originally geared mainly toward supporting China’s own development, the country’s China development Bank and Exim Bank have in recent years become central elements in Beijing’s efforts to project its power overseas and to secure access to natural resources, especially in developing markets. Africa looms large in that strategy. With various concessionary loans and investments, the Chinese government also has positioned itself as one of Africa’s major foreign partners. The financing and infrastructure projects have, in turn, helped to pave the way for Chinese companies in Africa.

Libya is flush with oil wealth, which has given its sovereign fund, the Libyan Investment Authority (LIA) a huge cash pile to invest. Libya’s young population gives it growth potential. But Libya is held back by Western suspicion of the government’s erratic application of law, its poor human rights record, and its recent history of connections to terrorism. That makes it hard to attract the foreign investment and expertise needed to kick-start its economy. Italy could provide a bridgehead in Europe for Libyan interests. Italy is one of Europe’s largest economies, but its population is aging and its struggling manufacturing industries have an appetite for Libyan capital. Libya was an Italian colony in the early part of the 20^th century, but Italy continued to do business with it after Italian rule ended in 1951. In the 1960s, Italian oil giant ENI cut deals to develop Libya’s oil reserves. After Col. Gadhafi’s coup d’état in 1969, other Western countries cut ties with Libya. Italy didn’t. In 2008, Italy and Libya signed a friendship treaty, in which Italy pledged to pay reparations to Libya for its brutal colonial rule from 1911-1951. Libya hopes its investment in UniCredit will help lure European companies to Libyan shores.

The US views the Somali gvmt as a bulwark against al Shabaab and a rare chance for stability in Somalia — though it controls only a few blocks of the capital, Mogadishu, under protection of African Union troops. Much of southern and central Somalia is controlled by al Shabaab. The rest is dominated by other militants, clans and along the northern coast, pirates exercising sea jihad. Al Shabaab largely funds its offensive against the Somali government by taxing businesses that operate in the territory it controls — much of southern and central Somalia — as well as with contributions from supporters outside the country. The Islamist militants-turned-pirates have been instructed to avoid ships from Muslim countries, in contrast to established Somali pirates. Pirates new to the trade apparently endure a steep learning curve. Some recently arrested pirates were caught without food, water or fuel, and appeared to lack basic knowledge of the sea. There are fewer fishermen and more fighters.

Peacekeepers repelled a recent offensive, but the gvmt failed to gain any momentum from the battle. Instead, political infighting has consumed the government and further undermined the stability of an east African nation seen by the US as a bulwark against al Qaeda, which has ties to Somalia’s strongest militant group, al Shabaab. Somalia’s transitional gvmt was established as part of a peace agreement brokered among Somali factions in 2008 with the support of the UN, US, and the African Union. There have been several such attempts since the fall of the last strong federal ruler, Mohamed Siad Barre, in 1991. While it represents Somalia, the transitional gvmt provides no gvmt functions and no security outside of the area it controls in Mogadishu. Its mandate expires next year, although parliament could vote to extend it further. President Sharif, who was appointed by parliament — Somalia is too unstable to hold nationwide elections — now must nominate a candidate for prime minister. If parliament rejects that nominee, he will have a second chance to submit a name for approval before he will be forced to step down himself. A gvmt collapse — in essence, the failure of the latest effort to establish a peace in Somalia — would be a major setback for the UN and the US and African nations that have contributed thousands of peacekeeping troops. The Somali government and African Union troops control only a thin slice of Somalia’s capital, Mogadishu. Much of the rest of the country is controlled by militants, while pirates operate along its shores. The Somali army is poorly trained and prone to defection because its soldiers don’t receive regular pay. Mr. Sharif has sought to bring together a unity government of factions and clans who wanted to work toward peace. That has meant finding cabinet posts for a host groups that don’t always trust one another and have the ability to sow disunity and endanger other gvmt officials security should their demands go unmet. The leadership must also content with a super-sized parliament. Both the presidency and the office of the prime minister are powerful posts in the gvmt.

A major obstacle that companies face in South Africa: a heavily unionized work force. South Africa’s workers in industry and public services have successfully agitated in recent years for wage increases that have outpaced low-single digit inflation — often by staging lengthy strikes.

Zimbabwe’s central bank is broke, dysfunctional and the custodian of a currency that officially no longer exists. On the bright side, it wants to dismiss ¾ of its staff and has a comeback plan. The Reserve Bank of Zimbabwe has been at the center of much of what’s gone wrong with this southern African country. Lending to organizations and projects favored by President Mugabe has left it deep in debt. Rampant printing of money sparked runaway inflation. To stabilize the economy after violent elections in 2008, the government last year abandoned the national currency in favor of the US dollar. As a result, Zimbabwe’s central bank no longer has a currency to manage or loans to make. Zimbabwe officials are now attempting to tear apart the bank in order to rebuild it. The revamp is intertwined with efforts to revive a struggling economy and restore the luster of mineral-rich Zimbabwe among foreign investors. Officials hope it can resume its past role as a credible financial regulator and a lender of last resort to head off potential runs on private banks. The changes at the central bank hew to a package of recommendations for the economy outlined by the IMF. That has stirred optimism among some foreign investors who are determined to look beyond contentious politics. Zimbabwe continues to boast one of the continent’s better educated work forces.

Alternative Investments

There is always a bull market somewhere. With stocks continuing to whipsaw and bonds getting even-pricier, investors are looking further afield for decent returns. Unglamorous niches are performing well in 2010, even as the Dow limps along. If you haven’t heard about these seemingly arcane plays yet, it may be because the smarter money is getting there first.

In general, commercial real estate ventures should be viewed as long-term holdings and as alternatives to dividend paying stocks and bonds.

During a recession, small unit leases may expire as some people attempt to save $, but large unit leases increase as people move in with their friends or downsize their home. The latest recession has been tougher on the self-storage industry than usual due to stubbornly high unemployment. Still occupancy rates have been strong in the Northeast and Mid-Atlantic. The main risk is low barriers to entry.

Despite continued bad news about the economy and real estate’s role in it, mutual funds and ETF’s in the real estate sector have rebounded during the past year. Real estate is a leveraged play on the US economy. If the economy continues to grow slowly, then real estate will continue to lead. Commercial real estate is still lagging behind a broader US economic recovery, but self-storage, medical and apartment markets are showing signs of strength. And the warehouse has market has improved as well.

International real estate has been on a wild ride in recent years. Global real estate funds contain REITs with less of a debt burden than US based REITs, and they invest in new markets that still promise future gains.

Private equity is having trouble unloading large acquisitions made before the bubble popped. Because IPO markets have become crowded, they are simultaneously trying to sell to other companies or other PE firms.

Asia

The change has been building for nearly a decade. It’s finally here. Asian companies and governments are asserting themselves as the deal makers who matter. In broad strokes, the lessons of the post-WWII era have come into play. Much as the US was left to rebuild a devastated world in its own image, so today are hale Asian companies filling a vacuum that the West occupied before the financial crisis. Asia’s dominance of the new-issue market is expected o remain a theme for the rest of the year, if not the years to come.

Australia will likely need to raise interest rates to contain a strengthening economy as it experiences the biggest mining and energy boom since the 19^th century.

China’s official purchasing manager’s index rose following 3 straight months of declines. China is moderating rather than melting down.

The Chinese gvmt’s determination to keep cracking down on its frothy real estate market may be a political necessity but risks hurting growth at a time when much of the world economy is weak, and contrasts sharply with efforts in the UD and Japan to add fuel to the fading global recovery. Despite gvmt measures in place since April, property prices have not fallen much in major Chinese cities, and housing sales have actually picked up in the last few weeks — signs the measures aren’t achieving their declared aim of curbing speculative purchases and making homes more affordable. Changing course now would hurt the gvmt’s credibility with the public. Many urban Chinese feel the surge in property prices over the past year has put home ownership out of their reach. Yet the repeated promised that tough politics will not be changed could also leave Beijing with less room to maneuver if growth slows more sharply than anticipated.

The shift inland could help solidify China’s dominance as a low-cost exporter, fending off challenges from emerging market rivals in Asia, Latin America, and elsewhere — even as China also makes progress up the value chain in higher-end, more capital-intensive industries. Companies are trying to build industrial centers that hire more local labor. Gone will be the factory towns where the company runs not only assembly lines but dorms, security, recreational facilities, and hospitals — responsibilities that companies are ill-suited to handle. Instead, they are enlisting local gvmts to build towns to house staff and take over social functions that the company has long kept in-house. That growth is prompting many laborers to want to stay closer to home, rather than move to the coast for work.

Clouding the positive picture in China is a continued pickup in inflation. Some economists suspect the gvmt achieved stabilization in growth in August by quietly loosening controls on bank lending and speeding up approvals for infrastructure projects.

China’s shift into more sophisticated manufacturing is raising tensions with some of its most important trade partners.

Banks around the world are flocking to China because of its siren call. However, their financial performance isn’t pretty. Profits in China for banks based in other countries fell sharply last year. The report underscores the obstacles confronting non-Chinese banks as they try to establish to rev up operations in the world’s second largest economy. Foreign banks have long struggled to build a business of any scale, since they are reined in by Chinese regulatory limits on how much local banking operations can lean on foreign parents. During the financial crisis, such restrictions helped China’s banking regulator insulate the country’s financial system. But non-Chinese banks are confined to a marginal role, while some of the largest homegrown banks in China have grown to rank among the world’s largest. Those disadvantages kept foreign banks from fully capitalizing on China’s robust economic growth in 2009, one of the few bright spots in the global economy. The numbers are yet another sign of the collision between government policies and intensifying competition in China. Executives in several industries have complained that Beijing is making it harder for foreign businesses to succeed. But public criticism has been relatively rare among multinational banks, partly because such lenders generally get a far smaller chunk of their overall profits from China than industries such as manufacturing and retail. With limited branch networks — the pace of expansion of which is tightly regulated by the gvmt — it is much harder for non-Chinese banks to generate deposits that can be funneled into loans.

China is considering plans that could force foreign auto makers to hand over cutting-edge electric vehicle technology to Chinese companies in exchange for access to the nation’s huge market. Businesses are worried that China’s indigenous innovation efforts are aimed at gaining control of foreign intellectual property. But as the Chinese market’s importance to global companies has increased in the wake of the global financial crisis, the government has sought to trade access for technology in an effort to speed the country’s industrial transformation. China is already the world’s largest vehicle market. But China has yet to produce a home-grown car company that can compete on the global stage. The government sees the emergence of electric vehicles as a chance to put its auto industry into the world’s top tier.

Despite all these fears, China would like to consolidate the auto sector, despite resistance from local governments, who benefit from jobs and tax revenues collected. This won’t happen until a crisis squeezes many smaller companies into merging — an unlikely prospect for now.

The dispute between China and Japan over a detained Chinese captain is being closely watched by many other Asian countries — including India, Vietnam, and the Philippines — which also have territorial disputes with China, and which have concerns about China’s expanding naval power. This year’s row has graver implications for both the US and Japan, as China is rapidly acquiring the naval power to enforce its claims. While US-China trade and economic ties have expanded rapidly in recent years, Washington wants to send a message to Beijing that is traditional alliances in Asia remain important.

China is moving faster to develop clean technologies such as nuclear power, electric vehicles, and wind power. China has the right mix of a big local market, innovation in technology, a low-cost supply chain and government policy support. China’s State Grid utility is larger than nearly all US utilities combined. The US needs to simply its regulatory structure and update its antiquated power grid. US energy policy has stalled to the point where the much talked-about smart grid is more of a hobby shop than a real business.

China is eager to exert more influence in the global financial system and its frustration over the dominance of developed countries in international institutions. Still China’s ratings companies play a limited role at home and aren’t likely to become a focal point of Beijing’s attempts to become more assertive in international markets. China’s bond market is still underdeveloped, and with both issuance and purchases dominated by state-owned institutions, the ratings firms don’t figure greatly in risk assessment.

A rift between China and Japan showed no signs of easing, as Chinese customs appeared to be targeting some goods bound for Japan with meticulous inspections. Rancor has continued between the two Asian powers even though Japanese prosecutors on Friday decided to release the captain of a fishing vessel whose detention after a collision with Japanese coast guard boats three weeks ago enraged the Chinese gvmt.

India invoked the toxic-gas leak at a pesticide plant owned by a subsidiary of Union Carbide in Bhopal 26 years ago, the world’s worst industrial disaster. In nearly all other counties with nuclear power, suppliers are immune from lawsuits while all liability is channeled to nuclear plant operators. Russian and French state controlled nuclear equipment companies have an advantage, since their governments provide a certain amount of liability protection. “India is a huge market, “Come on my terms or don’t come at all.” – sounds like China.

The Sensex has gained quite significantly helped by investments from abroad, news of good corporate earnings in the April-June quarter, and stable global markets. Analysts expect the Sensex’s northward march to continue in the near term as overseas investors bet on better returns given India’s high interest rates and strong corporate performance.

India’s vaunted tech savvy is being put to the test this week as the country embarks on a daunting mission: assigning a unique 12-digit number to each of its 1.2 billion people. The project, which seeks to collect fingerprint and iris scans from all residents and store them in a massive central database of unique ID’s, is considered by many specialists the most technologically and logistically complex national identification effort ever attempted. The country’s leaders are pinning their hopes on the program to solve development problems that have persisted despite fast economic growth. They say unique ID numbers will help ensure that government welfare spending reaches the right people, and will allow hundreds of millions of poor Indians to access services like banking for the first time. Critics question whether the project can have as big an impact as its backers promise, given that identity fraud is but one contributor to India’s development struggles. Civil-liberties groups say the government is collecting too much personal information without sufficient safeguards. India has been attempting to improve governance through technology for two decades. Programs have digitized land records, created web portals for government agencies and computerized tax filing systems. But the unique ID program is by far the largest and most ambitious effort.

Japan, Korea, Thailand stepped up the fight to curb their strong currencies.

With the Japanese stock mkt at 16-month lows, foreign investors fleeing the mkt, and the strong yen hurting leading exporters, the Tokyo Stock Exchange is fighting to remain relevant and compete with Asian rivals, especially those in China.

The risk of a new prime minister who strongly favors higher fiscal spending continues to send yields in Japan’s jittery gvmt bond mkt sharply higher. The gvmt may be running out of willing buyers for its debt. With a crushing debt load of 200% GDP, plus stagnant tax revenues, Japan has long looked like a selloff in the making. Japan is very close to its debt limit. If the incumbent loses, Japan’s debt could get downgraded. China has lately been a buyer of short-term Japanese bonds.

Japan warned the yen’s sharp rise was encouraging companies to shift spending overseas, which could hollow out Japan’s industry, undermining the economy in the longer term. Any intervention would also be aimed at curbing market volatility, not, attempting to turn the market trend around.

Japanese trading houses are focusing more overseas, especially in energy, to counter failing demand at home as Japan’s population ages and its technology become more efficient. Meanwhile, state-owned Chinese companies are increasingly finding value in partnering with foreign firms in their push abroad, especially in areas where they have had trouble going it alone. China uses thermal coal to generate 75% of its electricity and its steelmakers rely on coking coal as feedstock, but domestic production has struggled to keep pace with demand. China, long a net coal exporter, last year became a net importer — transforming regional coal markets and providing suppliers such as Indonesia and Australia with export income at a time when their economies were slowing down. In a sign of growing insecurity over domestic supplies, china last month agreed to lend Russia billions in exchange for 25 years of coal.

What makes Japan’s intervention different from 2001-04, BOJ is leaving the yen it sold in the financial markets, instead of mopping up the extra liquidity through sterilization. This is an important way that they are increasing their monetary base and a further weapon to fight a long deflationary spiral that has dragged down the economy. This could be the beginning of a shift to easier monetary policies in the slow-growing developed world in an effort to ease financial conditions.

Unilateral currency intervention, once a common tool among industrialized economies, fell out of favor in recent years, amid a perception that it was unfair to trading partners and ineffective over the long term. The only other developed country to intervene recently is Switzerland back in June. The G-7 has generally agreed in recent yrs that direct intervention should be used only to counter alarmingly rapid currency jumps, particularly those stemming from speculative attacks. The yen’s recent climb doesn’t fit that bill. Gvmt intervention in currency mkts was a cornerstone of economic policy in the 1980s. Two international pacts, the Plaza Accord and the Louvre accord, ushered in massive, multilateral currency management to adjust the levels of the dollar and the yen in an attempt to promote stability among the world’s largest trading powers. But the ascendancy of free market thinking led to the promotion of letting exchange rates float free of government intervention.

Even though Japan joins South Korean, Thailand, Singapore, and Taiwan in curtailing their currencies’ rise, but Japan may not be as successful as other Asian interventionists because the yen market is among the world’s largest currency markets. The reason intervention is reasonably effective in Asia outside Japan is because they are not as liquid as Japan, so CB intervention can have a disproportionately large impact.

Japan’s latest intervention, a de facto QE, may require closer vigilance on fiscal policy, as Japan may become the next sovereign debt risk.

A confrontation over a Chinese sea captain’s arrest has quickly escalated into the worst Japanese-Chinese dispute in years and is testing the ability of Japan’s new ruling party to manage relations with its increasingly powerful neighbor.

The dispute over the fishing vessel comes against a backdrop of concern in Japan and elsewhere about China’s growing military power. China’s navy, especially, has become stronger and is ranging further offshore, causing some at the Pentagon and in Tokyo to reassess the potential threat posed by China.

The episode could mark the start of a new period of friction between the Asian neighbors, with unpredictable consequences for regional stability. The issue could offer the US an opportunity to build security ties with Japan. As Beijing’s emergence as an economic and security powerhouse has sparked concerns among its neighbors, part of the US strategy is to try to serve as a counterbalance to China in the area, even as the American military moves to improve relationship with the Chinese army in an effort to reduce regional tensions.

While Japan’s general public, increasingly acclimated to the idea of a rich and powerful China, has show a muted response to the latest tension, right-wing groups are beginning to raise their voices. Right-wing nationalism has been a relatively small force in a country that has played down such sentiments since World War II. But conservative activists often emerge as noisy voices during contentious debates.

For the past decade, the North Korean gvmt and party experimented with market reforms but stuck chiefly to its system of central control and isolation. The regime has crushed revolts in the past, and there is no indication more are in the offing. But Mr. Kim said many in the country would welcome conflict with the outside world as a pretext for uprising. China’s leaders haven’t been able to persuade Mr. Kim to follow its development model.

The authoritarian ruler’s continued steps to set up his preferred successor raises a new question — whether he can carry it off. Generational handoffs are difficult enough in business. In modern politics, only a handful of monarchies attempt them. North Korea is the only Communist country that has tried, and the regime’s first family is going to try again. Kim Jong Il, meanwhile, appears to face a compressed timeline. The leader appeared to begin focusing seriously on succession after a stroke-like illness in August ‘08 left him visibly weakened. Kim Jong Il may also find the idea of succession is a harder sell to North Koreans, whose country is weaker and poorer than when he took power. The heir apparent is facing criticism within the North Korean military because of his age. The structure of the North Korean regime, with multiple intelligence agencies and security forces that operate in isolation from each other and report ultimately to Kim Jong Il, makes it difficult for serious resistance to form Mr. Kim’s meticulous methods as coup-proofing. Still, a power handoff would be challenging: “making an unprecedented transfer of power from the second generation to a third, in a Stalinist setting, is really a difficult endeavor. His sister’s appointment creates the potential for a rival center of power.

Pakistan hasn’t signed the NNPT and US and Indian officials worry that nuclear material might fall into the hands of Al Qaeda and Taliban militants based near the Afghan border in NW Pakistan.

The Philippine gvmt raised its first ever peso-denominated bond, a move designed to cut its foreign exchange risk. This sale is also the latest sign that the new gvmt is trying to attract more DFI. The stock mkt hit its highest level since 10/2007. With $ flowing into EM bond funds for much of this yr and investors on the hunt for higher yields, it’s no surprise the deal saw such strong interest. With the latest sale, the Philippines joins the ranks of other developing countries like Colombia and Chile, both of which have sold local currency global bonds this yr. The Philippines is one of Asia’s most aggressive sovereign borrowers, which is rated BB- with a stable outlook.

South Korea recovered quickly from the global economic downturn, boosted by a chap currency that helped exports. But the country is now experiencing a slump in real estate that economists say will hamper growth. In contrast to soaring property values elsewhere in Asia, residential prices are down. At the same time, demand for homes is down and some high-profile commercial projects are sputtering after project financing dried up as banks cleaned up their balance sheets in the wake of the 2008 downturn. The problems follow personal and corporate deleveraging throughout South Korea. Household debt is especially high and chiefly responsible for sagging demand for homes. Corporations and government have also overbuilt in recent years and are reining themselves in. South Korean consumption is likely to be constrained as a result, a development that will slow the country’s overall growth, especially as export gins begin to moderate in the coming months. Among the biggest drags on the market is the government. The national land agency has canceled dozens of projects to cope with its fast rising debt. The government is considering a bailout even as it adds one staggering new project in a central province where half of the gvmt’s ministries will move by the middle of the decade. The difficulties prompted numerous economists in recent months to ask whether the country is at risk of following its neighbor Japan into prolonged real estate trouble. So far, the answer has been no. The country’s major construction firms for the past 3 years have reshaped themselves to focus on opportunities outside the country as domestic demand has faltered. Large-scale construction projects have slowed due to financing troubles, regulatory holdups, or aversion to risk.

The war in Afghanistan is spilling across the border into former Soviet Central Asia, destabilizing the already fragile governments there and endangering key coalition supply routes. Tajikistan, an impoverished former Soviet republic that was ravaged by a civil war between a secular regime and the Islamist opposition in the 1990’s, is particularly vulnerable. Tajikistan shares a long, porous border with northern Afghan provinces that have become Taliban strongholds over the past year, and has experienced a spate of smaller attacks in recent months. Combined with ethnic unrest in neighboring Kyrgyzstan, the emergence of Islamist rebels in Tajikistan imperils the stability of the entire Central Asian region — including its most populous country, Uzbekistan, whose repressive government has so far been able to keep Islamist militancy in check. The US military in Afghanistan receives most of its fuel and about 30% of its ground supplies through Uzbekistan, Kyrgyzstan, and Tajikistan. If there is a major upsurge of insurgency in Tajikistan, both the Russians and the Americans are going to be scared. It’s not what the Americans need with Afghanistan going the way it is. And the Russians are very nervous about the way insurgency could metastasize through Central Asia in their direction. The insurgents are highly experienced, skilled fighters, more than a match for Tajikistan’s weak army. There’s a very high probability that this will lead to a revival of the civil war in Tajikistan. While the 1997 peace agreement called for power-sharing between the President and the rebels, the government has been steadily pushing the former insurgents out of positions of influence, fueling discontent. The recent movement of Central Asian militants to the northern Afghan provinces is one of the reasons behind the spike insurgent activities in that part of the country. In more remote districts of the north along the Tajikistan and Uzbekistan borders, Taliban-affiliated insurgents have been allowed to operate with impunity because the US-led coalition concentrated its resources on the traditional Taliban heartland in the ethnic Pashtun areas of southern and eastern Afghanistan. While US Special Ops have staged an aggressive campaign to wipe out insurgent leaders in Afghanistan’s north, some US officials said this has only served to drive the militants into havens in the sparsely patrolled marshy borderlands along the Panj River, which separates Tajikistan and Afghanistan. The US hardly used the Central Asian supply route until 2 years ago, and turned to the northern alternative only after allied convoys started coming under regular attack while passing through Pakistan in late 2008. Uzbekistan is currently the most important Central Asian conduit for supplies into Afghanistan, and the Uzbek state railway company recently built a spur over the border that is extending to the vicinity of the northern Afghan city of Mazar-i-Sharif. Taliban—affiliated rebels are intensifying their ops in Central Asia because they seek to disrupt the US-led coalition’s logistics routes.

Rekindled ambitions for another street protest suggest Thailand’s gvmt efforts to bridge social fissures are progressing slowly, if at all.

The near-collapse of one of Vietnam’s flagship state-owned companies is exposing the limits of this country’s economic renaissance. Touted as one of the stars of a new generation of emerging markets, Communist-run Vietnam has risen from years of war to become an important cog in the global economy. Much of the growth has been driven by small private businesses, with back-alley workshops making goods for Europe or the US while foreign investors pour billions of dollars into footwear, clothing, and electronics plants. About 1/3 of Vietnam’s economy, however, is controlled by state-owned companies — part of a policy to ensure that key industries such as oil, mining, and shipbuilding stay under Vietnamese control. Now the dangers of that strategy are becoming clearer amid a deepening financial scandal that is raising questions among investors about how much longer the country can afford to pump up its state enterprises. While equity markets in nearby Indonesia and the Philippines breach record highs, Vietnam’s main stock index has dipped since the start of the year, as investors worry about the sustainability of the country’s boom. That could alarm foreign manufacturers which are increasingly singling out Vietnam as an alternative production platform to China, were wages are now rapidly rising. Vietnam’s troubles have depressed its currency, and while that lowers some costs, it also pushed up the cost of raw material imports and has in some cases led to a shortage of dollars. Many of Vietnam’s 4,000 state companies have expanded their reach in recent years as capital flowed into the country (much like South Korea’s famous chaebols). More often, though the companies are too inefficient to compete on the global stage. Government instructions to state-run banks to extend inexpensive loans to government linked companies, especially during the global financial crisis, triggered resentment among smaller, private businesses that have been struggling to secure credit. State-owned companies are also contributing to a worsening budget deficit, which h has helped trigger 3 currency devaluations in the past 9 months that cut the value of Vietnam’s currency, the dong, by 10% against the US dollar at a time when many other Asian governments are scrambling to tame the rise of their currencies. Vietnam’s mammoth state-owned enterprises use so much capital and produce so little in comparison to the private sector that it forces Vietnam to import more capital than it would have to otherwise. Vietnam launched a major restructuring of the state-owned sector in the 1990s as part of its process of doi moi, or renovation, amid the collapse of the Soviet Union. While most of the former Soviet satellites went for a big-bang approach, rapidly privatizing industries and removing the state from big business, Vietnam’s communist Party remained in power and chose to follow China’s more cautious path of gradual liberation while maintaining tight political control of the country. Vietnam cut the number of state-owned enterprises through mergers and privatizations. State-owned companies account for 1/3 of Vietnam’s economy now. But the overhaul has slowed considerably in recent years and some state companies have gotten bigger. In some respects, Vietnam’s approach has worked well. The Asian Development Bank and other agencies applaud Vietnam for quickly expanding its economy while avoiding some of the glaring disparities that plague many other fast-growing economies in the developing world.

Commodities

We had a unique storm last quarter. While low interest rates will continue to support commodities, some of the engines behind the Q3 rally are likely to fade, such as the extreme weather events and supply shocks in the agricultural market. A wild card for commodities is whether the policies implemented by the central banks will be able to revive the economies and generate demand — an ultimate engine for commodities. Mr. Worah considers the state of currencies to be the biggest driver for commodities. Central banks and policy markers globally are looking for a weaker currency in order to fuel the economic recovery. If these policies don’t work, it’s somewhat bearish for commodities.

Agriculture

Wheat set the stage for the Q3 rally in commodities, which soon spread to corn and soybeans. Besides staples, the so-called soft commodities such as sugar, cotton, and OJ also soared on weather-related supply disruptions. We happened to be in the grips of a very strong La Nina year, in which cooler than normal temperatures in the Pacific Ocean lead to extreme weather events such as drought and flooding. La Nina conditions typically last for 6-9 months, and most of the models suggest that this one will peak in Q4. Also boosting the agricultural market was the growing appetite from China, the world’s most populous country. Partly due to the dry weather at home, China saw its corn imports soar. Questions were raised over whether China is turning from a self-sufficient corn producer into a net importer to meet its rapidly rising domestic demand, which would be a game-changer for the agricultural market. Similarly, China’s sugar and wheat imports also rose significantly. Analysts were watching the trend with great interest to gauge whether this was a one-off surge or something to last longer.

Potash is controlled by an oligopoly of 3 producers, who own Cantopex, which handles their sales outside of North America, which comprises 70% of global potash capacity. The thrust into fertilizers is part of a clear trend for mining companies to diversify away from metals and mining and into other upstream natural resources.

Russia extended its wheat ban until late 2011. To be sure, Russia is known for being unpredictable and could lift the export ban earlier than expected, if rising supplies push prices down there. The world’s stockpiles of agricultural commodities are much higher than 2 yrs ago and prices far lower, but many worry the situation will worsen.

Corn should also benefit from Russia’s extended ban because the high wheat prices have pushed livestock producers worldwide to use more corn and less wheat for animal feed. Governments may start to panic if there is another shock to global food supplies beyond Russia’s borders. The size of the US corn crop is critical in the global food picture, because it ships more than half the world’s corn exports, and corn is a key livestock feed. China is the world’s 2^nd biggest consumer of corn after the US, and a potentially crop-damaging frost in its northeast agricultural region triggered corn’s jump.

Failure to boost farm investment in poor countries after a global food crisis in 2007-08 could prolong a recent jump in food prices, contributing to inflation in the developing world. In the wake of the 2008 crisis, governments of developing countries and donor nations, as well as private investors, proposed a wealth of new spending, and industrialized nations committed billions of dollars to promote sustainable agriculture and emergency food assistance. The efforts included plans to develop unused or underused lands to farming in the Philippines, Cambodia, and Indonesia and to expand farm rods and grain storage infrastructure in India. But in Asia, the source of much of the world’s new food demand, some projects aimed at increasing production have been dropped or delayed amid the financial crisis, limiting the gains. Disputes over land ownership, lack of capital and concerns over environmental issues have held back other investments.

Cotton prices breached the $1-a-pound level for the first time in 15 years as delayed harvests and booming demand in Asia are cutting into supplies putting clothing makers on edge. Prices have surged since the beginning of the year due to bad weather in China, which is both the world’s #1 grower and importer, and the flooding that has washed out Pakistan’s fields. Global cotton inventories are estimated to fall 22% from a year ago as demand outstrips supply. The rally has been driven by panic buying. High prices are a boon for producers in the US, the world’s biggest cotton exporter. The US is shipping at a torrid pace to keep up with demand.

For only the 2^nd time since the Civil War, cotton for near-term delivery is priced at more than $1 a pound. Its spectacular leap this year has doubled the better-publicized gold rally. And in large part, it reflects a fundamental imbalance of global supply and demand. For the 5th year in a row, cotton consumption is expected to outstrip production. Yet other factors are at play as well: a weaker US dollar and heightened interest from investors in commodities as an asset class.

A series of hurricane scares have halted the orange juice market from its midsummer lows, with futures prices hitting a 3 year high on the latest storm threats to FL’s citrus groves. The 2010 hurricane season has spared FL’s fragile orange groves so far, with all storms steering well clear of the peninsula. The question is whether the really is expected to stick. Demand still remains a problem. OJ sales are on pace to be the lowest since the late 1990s, as rising prices push consumers toward alternative beverages.

Energy

Energy turned out to be the laggard during Q3, led by natural gas’ plunge as a result of a massive surge in supply. Robust demand in emerging markets was largely offset by pessimism over a persistently oversupplied US market. Most inflows in commodity funds went into precious metals.

The extreme gasoline glut came as record refinery output and high imports more than made up for robust consumption. Refineries boosted production to take advantage of relatively, strong profit margins, and foreign fuel cargoes were drawn to the US on expectations for a summer demand surge that proved unrealistically high. The buildup in supplies also provided a buffer against potential disruption to gulf Coast refining by hurricanes, though the region has so far been spared any major storm damage. So long as bloated gasoline inventories keep a lid on oil futures, drivers should see cheaper prices at the pump. The gasoline surplus won’t be reduced anytime soon. And the summer demand boost looks to have ended prematurely. Demand typically tails off after Labor Day.

Continued uncertainty about the outlook for the global economy has served as a cap on crude-oil prices, while vigilance on the part of OPEC is providing the floor.

E&P companies can’t seem to stop drilling for more natural gas despite an enormous glut from newly exploited shale reserves crushing prices. What is more, so far this year they have raised more new equity and debt — more than they raised in the whole of last yr — to help finance it. That is despite the E&P sector generating a poor ROC. Much of the cost of business for an E&P company is incurred upfront, plowing capital into the ground to drill a well. With all that $ spent already, gas prices have to fall very low indeed before an executive decides to shut off a well. Fragmented industries don’t help. The temptation to spark a price war or try to outgrow a neighboring gas producer is high.

China and India are the only major countries that are not switching to natural gas, only because they don’t have any. China still remains reliant on coal, with more coming from hydropower and nuclear. India also relies on coal but is importing LNG to take advantage of the growing global glut.

Metals

China’s role was even more pronounced in the base-metals markets, as the developed economies were still mired in sluggish recovery. China’s imports of copper, nickel, and lead rebounded during the quarter, reinforcing the belief that the country’s policy-induced slowdown may be bottoming. The trend also was supported by China’s better-than-expected industrial production in August, the latest data available. Tin, a thinly traded metal, surged on demand from China, the top consumer for the metal that is used in electronics and food packing. Toward the end of quarter, gold took center stage by springing to a series of records as it became clear that the world’s central banks would continue to depreciate their currencies to fuel growth.

This spring, gold benefited from the threat of European sovereign debt defaults, and this summer it benefited from fears of a double dip recession. Positive economic data could cause gold to sell off in droves.

As investors juggle fears of a double dip recession with hopes of further QE to combat it, gold and mining stocks benefit.

Gold continued its record run and moved closer to $1300 an ounce on the Fed’s acknowledgement it was ready to do more to stimulate the US economy. The dollar weakened sharply after the Fed’s statement. Investment demand for gold will remain strong heading into the fourth quarter, supported by speculation about possible monetary stimulus, as well as concern above sovereign-debt levels and the potential for a double dip recession in developed economies. Many investors have been recently targeting $1300. September historically is as strong month for the metal, as it is underpinned by high demand from Asia during festival and wedding seasons there.

Lately, hedge funds have been helping compensate for the lack of industrial demand. The recent strong silver rally has driven the traditional relationship between gold and silver prices back down toward the typical ratio of 62-to-1. Silver prices tend to swing more widely than gold. The poor man’s gold is starting to shine. Long in the shadow of the yellow metal, silver has quietly been on a tear of its own. Helping drive demand is that silver is easier to buy. More broadly though, appetite for all precious metals is growing as the values of the US$ and other paper currencies decline. Certainly, the rise in gold and silver prices could hardly be attributed to worries about near-term inflation. Rather, the rally, particularly in the past month, ,seems to be keying off the prospect of further policy easing from the Federal Reserve precisely because of weak inflation rates and tepid economic growth. The biggest risk for silver and gold bugs is that the outlook for US economic growth stabilizes, and the dollar does too. Yet silver, unlike gold, also has industrial uses in electronics, solar energy, medical devices and increasingly popular radio-frequency identification, or RFID, tags. Silver may not be heading back to its record-high levels of about $50 an ounce, but it probably has room to run before the rally tarnishes.

The recent rally in silver is a red flag. Traditionally, silver tends to outperform gold toward the end of a precious metals rally. Silver is regarded as a cheaper, but more volatile, way to play gold’s rise. When investors start to buy silver, it gives the first hint that we are moving towards a manic phase.

The recent price increases for steel, which follow a summer of soft prices, reflect cutbacks in China as steel producers there lower output to meet the government’s year-end energy savings target. China has long been both a savior and a threat to the world’s steel industry. Its economic stimulus program led to steel-intensive infrastructure building, with producers running at near-full capacity to meet the demand. But as the stimulus spending slowed, concern mounted that China would export its excess, causing prices to fall. Several trade cases charging dumping and the use of illegal subsidies often used as a pre-emptive strike have been filed recently by North American, Australian, and European countries to stymie Chinese steel imports. Now, Chinese steelmakers are cutting back production, easing those concerns. But some steel makers doubt that the production cuts in China will be widespread and sustained.

Copper has surged since early June, as demand from China has stayed robust amid indications global supplies may be tightening.

The real way to play nuclear plant investing is to watch the price of uranium. Uranium mining should become increasingly more lucrative as half the world’s mines are in China and India. There will be a bidding war to lock-in long term supplies.

Inflation/Deflation Watch

3-month LIBOR has fallen to its lowest level in 5 months due to a lack of demand. It is a sign of cash hoarding that could stoke deflation. The combination of low borrowing rates and a huge stockpile of cash should be tinder for a wildfire of economic growth and inflation. Instead, growth remains sluggish and inflation a distant risk. Demand for cash versus investable assets is a hallmark of deflation fears. However, LIBOR might no longer be the best early indicator of financial market distress, since banks are being pushed by regulators to borrow longer term.

Demand for TIPS has stayed relatively robust. This partly reflects a hunger for any type of safe-haven security at the moment. Bit it also suggests that investors aren’t convinced about deflation and still see a need to protect against longer-term inflation. The difference between 10 yr TIPS and Treasurys means annual inflation needs to rise only 1.6^ for TIPS to generate the better return.

Investors who worry about disinflation or outright deflation should consider investing in regulated utilities. Investors who believe the economy will strengthen would do better to bet on merchant generators and diversified utilities. (Merchant generators take a mkt price for their electricity.) Low interest rates make regulated dividends attractive.

Ironically, the weaker dollar is one factor helping fend off deflation in the US, pushing up commodity and import prices. Better inventory management is another, which prevents discounting later.

No period in history can trump the spike in yields that resulted from then Volcker’s battle with inflation, when he raised the fed funds rate to 22% in July 1982 and yields on 10-year bonds surged from around 9% to as high as 16%, causing a loss of 11%. By that point, no one was interested in buying Treasurys. If another rate shock were to happen to the US, it would be over its own sovereign debt risk.

After rushing to the safety of Treasurys this year, PIMCo has pared back its holdings of US government debt, which fell from 63% in June to 36% in August.

If the Fed artificially drives down Treasury yields and leaves TIPS untouched, then inflation expectations would appear lower than they really are. That would run counter to the Fed’s desire to push a higher inflation rate. That could undermine investor confidence in the inflation-expectations signal, making the gauge less useful. So the Fed also is buying TIPS, trying to offset one distortion with another. Investors are left in the “Alice-in-Wonderland” realm of having to read between Fed distortions to digest what the real value of different assets should be.

Election Watch

The post-election bounce may not happen this year due to limitation in fiscal policy and monetary policy. Obama may not have the ability to stimulate the economy more if the Republicans win. (Healthcare stocks are playing catch-up with Consumer Staples, now that uncertainty over healthcare reform has been lifted.) Also, the only arrow left for the Fed is QE2. With leading indicators pointing to sluggish growth, it won’t matter who wins the election.

For all the talk, paralysis may be more likely. This may be just what politicians from both parties prefer. Scrapping guarantees would likely send mortgage rates up and house prices down. That would ultimately help set a clearing price for housing. But it would hardly score political points, given that housing accounts for 25% of US households’ assets. Granting full government backing to mortgages, on the other hand, would add to already excessive US debt and result in even greater distortion of housing markets, possibly paving the way for worse crises. Given those unpalatable outcomes, odds are any electoral upheaval will entrench the house status quo — to politician’s relief.

Many people have been surprised by the rally’s size, because the underlying economic data remain mixed. Analysts who follow election-year behavior have seen this before. Uncertainty about the election may help explain the lower-than-average trading volumes that have characterized the stock market in recent months. Industries whose stocks make up about 40% of the value of the S&P500 — financials, energy, and healthcare — have been raked over the coals by Congress this year. Wall Street is hoping Congress will ease up after the election. Making the tax issue especially prominent this year is that it affects not only income taxes but also capital gains taxes and dividend taxes, all of which are scheduled to rise next year. In seven other years similar to now, the market declined in the summer before the election and then began a rebound at the start of September, similar to what happened this year. The big question on investors’ minds is whether the September rally can be sustained. In the past, stocks have tended to rise in the autumn before the election, waffle just after the vote, and then continue higher. November, December, and January typically are among the year’s best months for stocks. In two of the seven years — 2002 & 1938 — stocks fell during the six months after the election. At the end of 1938, stocks were entering one of several bear markets following a 1937 cutback in government economic stimulus, even though the capital-gains tax had been cut in 1938 and government spending was boosted again. Economists today are loudly debating today whether that period is similar to the current one. In both 1938 and 2002, war also affected markets. Investors worried in late 1938-39 about the coming war in Europe. In late 2002-03, stocks were sagging partly because of the looming invasions of Iraq. Today, war also is a concern.

Europe

Europe’s stress tests are found to have minimized risk. The misleading findings by BIS undermine a primary goal of the stress tests — to reassure investors worldwide the soundness of Europe’s financial system. The upbeat results initially soothed markets. But fears have flared up again as Ireland and Greece continue to struggle. Among other warning signs, the costs of insuring many bank and gvmt bonds against default have jumped above their pre-stress test levels. Some banks excluded bonds held by subsidiaries, while others reduced their holdings by counting netting out short positions.

The Euro Zone’s next big headache is divergence. Every silver lining has a cloud. Whatever relief the ECB may feel at the burgeoning recovery will be tempered by concerns over the growing divergence between countries. This divergence may be persistent as a result of austerity politics, posing a new headache for policy makers shackled by a one-size fits all interest rate. The ECB’s traditional monetary policy toolbox offers little to tackle rising internal imbalances. With its focus on inflation, wage pressures in strong economies may force it to raise rates in 2011. In that case, its best hope might be to use unconventional policy measures such as a bank liquidity provision or bon purchases to help struggling southern European economies. That will be a tricky balancing act.

Borrowing costs have not declined for struggling countries on Europe’s fringe. Yield spreads between government debt in Greece, Ireland, and Portugal and their safer German equivalents are hitting or approaching record highs, making it harder for the countries to finance mounting debts. When the program started, the ECB was much more aggressive. Those amounts dwindled as debt markets stabilized over the summer and the euro-zone economy showed signs of rebounding. By early August, investors speculated that the program would end soon. But investor concerns over euro-zone governments’ high debts have flared anew. Southern Europe and Ireland face years of weak growth as their economies restructure, draining government revenues. The latest increase in debt purchases is an illustration that the sovereign debt crisis is surfacing again, but it’s not as severe as May.

In the past month, financial markets have turned their sights on Ireland and Portugal. Doubts remain over the solvency of banks on Europe’s stricken fringe. That leaves them dependent on Mr. Trichet’s largesse, in the form of “temporary” lending facilities introduced by the ECB when the crisis first hit. Despite Mr. Trichet’s assurances that the bond-buying program is a stop-gap, it not only continues but has also increased in recent weeks — with no end in sight.

The last 9 months have exposed deep flaws in the euro zone — both in its inability to enforce fiscal discipline during the boom and its sluggish response to the sovereign debt crisis. While Europe continues to run a currency union without a fiscal union, it remains vulnerable to future crises.

A stalemate between Belgium’s 2 feuding language groups, which has left the country without a government for 5 months, has unnerved Europe’s government bond markets — but a successful debt auction on Monday showed investors still consider the divided country a better bet than other heavily indebted EU nations.

In most countries, booming exports, falling unemployment, and the strongest economic growth in a generation would be a boon to the ruling political elite. Not in Germany. Germany’s renewed strength has made it the envy of Europe. Yet for weeks, approval ratings for Chancellor Angela Merkel’s ruling center-right coalition have hovered at or near their lowest level since the gvmt took power in the fall. Part of the gvmt’s problem in selling the recovery is that even though Germany’s economy is improving, voters remained concerned about the longer-term outlook, especially with much of Europe struggling to reduce debt loads. Despite German’s continued insecurity over the economy, however, many see the persistent conflict between ruling partners themselves as another reason for their unpopularity. The battles within the coalition have convinced many voters that the gvmt is dysfunctional. So far, attempts by Ms. Merkel have failed in bickering. The sniping has come as a surprise, because the Christian Democrats and Free Democrats shared power for 16 yrs when Helmut Kohl was chancellor and have long been regarded as allies. After years of gridlock under the previous gvmt — a so-called Grand Coalition — the new center-right coalition vowed to reform the economy, labor market, and educational system. Critics say the infighting stems from Ms. Merkel’s consensus-driven, hands-off leadership style.

Germany’s decision to extend the life of their nuclear reactors is a major policy shift, which decided in 2000 under a center-left gvmt to phase out nuclear power by 2022. The current center-right gvmt pledged to hang on to the reactors for longer when it won office last yr. Opinion polls have consistently shown that a clear majority of German voters support the existing plan to wind down nuclear power. Germany has been at the heart of antinuclear movement in Europe for decades, even as the country continues to draw about a quarter of its electricity from its reactors. The country’s environmental movement scored one of its greatest victories a decade ago when Germany’s gvmt and energy corps signed a deal to phase out nuclear power. But warnings that Germany can’t meet its energy needs or its ambitious goals for reducing greenhouse-gas emissions without nuclear power have undermined the consensus behind that plan. Public opposition in Germany to nuclear power, driven by its safety risks and the problem where to store nuclear waste, remains widespread. In return for the controversial extensions, the utilities that operate nuclear plants in Germany will be obliged to contribute to a nuclear fuel tax and a new fund for renewable energy research.

Even though Germany’s industrial production is slowing down, they are pressing ahead with austerity measures.

Despite radical steps by the Irish gvmt, Ireland’s biggest banks still face huge losses on loans to property developers, a legacy of Ireland’s decade long real estate boom and bust. The country’s recurring banking troubles show how difficult the road remains even for countries like Ireland that moved swiftly to tackle their financial and economic problems. Ireland’s renewed banking problems are sparking fears that the EU’s rescue of debt-laden Greece won’t be its last.

The Irish government’s moves show how problems in its country’s banks will be difficult to unwind, threatening Ireland’s economy and the government in the process. Fears about the banking woes, which in turn threaten to destroy confidence in the government’s own finances. Ireland’s problems go beyond its banks. Because 50% of Ireland’s GDP is comprised of exports, a significant slowing in the global economic recovery could hurt Ireland more than others.

Despite Ireland having a successful debt auction and making a well-received decision to split Anglo Irish into 2 banks, its rescue plans are becoming increasingly more expensive. What’s more disconcerting about recent pressures on Ireland is that Ireland has been the poster child for successful austerity measures. If Ireland can’t pull through by doing all the right things, how can markets get bullish about the other PIGS?

One big worry is that Ireland’s economic woes will amplify its fiscal and banking problems. A weaker economy means less tax revenue, making it harder for the government to meet its goal of cutting the deficit to Europe’s limit of 3% by 2014. As the economy weakens, Irish borrowers will find it harder to repay their loans, saddling the country’s banks with more bad loans. That, in turn, could force the Irish government to provide more financial assistance, eroding its own creditworthiness. In recent weeks, some investors have begun to fear a Greece-style bailout for Ireland, though many observers say it is unlikely for now, in large part because Ireland has financed its budget until the middle of next year. The velocity of Ireland’s contraction will likely rekindle a debate over whether Europe’s pursuit of austerity in the face of a fading recovery is doing more harm than good. Just months ago, Ireland was winning widespread praise for the quick and decisive steps it has taken to cut its deficit.

The Irish may need to make their own luck. It wasn’t supposed to be like this. Ireland may have to follow Greece in asking for a bailout. In order to get out of this hole, it must do 3 things: 1) It must sort out its banks to reduce uncertainty over final cost, 2) Ireland needs to promote growth, given its advantages (low corporate taxes, young & educated population, and good infrastructure), and 3) Ireland needs to speed up its deficit-cutting plans instead of deferring in to 2012-14. Bringing these measures forward raises the risk of a double-dip recession but may be the only way to restore confidence. Besides, if Ireland did seek a euro-zone rescue package, it would likely be conditional on more fiscal tightening anyway.

Concerns over the financial stability of countries on the euro-zone’s fringe mounted as one of Ireland’s largest banks had its credit rating cut, and political tensions fueled doubts about Portugal’s deficit-cutting plans. Financial markets are on edge as crisis-hit euro-zone countries try to pull off a daunting task: protect their banks while slashing budget deficits against a backdrop of economic stagnation and soaring joblessness. The currency zone’s overall recovery masks deep divisions within the region.

Ireland’s return to critical condition comes after winning plaudits earlier in the year for its fiscal discipline. Despite already hard cuts, the country’s sluggish economic growth, soaring unemployment and rising financial losses could prevent the government from reducing a budget deficit that has climbed to roughly 12% of gross GDP. The government in Dublin could reduce the cost of bailing out Anglo Irish by taking a tougher line with creditors, pressuring them to accept bigger-than-expected losses on their bond holdings. While such a move would likely prove politically popular, it could damage Ireland’s reputation among global investors and, by extension, make things tougher for its other banks. Ireland won’t suffer a Greece-style funding crisis. Ireland has already financed its budget needs through the first half of 2011, doesn’t have major debts coming due soon, and holds a lot of cash reserves. Investors, however, are fretting about Ireland’s deficit, which is far above the Eu’s 3% limit.

Portugal lifted markets temporarily with its successful debt auction, but it had to pay sharply higher yields than it had recently. Portugal’s banking system is healthier than Ireland’s, but its economy and its government finances remain weak, and it needs to continue to sell debt to investors.

The auction of Portuguese government debt overshadowed concern about the credibility of European bank “stress tests”. European markets have tightened, but they do remain open.

Portugal’s minority gvmt announced tough new austerity measures, including public-sector salary cuts and tax increases. The situation in Portugal reflects a larger debate over whether stimulus or austerity is the best path for growth in the midst of a fragile global recovery.

What became clear from the financial crisis is that Russia is not a sustainable BRIC. Russia has no alternative but to modernize its economy and political system. One motive for moving closer to Europe is fear of China’s economic powerhouse and what it will mean for Russia’s increasingly sparsely populated lands. Up to now, the EU’s own regular meetings with Russia have achieved little, encouraging some Russians to speculate that the only thing that interests European gvmts about Russia is its natural gas. Russia’s world view focuses more on power than on rules, which largely guide the EU’s behavior. The EU won’t cozy up to an autocratic power with rampant gvmt corruption, an arbitrary legal system, and scant regard for human rights. Moreover, the suspicion will remain among many in the EU that as soon as oil prices go back up, Russia will start throwing its weight around again. Much closer union between Russia and the EU, however, appears to be a long way off. For one thing, the EU is still in the heroes of a financial crisis that is likely to keep it absorbed and unwilling to embark on major new initiatives. The perceived benefits of hugging the Russian bear may not be tempting enough to bring EU countries together. And then there is Russia.

Russia is seeking to diversify energy exports away from Europe to Asia’s growing economies amid lower demand for Russian natural gas and falling market share in Europe.

Analysts and traders have ascribed the ruble’s recent weakness to a variety of factors, such as Russia’s deteriorating current account and corporate loans due by the end of the year. Until just a short time ago, it was all about oil prices. The price of oil hovered around $78 a barrel for Brent crude, the high end of its trading range for the past several weeks, but this didn’t seem to encourage ruble buying.

A new Russian oil route opens to China, heralding a new era of energy cooperation and another symbolic eastward shift in the global balance of economic power. The pipeline’s completion symbolizes a new phase of relations between Russia and China — now respectively the world’s biggest energy producer and biggest energy consumer — after decades of mutual distrust dating back to a bitter row over Communist ideology in 1956. It also reflects a shift toward closer commercial and political ties between two of the world’s largest emerging economies after two decades in which relations were largely limited Russian arms sales to China, and opportunistic anti-US cooperation in international bodies. Driving the relationship now is Russia’s desire to divert more of its energy exports away from Europe, its traditional market, and into China and other fast-growing Asian economies. Beijing wants to improve its energy security by diversifying sources and supply routes. The pipeline is expected to double Russian oil exports to China, now carried mainly by a slow and expensive rail route, and to make Russia one of China’s top three oil suppliers.

Zombie buildings shadow Spain’s economic future. It is the hangover after an epic fiesta. Uncertainty over Spain’s capacity to recover has increased the pressure on Spanish stocks and bonds. As international markets have turned away from the country, Spanish banks have had to rely on the ECB to keep vital credit flowing through the economy. Investors believe banks need to be more transparent about the number of bad loans and other assets they have on their books. Instead of disclosing troubled credit, many Spanish lenders have chosen to refinance loans that could still prove faulty and to report foreclosed or unsold homes as assets, often without posting their drop in market value. Even after many banks passed this summer’s government imposed stress tests, economists believe such assets still pose a danger. One risk is that Spanish lenders could be following in the footsteps of Japan’s so-called zombie banks, holding onto capital in order to cover their losses. For years after the collapse of Japan’s economic boom in the early 1990’s, the country’s banks held on to trouble properties and other non-performing assets as they lost value, in hopes that the market would recover. That kept capital tied up in a languishing sector, preventing lenders from financing more vital sectors of the economy.

Risk aversion towards Spain has subsided as the government has shown progress in reducing its deficit at a high political cost to its leader.

Sweden’s economy is booming. However, a far-right party that blames Muslim immigrants for social ills won seats in Sweden’s parliament for the first time, marking the latest advance of ati-immigrant populism in Europe. The result is a shock for Sweden’s political elites and many ordinary Swedes, who have long prided themselves on being one of the Western world’s most tolerant and open societies. The Sweden Democrats’ populist campaign against immigration, particularly of Muslims, has underscored the spread of a pan-European backlash against liberal immigration policies, which is increasingly rattling the region’s political establishment. Across Europe, radical parties exploiting xenophobia are gaining votes and influence, profiting from economic uncertainty in the wake of a deep recession and tapping fear that Muslims and other minorities cause crime, terrorism, and the erosion of national identity. The trend risks deepening Europe’s social tensions and the alienation of many minorities, while making it harder for policy makers to argue in favor of immigration. Angst over migration, and about Islamic influence, is also on the rise in the US, but the US is more tolerant of a diverse society than in Europe, where large scale immigration is a newer experience. Sweden’s paternalistic welfare state is partly to blame for some immigrants’ marginal status in the economy. Europe has had far-right fringe parties throughout the postwar-era, but their clout has been growing steadily since the 1980s, where economic sclerosis created new opportunities for charismatic populists to blame immigrants for unemployment and crime.

For the past 10 of 13 yrs, Mr. Blair stood at the helm, having risen to power in 1997 on the back of UK’s “New Labor” movement to shed the party’s socialist trappings and embrace more centrist politics.

UK Union tactics have so far been ineffective. However, their drive underscores dangers facing the British gvmt as it prepares to reveal where the ax will fall I a spending review this autumn. It also reflects unions’ growing activity across EU as they fight budget cuts and political overhauls aimed at cutting budget deficits. Many believe that Tories’ aggressive budget cuts stem more from a small gvmt ideology than concern about fiscal problems. While Liberal Democrats campaigned saying budget cuts needed to be delayed to protect the nascent recovery, the Conservative’s policy was for immediate cuts — and that is what is now happening.

Junk Bonds

Junk bonds, coming off a record August, may take a back seat to safer investment grade debt in September until investors see more consistently strong economic signals. That fondness of bonds is likely to rise in Sept and Oct, often volatile months for stocks.

To some extent, the bull case for junk bonds is based on a declining rate of corporate defaults lately and a belief that, as long as the economy doesn’t relapse into recession, the low default rate will continue. The financial crisis purged many weak borrowers from the system, and corporate balance sheets are generally stronger today than before the crisis. However, a double dip recession could hurt another, albeit smaller, wave of borrowers. The demand for bonds has allowed some of the riskiest borrowers to sell bonds with fewer protections for investors (much like in 2005-07) — an unintended consequence. One reason why yields keep falling is lack of supply. Despite nearly two years of heavy borrowing by the fed and non-financial corporations, the total amount of debt outstanding in the US is still lower than it was at its peak in the first quarter of 2009. Few analysts say the bond market is anywhere near as risky as it was several years ago. It’s more accurate to say that we’re still disgorging the last credit bubble than that we’re starting a new one. New credit bubbles don’t typically form immediately in the aftermath of old ones.

The great debt storm has passed. And the damage is a lot less worse than feared. Corporate debt default rates are expected to fall to the same levels that preceded the financial crisis of September 2008, marking a swift turnaround for the fate of the most troubled US companies. That should bode well for the nation’s unemployment rolls. While business fundamentals or a double-dip recession could eventually fell these firms, for now they have ample access to capital.

Last year, we saw everyone come to market, selling shares or bonds to secure their balance sheets. This year, there’s not as much rescue financing and not enough financing to fund growth. In other words, a lot of companies did big bond or stock deals in 2009 and haven’t need to tap the market in 2010. Until we see more robust economic growth, we may find last year was a high-water mark.

Some companies’ intermediate-term debt was trading at lower rates than the dividend yield on their stocks, a clear signal that investors are clamoring for yield in corporate bonds but still nervous about the direction of stocks after more than 10 years of sluggish returns. Investors also sought yield in the junk bond market. Corporate bonds, including junk-rated issues, look safer than they used to because default rates have fallen sharply recently. Banks, meanwhile, want to move more loan exposure to investors because the banks face increasing capital restrictions that investors don’t. Meanwhile, credit investors are in the sweet sport of a slow growth economy. Companies are being cautious with their money, and that means that they’re not spending on the extra plant, but to maintain capital expenditures and pay their existing obligations.

Latin America

Brazil’s economy maintained its torrid pace of growth in the 2^nd quarter, continuing a boom in Latin America’s largest economy despite a series of interest rate increases and the expiration of tax breaks for consumer goods and other EO gvmt spending. Of the world’s major economies, only china is doing better. The pace of growth surpassed most economists’ expectation. The robust expansion amid broadly low inflation demonstrates the continued importance of EM economies as the world emerges from the financial crisis and global economic slowdown. BRCI continue to fuel growth as the developed world struggles with sluggish recoveries.

Colombia’s army killed the military leader of the country’s communist guerrillas, dealing a major blow to the four-decade insurgency. The operation was helped y undercover intelligence gathered from close associates of his. Such intelligence operations are becoming a hallmark of Colombia’s armed forces. The FARC has been fighting successive Columbian governments since 1964. In the late 1990s, the FARC numbered around 18,000 fighters and threatened to encircle Bogota. Former President Uribe made the fight against the guerillas his central aim, and put them on the run. After Santos took power, he vowed to continue the campaign against the guerillas.

Cuba’s effort to reorient its labor force represents the country’s biggest step toward a freer economy since the early 1990s, when Havana embarked on a brief attempt to make changes in a bid to survive without subsidies after the collapse of the Soviet Union. The revamp is also the most drastic effort to revive the flagging economy since Raul took the country’s helm more than 4 yrs ago after Fidel fell gravely ill. Many hoped the younger Mr. Castro would push through Chinese-style measures to open the economy when he took power in 2006. With the president’s ailing revolutionary bro lingering in the background, changes never came. But pressures have mounted in the wake of the global financial crisis, as the island’s economic conditions have deteriorated. Lying off gvmt workers, however, is unlikely to do much to solve the country’s problems, since let-go workers have nowhere else to turn to earn a living. Fidel admitted accidentally that the Cuban model no longer worked for any country, much less Cuba. This shows that the elder Castro had given his consent to this transition. Cubans who decide to go into business for themselves will find a series of obstacles, including very high taxes, lack of access to credit and foreign exchange, bans on advertising, limits on the # of people they can hire, and a litany of small-print gvmt regulations. Privatization will be slow and painful, requiring major changes in the way the private sector is handled. Cuba is one of the last true Communist economic systems in the world, a place where the state dominates nearly all spheres of life. FDI is restricted to joint ventures with the gvmt and limited to tourism and oil. After running up a huge current account deficit in 2009, Cuba has had to cut back sharply on its imports and stopped foreign jt ventures from repatriating profits. Tourism has been flat, nickel prices fell sharply last year, and many question how long Hugo Chavez can afford to ship oil products from Venezuela for free.

Monterrey, Mexico is caught in a war between two powerful and bloodthirsty drug cartels, the Gulf cartel and the Zetas, a splinter group that used to provide its security muscle. The two groups fell into open war at the start of the year. Monterrey sits near the US and is used as a staging ground to smuggle drugs north. Residents not only face the threat of getting caught in the crossfire: Gangs are also carrying out a wave of kidnappings — most of which go unreported because of fear of police involvement — and extorting local businesses, demanding protection money. The decline of Monterrey presents one of the biggest challenges for President Felipe Calderon in the three and a half years since he took power and declared war on powerful drug cartels. The city of 3.7 million, surrounded by dramatic mountains, is Mexico’s third biggest after Mexico City and Guadalajara, accounts for 10% of the country’s annual output, and is a symbol of modernity for the rest of the nation.

Mexico outlawed the killing of reporters, modeled on a similar one used in Colombia during the 1990s. However, skeptics think this measure is meaningless, since the federal government is so messed up that it can’t protect itself.

Venezuela’s mix of soaring crime, economic contraction, and 30% inflation may prompt voters to cast anti-Chavez ballots. Mr. Chavez isn’t running for election. However, heat he is after is a crushing win that would propel him toward victory when he runs for re-election in 2012.

Opposition candidates won enough seats to strip Mr. Chavez of his 2/3 majority — the fraction needed to pass major legislation and name court justices. The result is significant because Mr. Chavez has relied on a rubber-stamp Congress to pass laws that have centralized power significantly during his 11-year presidency. More importantly, the results provide momentum to a fragmented opposition that is still searching for a candidate to challenge Mr. Chavez in presidential elections in 2012.

Mergers and Acquisitions

Corporate boards gradually put aside nagging worries about a double-dip recession, European budget crises and political uncertainty in the US. Having hoarded cash for the past 2 years amid the financial crisis and recession, companies showed they were finally comfortable spending it on strategic acquisitions. Many deal makers expected a steady increase in M&A volume for the rest of 2010, rather than a quick jump. Increasingly, European and US companies are likely to target companies in emerging markets, which offer faster growth than their more mature home markets.

Middle East

Iran had moved from an Islamic Republic state to one that was ruled by a military dictatorship, under the political and economical influence of the Revolutionary Guards Corps.

Iraqi politicians have squandered the huge opportunity presented to them by the US-led invasion in 2003. The certainty of terror has been replaced by the uncertainty of politics.

The Palestinian economy grew by a resounding 9% in the West Bank and 16% in Gaza through the first half of 2010, due to the easing of Israeli restrictions, donor aid, and aggressive financial sector overhauls by the Palestinian Authority. The latest IMF growth figures are likely to sharpen debate between those who say Israel has taken sufficient steps to improve Palestinians’ daily lives and those calling on Israel to go further. The IMF mission issued a stark warning: The robust growth isn’t sustainable without progress in the peace process and the lifting of further Israeli restrictions.

Despite the dramatic growth spurt in recent months, the Gaza economy is still in the doldrums, well below what it was in 1994, when the Oslo Peace Process was first launched, or in 2007, when Israel tightened its blockade of the territory after Hamas seized control from the Fatah Party led by Mr. Abbas. Gaza’s growth has to be viewed in the context of its past years of negative growth, a punishing war with Israel, and unemployment at more than 35%. With that as your starting point, 16% growth still leaves Gaza’s economy in desperate straits. The growth spurt in Gaza is a one-time affair, the buying spree of a people unable to purchase many basic items for nearly 3 years. Growth rates are expected to slow, with total growth in Gaza for 2010 forecast at 8%. The economic boom has helped deflect mounting Palestinian frustrations with a peace process most of them appear to have lost faith in. If Palestinians’ economic fortunes were to falter, it could contribute to their anger again spilling over into violence. The economic jump in Gaza reflects the impact Israel’s limited relaxing of restrictions on imports of consumer goods has had on the territory. Israel began quietly easing the restrictions earlier this year. It publicly lifted many remaining ones in the wake of the international outcry that followed a botched raid in May of a Gaza-bound aid flotilla.

Less talked about is the Palestinian Authority’s financial sector reforms, particularly those implemented in the past 12 months. These include bringing banks into line with international standards and establishing a modern credit scoring system that made it easier for Palestinians to borrow money. The PA has streamlined public payrolls and reduced spending on subsidies, allowing it to decrease dependence on foreign aid. Israeli officials say they will continue to facilitate Palestinian economic growth as long as security remains stable. But they also have made it clear that in Gaza unlimited economic growth isn’t the goal. The restrictions are aimed in part at maintaining the pressure on Hamas. Israel may be nearing the upper ceiling of what it is able to do for the Palestinian economy without a far more radical policy shift.

Turkey voted to amend the nation’s constitution, delivering a surprise boost to PM Erdogan and his Islamic-leaning gvmt ahead of elections in 2011. The referendum has been touted as a key battle in the struggle to determine Turkey’s future by both sides: the country’s secular establishment and a rising conservative elite that Erdogan represents. Changes to the judicial bodies worry many Turks concerned by what they see as signs that Mr. Erdogan and his party are interested less in democracy than in securing control over all the levers of power in order to crush opposition. Economists and businessmen said investors were likely to welcome the clear vote of support for Erdogan, as they look for indications that his party will be able to win a 3^rd term of stable, single-party gvmt in elections due next summer. Many were suspicious about the gvmt’s intentions, but the mkts like stability and this result will contribute to that. The referendum results should make the ruling party more comfortable about its popular support, possibly reducing temptation to loosen fiscal policy in the run-up to elections.

Turkey’s business lobby called for an all-new constitution, s the country’s stock markets surged to a record high in the wake of a referendum victory for the gvmt on changes to the existing one. The struggle to define its future will likely continue.

Turkey reported double digit economic growth in Q2. Turkish fundamentals are good, boosted by a jump in consumption and investment. They have returned to their peak prior to the financial crisis and have a positive outlook, yet they are still 2 notches below investment grade. Turkey is vulnerable to a hard landing should the global economy hit another bump in the road, causing external financing to dry up.

Turkey’s rapid recovery from the global downturn is giving a new boost to the government’s plan to turn Istanbul into an international financial center. Istanbul is the engine of a consumer-led recovery that saw Turkey tie China as the world’s fastest growing economy in Q2. Istanbul’s banking sector has been at the heart of that success. But turkey’s plan for Istanbul faces massive challenges. Turkey’s economy is tiny relative to China’s. It has developed a swagger in recent years as a rising middle class fuels a consumer boom that is turning the city into a fashion and tourism hub.

Munis

Harrisburg, PA is expected to avoid an anticipated default on a GO payment. The State would expedite funds and grants to its capital city. The city remains on precarious financial footing and needs a long-term solution for its debt tied to an incinerator project, which is 4x its annual budget. The city has been mired in political stalemate over how to deal with the burden.

Tax revenue to state and local gvmts edged up in Q2, but most of its sources remain crimped by the lingering impact of the recession. The slow revival of tax revenues suggests budgets and spending will remain tight through this year and beyond. Property taxes have continued to grow through much of the recession and recovery, despite falling property values and depressed construction. That is partly a result of localities raising their taxes to cover budget gaps, but also reflects a time lag: It can take localities two or more years to adjust their taxes, in this case downward, to reflect reassessed property values, so many of them continue to collect taxes based on the higher price levels from before the hosing bust. Following the last recession in 2001, it took about 2 years for state and local tax collections to surpass pre-recession levels. This time, it’s expected to take much longer, largely because the recession was longer and deeper than any downturn since the Great Depression. One big drag on growth is the stubbornly high unemployment rate.

North America

Manufacturing accelerated last month in both the US and China, defying mounting signs of a global slowdown and cheering investors. The recovery will be a zig-zag pattern but now with an upward slope. 2 early boosters of the recovery — stimulus spending by gvmts and inventory rebuilding by businesses — are fading fast. The big question is whether, and when, consumer spending and business investment will pick up the slack. Reflecting the uncertainty, most countries’ stock markets are well below their peaks in the spring. The stalling growth is comes as policy makers are curtailing stimulus spending or, even tightening credit to avoid overheating.

Growth in advanced countries tends to be depressed by a full percentage point for an entire decade following severe financial crises. Unemployment is expected to remain stuck at 9% throughout 2011 — presuming there are no additional big shocks. But the odds are not great, since we have them all the time. A prime candidate is the return of the euro zone’s public debt crisis.

The US is growing at close to a stall speed that is too slow to keep up unemployment from rising and house prices from falling further. As a result, banks could face higher losses and lend less, pushing consumer and business spending down, and a negative feedback loop would tip the US back into recession. The odds vary from 20-40%.

Failure to act on the expiration of Bush-era tax cuts could have a negative effect on sentiment without doing much to reduce the vast US budget deficit. It would be the worst of all worlds. The US has ample resources to restimulate the global recovery. US companies are sitting on almost 2 trillion dollars — the highest level, as a share of their total assets, since 1963. If and when uncertainties over income taxes, health care, and government policy clear up, companies could grow confident enough to deploy that cash to hire workers and invest in new projects. That, in turn, could inspire US consumers to return to the malls.

Coyote fees have increased in tandem with bolstered enforcement. Because return on their investment to gain access to the US labor market now looks much less certain, many potential Mexican migrants are postponing journeys until the economy grows again.

The recovery spreads fitfully and advances unevenly across the US, as regions reliant on mfg and farming show progress while those more dependent on housing continue to struggle obviously. Factories, farms, and mines were all seeing continued gains in demand and sales. Unemployment is relatively low in farming and resource rich regions across the upper Great Plains, while it is elevated in the Sunbelt cities. The decline in house has pushed some states back into recession after a brief upturn.

Capital goods demand seems to be slowing simultaneously across most industrialized economies.

Many of the country’s small banks are still in big trouble. Some have fallen out of compliance with stock-exchange requirements, and others have gotten delisted altogether as a result of their woes. Scores have missed dividend payments owed to the government under TARP. Community institutions represent the bulk of the 829 institutions on the FDIC’s problem list. They also make up the majority of the 118 banks that have failed this year. Faced with slow growth and competition from big banks, many of these small banks pumped earnings in recent years by expanding into commercial real estate. Such growth has come back to haunt them now. Banks that are under pressure to raise capital are finding themselves in a difficult spot because investors are increasingly skeptical about the future of some of these institutions. More than 90 financial institutions, most of the community banks, missed May dividend payments on preferred stock they received under TARP. That number could grow later this month when the Treasury releases a list of banks that missed August payments.

Regulators are on pace to shut more banks this year than 2009, when 140 failed. All told, 293 banks have been seized since 2007. That total is still well short of the tally in the S&L crisis of 1987-92 when over 1,000 failed.

Basel III would require global banks to maintain basic levels of capital equal to at least 7% of their assets — much more than existing standards of roughly 4% for large US banks. The effort would transform banking, potentially forcing banks to take fewer risks, make less profit, and face more government scrutiny For banks, the rules could require them to raise capital, shrink their balance sheets and dump business lines deemed too risky. They’ll likely have to keep in reserve more earnings to protect against potential losses, which will leave less money to pay investors and employees. But under pressure to avoid derailing the stuttering economic recovery by crimping credit, regulators agreed to phase in the rules over more than 8 yrs – a longer time frame than US regulators had hoped for.

Regulators are also delaying bank’s ability to payout higher dividends, by requiring them to show strong cash flows, even in a faltering economy. This could weigh on bank prices. For decades, bank div yields were above that of the S&P500. During the housing bubble 2005-06, banks paid out nearly half o their regular earnings as dividends. Last year, that payout was < 15%. The reason: In the financial crisis, all but a handful of big financial companies slashed their divs, which sent waves of fear through world mkts.

Unlike home owners, banks often are much quicker o slash prices to unload properties quickly. Even though mortgage defaults kept mounting, housing markets began to stabilize early last year as low prices and gvmt interventions broker the downward spiral. HAMP has fallen short of its goals. Yet the program served as a closet moratorium on foreclosures that staunched he flow of bank-owned homes to the market. The problem is that these measures are wearing off. Demand plunged not surprisingly, after the tax credits expired, and unsold homes are piling up. More foreclosures could move onto the market as borrowers fall out of the loan modification program. We see the perfect storm brewing with rising supply and falling demand. Prices also have come down so much already they have less distance to fall. During the housing boom, prices inflated much faster than incomes rose, thanks to speculation and lax lending. The fastest cure for housing would be job creation, because it would boost demand for homes while putting delinquent borrowers back on solid footing. But if that doesn’t materialize, policy makers face a thorny question: whether to intervene if price declines accelerate beyond the 5-10% that most economists expect. Ultimately, market fundamentals will prevail. That leaves few attractive options. Prolonged intervention could backfire by creating uncertainty that keeps buyers on the sidelines. Extending foreclosure timelines also risks inducing more borrowers to default and live rent-free. Letting the market take its medicine sounds more appealing than it did 18 months ago. But it risks saddling taxpayers and the banking system with billions more in losses and trapping more borrowers in homes on which they owe more than the house is worth.

Washington is at risk of undercutting an already sluggish economic recovery if it failed to provide quick, additional support to businesses and individuals. The biggest challenge facing the economy now was Washington in paralysis. If the government does nothing going forward, then the impact of policy in Washington will shift from supporting economic growth to hurting economic growth. The typical error most countries make coming out of a financial crisis is they shift too quickly to premature restraint. You saw that in the US in the 30s, you saw that in Japan in the 90s. It is very important for us to avoid that mistake. The 2 big worries plaguing the stock market — policy uncertainty and sluggish prospects for economic growth — aren’t likely to dissipate if gridlock takes hold in Washington. If anything, the market may find itself stuck as well.

Efforts to tame America’s ballooning budget deficit could soon confront a daunting reality: nearly ½ of all Americans live in a HH in which someone receives gvmt benefits, more than at any time in history. At the same time, the fraction of American HH’s not paying federal income taxes has also grown to an estimated 45%. ½ of those don’t earn enough to pay taxes, the rest take so many credits and deductions that they don’t owe anything.

Beggar-thy-neighbor currency devaluations proved ruinous for the global economy in the 1930s. IS the world setting off down the same slippery slope again? Japan’s decision to intervene to drive down the value of the yen blew a hole in the developed world’s united effort to push China and other Asian countries to stop holding down their currencies. Meanwhile, speculation the US and UK could soon resume quantitative easing has hit the dollar and sterling. The resulting tensions are bad news for the euro zone but a gift to gold bugs. The good news is that interventions have aimed more at containing currency strength than inducing weakness, and with limited success. The risk is that the lure of beggar-thy-neighbor competitive devaluations may grow if the US and UK embark on further QE. As in the 1930s, competitive devaluations are likely to increase international tensions and risk protectionist responses. Meanwhile, they will do nothing to address the global imbalances that led to the crisis or tackle the chief problem facing the advanced economies today: a lack of domestic demand in many countries. Short term, the euro zone has the most to lose from rising currency tensions, given the relative hawkishness of the European Central Bank. A rising euro could cause further problems for Europe’s periphery as well as for the German export engine at the heart of the European recovery. Longer term, the biggest gainer is likely to be gold. It remains a refuge for those unwilling to put their faith in politicians.

Wholesale credit unions were bailed out at the expense of retail credit unions. Wholesale unions don’t deal with the general public but provide essential back-office services to thousands of other credit unions across the US. The majority of retail credit unions are sound, but they will have to shoulder the losses, not the taxpayers. Still, it marks the latest intervention by the US gvmt into a financial system weakened by the real-estate bust. Bad bets on mortgage-backed securities have now killed 5 of the nation’s 27 wholesale credit unions since March 2009. The federal gvmt, which now controls 70% of the total assets at such credit unions, said the surviving institutions will be reined in so that they take fewer risks with their investments. Wholesale credit unions, also known as corporate credit unions, invest money for retail credit unions and provide them with check clearing and other services. Since the start of 2008, 66 retail unions have failed, compared with 290 banks or S&L’s. Under federal rules, wholesale credit unions were supposed to invest only in safe, liquid assets. But some chased higher returns by loading up on securities backed by subprime mortgages or other risky loans. Their portfolios were decimated by the mortgage meltdown. Wiping out the capital of the failed institutions will cover a chunk of those losses, but the remaining will be passed along to the nation’s 7,445 federally insured credit unions in the form of future assessments. The changes won’t immediately affect customers of retail credit unions throughout the US. But it is possible that assessments on the industry could result in higher interest rates on loans and lower payouts on deposits, if credit unions can’t otherwise cover their obligations.

Real Estate

For the broader commercial real estate market, the renewal of the CMBS market is a critical step in the road to recovery. Owners and developers have relied on the securities market for the bulk of their financing during the past decade. The rebounding CMBS market has outshined most other businesses that also depended heavily on securitization, such as credit cards and home mortgages. But CMBS borrowers have turned into an exclusive club consisting mostly of owners of properties with steady cash flows and low leverage. Those borrowers are benefitting from great rates. But investors are well aware that there is a great deal of pain still to be felt in commercial property. Rents and occupancies are still weak in many markets. For those who can’t and don’t want to dig into hundreds of potentially underperforming loans packaged into deals issued a few years ago, the clean new-issue stuff sounds like a compelling story. The newer deals also are structured in a way that incorporates lessons learned from the recent downturn.

The dearth of financing is forcing developers to get creative about ways to proceed with projects that have been languishing on the drawing board for years. During the boom, developers often were able to obtain financing for office-building or retail projects before signing tenants. But ever since the recession hit, the financing spigot has run dry. Steep losses on top of the market deals and a drop in demand for space have put builders on the sidelines, while many lenders are swamped with boom time loans gone bad. Demand for design services is still declining — a sign that an uptick in new construction isn’t expected in the next 9-12 months. But some developers think all that gloom makes for opportunity, arguing that a lack of new construction means demand for the state-of-the-art buildings could outstrip supply within a few years.

Multifamily building sales defy the slump. As sales heat up, plenty of new inventory is hitting the market. To be sure, this activity still is well below peak levels (1/6). At the same time, the pickup in sales volume is pumping up prices from their depressed post-housing-crash levels, increasing the risk for buyers. Looking at it another way, buyers of top-quality properties in the best markets generally are getting yields of close to 5%. One year ago, investors were getting yields of close to 6%. The pickup in sales activity comes at a time of uncertainty as the market deals with a prolonged economic slump, and the sector could face pain. About a ¼ of recent transactions have come from distressed sellers, with many others coming from pressured sellers. Buyers maintain the sector is a sound bet, given that most of the current prices remain below construction costs. Apartment operators performed better than expected during the downturn when some industry watchers feared renters would downgrade or move home in droves. Landlords had to offer rental discounts and other freebies to keep units filled, but most skirted drastic vacancy spikes and plunging rents. Also there has been little new development in the past few years, which some industry watchers expect to create a supply shortage in some markets down the road.

Short Selling

Short selling rose in late August. Meanwhile BEARX is less aggressively short. The fund is shying away from placing bets on individual names in favor of shorting SPY — less short positions than 2008.

Technically Speaking

Two potential catalysts for a return to risk:

1. Stepped-up M&A/IPO activity
2. Pressure on hedge funds/private equity firms to start making $ for their investors

During the first few months of 2010, stocks headed higher as hedge funds upped their stock buying while retail investors were still selling.

A key sign of revival of risk would be an easing of the extremely high levels of correlations seen during the summer among a range of investments. Investors are lumping assets into a risky bucket and safe investments. The result has been high correlations among investments that historically have little connection. Investors also are drawing little distinction among individual stocks. These high correlations reflect a lack of conviction.

Investors are in a “prove it to me” state of mind when it comes to stocks.

The S&P500 death cross coincided almost exactly with the YTD low for US stocks.

Two years after breaking the buck, some MMF’s are making new bets on risky securities, raising the chances for problems despite new rules designed to make the market safer. Funds are taking new risks now in part because of unintended consequences stemming from the new rules. Many companies that issue short-term debt, concerned about refinancing on short notice, are now seeking longer-term funding instead. The result: The pool of available securities for money funds to pick from is shrinking, reducing their diversification and adding risk. A shrinking investment universe has left money funds with hefty exposure to the financial sector. Most of them are big banks in Europe. The dwindling pool of securities has also helped drive down yields. To boost their returns, some funds are increasingly using complex, and sometimes risky, investments. Several European banks in recent months have issues “step-up” CD’s that typically allow investors to get their money back within 7 days but offer interest that increases periodically if investors don’t exercise that option. That the instruments fit in with the new 30% rule is a big plus. The more complex instruments might be difficult to sell during a market panic. Some funds are also taking a riskier approach to the common money fund strategy of investing in repurchase agreements. A number of money funds have lately broadened the types of collateral they will accept to include not just government securities but also corporate debt and stocks.

The leveraged loan market is making a surprisingly swift comeback, as investors chase yield. Most of such floating rate loans were used to refinance old debt, but the balance is beginning to shift, with nearly 25% of all deals since June being used for leveraged buyouts. For now, they remain cheaper than junk bonds, pay up to 5% depending on its floating base rate — which is less than a junk bond, but with more protection for investors because loans get paid before bonds in a bankruptcy. Mutual funds have picked up some of the slack. Loan-focused mutual funds have enjoyed steady inflows since the end of 2008. Investors are being compensated well, with loans offering coupons of more than 4% points over LIBOR. During the boom, that spread fell below 3%.

Oil and stocks are breaking off their 9-month relationship. The correlation between crude-oil futures and S&P500 has tumbled close to the year’s low. Traditionalists in both markets insist the two were never meant to be together in the first place. Short-term moves in the stock market can sometimes serve as a proxy for future economic growth, and with it, oil demand. But over the long run, the markets are usually pulled apart, as higher energy prices can drive down shares by increasing costs for companies and taking up a larger share of consumer spending. It seems quite natural that they would move in the same direction when you’ve hit the bottom and then are on a recovery.

Individual investors and pension funds have been pulling money out of stocks, leaving shares more vulnerable to trading by hedge funds with short time horizons. Some stock pickers say the current macro focus is only temporary, and will generate great investment opportunities simply because companies with different outlooks shouldn’t be moving in lock step long-term. Eventually, stocks will move in line with their fundamentals. Between October 2008 and February 2009, correlation hit 80%. It spiked back over 80% during the European debt crisis. What has caught many investors off guard is that correlation stayed high over the summer. In mid-August, correlation was 74%. In recent weeks, it has drifted down to 66%. As investors grow frustrated with stock picking, they’re flocking to mutual funds that specialize in macro investing.