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First Quarter 2011

Despite chaos in the Middle East, and Japan, the U.S. economy is showing robust signs of recovery. Manufacturing in the U.S. has expanded to a seven year high on inventory rebuilding, and is in fact the leading sector in the economy. The U.S.unemployment rate has dropped to a two year low of 8.8%, and higher payrolls are leading to a pickup in consumption. A weaker dollar has led to a dramatic expansion in exports,and the agricultural sector (the largest U.S. export) is doing particularly well due also to high food prices. Company CEO’s are bullish, as are small enterprises which may have lagged in this economic rebound, but are now snapping back suggesting that the recovery is becoming self sustaining. Despite a depressed real estate market, stocks have had a good quarter, leading to a positive “wealth effect”. There is still a great deal of money flowing out of low yielding money market funds and into stocks.

Despite the fiscal disasters of Ireland, Greece, and Portugal (which only total 5-6% of the European economy), the German economy is so strong that it is pulling Europe up with it, particularly France and Italy. Economic restructuring in Spain has been drastic, and will work. There is relative optimism that Europe has put the worst of its economic fires out.

In the emerging markets, there has been monetary policy tightening in order to subdue inflation, but commodity demand from these regions remains very strong. Brazilian interest rates are nearly at 12% and are expected to rise again in April. Nonetheless, the Brazilian Finance Minister has noted that inflation was already starting to ebb after the recent spike in food and energy costs. China too has been raising interest rates and will probably do so again soon in an attempt to cool down its inflation. Chinese electricity growth (a better measure of GDP growth than government statistics) is estimated to reach 12% in 2011. Emerging market companies are under increasing pressure over raw material cost prices, because they have greater difficulties passing higher costs on to consumers and have lower margins on their exports than American companies.

Chinese inflation is largely imported. While Chinese consumer prices were up 8.7% from a year ago, 90% of that price rise was from food alone. Excluding food, Chinese “core” inflation is only at 1.6%, and without energy the “core” rate is only 1.1% Chinese core inflation actually decreased in March vs. February. Assuming that food and energy prices may begin to stabilize now, it is likely that we are nearing the top of the emerging market interest rate cycle, and as inflation begins to calm down, emerging market companies should begin to perform better. Until that point, however, expect American stocks to outperform.

Inflation in the U.S. is understated because of the bearish housing market. If we look at “pipeline” inflation, like factory orders, there are huge price pressures building . Import prices from China are up as well. The Federal Reserve’s U.S. “core” inflation is only at 1.1% over the past year. The CPI stripped of its housing component, which comprises some 40% of core inflation, is considerably higher, closer to 2.7%, and likely to rise further. With input costs rising sharply for manufacturers, it is only a matter of time before higher costs catch up with consumers. This would correspond with Walmart CEO Bill Simon’s recent announcement that “inflation is going to be serious”. Europe has an even more acute inflation problem than the US because of indexation of wages, high unionization, and no housing component in the statistic.

In an inflationary environment, long duration bonds are a losing proposition. Gold, Silver, Copper, Iron Ore should continue to benefit from the economic outlook or from fears over inflation. Oil should stabilize near current elevated levels, but longer term will be driven still higher due to demand growth outstripping supply growth. U.S. stocks are breaking out, while the Dow Transportation Average, commonly considered a predictor for stocks is showing broad based strength.. The Federal Reserve’s “QE2” policy will finish at the end of June, and the Fed’s balance sheet will stabilize until September. While some analysts expect another round of quantitative easing, it is more likely that further recovery will eliminate the need for it.

Grant Rogers

Partner

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