>GLOBAL DISEQUILIBRIA: Don’t expect lasting stability

Our basic view remains unchanged; we remain positive on equity markets, credit spreads and most commodities because liquidity flows are still very positive and key indicators discussed below are supportive. However, we still are very concerned about the artificial nature of the economic recovery and financial markets and when the relatively benign environment might change for the worse.

Past issues have pointed to the widespread and huge disequilibria in the U.S. economy and financial system. That is also true globally. No one knows what’s real and what is not when it comes to the economic recovery and market prices for assets and currencies. Market forecasts are always a big part of the game; in today’s context, we can’t attach much confidence to any of them. Rather, it makes more sense to think in terms of whether the environment is favorable for assets or not and to watch for benchmarks to gauge when that might change and how it would affect the different markets.

One thing we do know: markets eventually correct disequilibria and it is usually painful. However, time lags are variable and frequently longer than most people can imagine. But when the adjustment comes it is usually swift and substantial. This makes for an uncertain environment because the risks are not easily quantifiable.

Financing the U.S. Treasury Debt
As we have pointed out frequently in past letters, the explosion in the deficit and the government debt to GDP ratio is not a problem in the short run when the U.S. economy is in recession, inflation is low, private savings are rising, the dollar is firm and the existing debt ratios relatively moderate. But now that the economy is growing, possibly quite fast, financing the deficit may not be easy at existing interest rates as people are looking ahead to government debt ratios which will be anything but moderate.

Who has been buying the massive issues of U.S. government debt? In an interesting recent piece, “Is it all Just a Ponzi Scheme?,” Eric Sprott and David Franklin looked behind the published numbers to see who bought the $2 trillion of net new U.S. government debt last year to finance the budget deficit and other cash requirements. The Treasury data shows the “Other Investors” sector increased its holdings of government debt by 200% in 2008 and 2009 (Charts 1& 2). Similarly, flow of funds data shows that the ‘Household” sector was the largest net purchaser in late 2008 and 2009. These two categories - “Other” from Treasury statements and “Households” from FRB statements are residuals: if the figures don’t add up, they are used to “balance” the numbers.

Investment Conclusions
January was a month of correction. U.S. and international stock markets were virtually all down, some by negligible amounts, others such as the key Shanghai market, by as much as 10%. Shanghai was hit hard because the government ordered a clampdown on bank lending and increased reserve requirements to counter too rapid economic growth and strong asset price increases in some real estate markets. Commodities and precious metals also sold off in January.

U.S. 4th quarter GDP data indicate almost 6 % real growth and many are predicting a mini boom to last for some time. One of the main arguments used to project strong growth is based on past experience which shows deep recessions are followed by rapid recoveries. If this occurred, the expectations of continued easy money and ultra low interest rates would

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