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Second Quarter 2008

Several key variables are impacting flow of accounts between commodities, oil, and food. In the short term the key variable is oil, which has resulted in inflationary pressures. In the medium term however, there are two deflationary variables in play. Oil acts as a tax on oil consuming nations by oil exporting nations. This has a big impact on consumer spending and corporate profit margins. The second deflationary variable is the housing market and associated credit crunch. The cost of money has risen sharply, impacting both investment and consumption. Another linked deflationary point is the destruction of household wealth, principally in the form of housing, but also in the form of equities and bonds, both domestically and internationally.

The biggest risks to today’s investor are central bank missteps. Faster growing economies are creating problems, because their high rates of food and energy inflation are not being reacted to with sufficient vigor. As an example, the Indian central bank just raised its key interest rates to 8.75%, while inflation in India tops 11%. While positive “real” (inflation adjusted) interest rates are necessary to curb inflation, the Indian real interest rate is –2.25%. This is particularly a problem in Asia and the Middle East among developing economies, with the exception of Brazil, which has learned from its inflationary past. The result of this is that central banks in more mature markets, like the U.S. and Europe, may have to compensate by raising rates by more than they might have otherwise, and certainly more than the market is currently expecting. Until we see oil prices coming off or emerging market central banks acting with more vigor by raising their interest rates considerably higher, the risk is that equities and bonds continue to under perform and that oil and gold exposure may continue to remain safe havens.

Should fears of stagflation subside, equities may begin to recapture a good portion of the ground they have lost this year. For now, given the risks, it makes sense to remain with a defensive posture. Longer term, a key risk to U.S. economic growth is the need for Americans to rebuild their savings after many years of spending more than they have earned, clearly suggesting a longer period of sub-trend growth.

For the first two quarters of 2008, the Dow declined 14.4%, the S&P lost 12.8%, and the Nasdaq fell 13.5%.
Grant Rogers Elizabeth Allen

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