Thesis as of Mid 2012

7/31/2019 Thesis as of Mid 2012

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Macro Outlook (Mid- 2012)

Rodrigo C. SerranoNew York, NY

Direct 305-510-0181Email [email protected]

Websites:http://rcsinvestments.wordpress.com

http://rationalcapitalistspeculator.tumblr.comhttp://www.linkedin.com/pub/rodrigogserrano

July 4, 2012

Table Of Contents (p. #)

Executive Summary (1) Global Economy/Trade (2) U.S. Monetary Policy (8) U.S. Government Policy (11) Confidence (15) Inflation (15) Industrial Production (17) Consumption/Borrowing (18) Jobs (19) Service Industry (20) Housing (20)------------------------------------------------

Executive Summary

Globalizations dark side has arrived. Theglobal economy is currently held hostage

by a political crisis in the Eurozone,critically harming the already weakfoundations of the global recovery.

Fiscal prescriptions demanded byGermany and other core-countries have led

to recessions throughout the periphery,along with increasing nationalism. While

last weeks announcement for a euro-widebanking regulator, to be instituted by theend of the year, drew worldwide acclaimand caused a powerful rally in riskmarkets, the accord is unlikely to eliminate

the festering wound threatening our globaleconomy. Theres a dangerously high

probability that Europes announcementhas come too late and that European

officials will find themselves obligated totake very uncomfortable and hurried stepstowards fiscal union in the months to come.

Meanwhile ongoing austerity in Europehas led to a larger than expected slowingin China, as the export-dependent

countrys largest client is falling into a deeprecession. Chinese officials have instituted

policies aimed at both subduing thecountrys buoyant real estate market andmoderating inflation. With no significantstimulus on tap, I am skeptical that thecommunist country can withstand anexogenous economic and financial shockemanating from the Eurozone.

Finally the Eurozone crisis has begun to

affect U.S. consumers and businesses.Confidence and clarity in future growthhave diminished. Job creation and

business investment have slowed. Thenational savings rate just hit a 4-monthhigh and is a testament to the growing

worry over events transpiring across theAtlantic.

We are currently in the midst of a crisis ofconfidence, which may lead to the self-

fulfilling prophecy of global recession.

The coming year may mark the nextdisorderly phase (2008 was the first) of

what Ive called the Global EconomicRestructuring process; which has been thefundamental macro trend to recognize and

track over the past few years. Continued


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intervention and manipulation on the partof political and monetary officials havedelayed this adjustment and in fact have

worsened todays large imbalances.Indeed, they have created an uncertainenvironment, damaging confidence for

long-term investment.

To be sure, government officials will likelycontinue to intervene in our capitalmarkets should economic conditionscontinue to deteriorate. These actions maycause bullish shifts in sentiment as well as

powerful relief rallies, especially given that

investors have grown to embrace centralbank intervention as a panacea. However,in the absence of significant fiscal stimulus(both in the U.S. and Europe), monetaryauthorities may find themselves unable tostop the eventual process of restructuring

that needs to take place.

The coming years are likely to remainturbulent as China continues on its courseto become the worlds consumer, as theU.S. was for many decades, while the U.S.and most of Europe retool their economies

to feed Chinas eventual insatiableconsumer demand. There are wildcards inregard to the long-term direction of theglobal economy however, the mostsignificant being in the presidential election

this coming November.

Regardless, if world leaders cansuccessfully navigate the treacherous

waters of global restructuring over thecoming years, eventually todays seeminglyendless period of weak economic

performance will lay the foundation for apowerful secular bull market that may lastfor decades.

Until then, investing today will requireflexibility, risk management, and a

willingness to embrace the fact that buy-and-hold investing has taken a back seatfor the time being.

Global Economy/Trade

Events transpiring in Europe since my lastthesis update, roughly 6 months ago, havebeen generally in line with myexpectations. As far back as a year ago, Irecognized that Europe was on a path

towards political crisis, due to a fermentingcurrency crisis in the region. The lull in

protests across the Eurozone during the

winter and spring months dissipated andremonstrations have become more intenseas of late.

However, contrary to my expectations ofno quantitative easing and despite obviousdispleasure from the Bundesbank, theECBs 2nd long-term refinancing operationin February was perceived as such,improving investor sentiment worldwide in

the early months of the year. However,this step did not result in a permanentsolution and continued uncertainty hasreduced bullish sentiment, affecting theglobal economy, in particular China.

Chinas manufacturing sector has nowmatched the length of contraction seenduring the 2008 financial crisis. However,

this contraction hasnt been nearly asacute. Overall, continued weakness in the

Asian nation was mostly in line with myexpectations of a clouded outlook withsignificant downside risks. I did, however,underestimate the resiliency of the realestate market. Price depreciation hasslowed and has brought bulls out of the

woodwork rightfully stating (so far) thatChinas important real estate market hasfinally stabilized.


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Looking ahead, my short-term outlook forglobal trade in the coming 6 monthsremains bearish. The probability of a

disorderly fragmentation in the Eurozonehas increased from 50%, stated in my priorthesis update, to 60 to 80%. Should wehave a negative conclusion, theres a 50 to80% likelihood of a subsequent hard

landing in China due to an acuteworldwide financial exogenous shock. Allin all, not a pretty picture.

Last weeks accord to use the EFSF/ESMto conduct direct bank recapitalizations,

setup a region-wide bank regulator, andaddress the thorny issue of seniority withregard to Spains bailout was greeted withmuch enthusiasm amongst investors.

Let me first state that I wholeheartedlyagree that this is a big and unexpected stepforward towards a fiscal union in Europeand the specter of a financial meltdown in

the coming weeks has been reduced.However, the devil lies in the details of theagreementas always.

Direct bank recapitalizations are unlikelyto come before 2013. In addition, the aidwill come only after European nationsrelinquish sovereignty of their financialindustries to the EUs new banksupervisor, which is supposed to be formed

by the end of the year. Moreover,important details remain missing andimplementation risk looms.

Next, in todays headline-driven world, itseasy to unwittingly focus on the trees and

lose sight of the forest. Taking a step back,heres what I see.

First, both the EFSF and the ESM do nothave enough resources to combat the crisis,

as clearly illustrated in the graphic belowcreated Ray Dalios Bridgewater.

Source: Bridgewater ZeroHedge

While it is possible that a banking licensemay be granted to the ESM, therebysignificantly increasing its capacity, this

bullish prospect is becoming increasinglydubious due to my second point below.

Patience among Eurozone leaders, andmore importantly, their constituencies isrunning perilously thin. Despite last weeks

bullish summit result, negotiations weredescribed as horrid. Additionally, majorGerman newspapers lambasted Merkel,announcing that she caved in andrelinquished the countrys wealth to bailout

profligate periphery-countries. Likewise,lawsuits challenging the constitutionality ofthe ESM are increasing in frequency. Theprospect of a referendum grows with everypassing day. Meanwhile, newspaper

articles from Greece to the UK haveincreasingly brought back nefariousmemories of Nazism, framing Merkel as adictator. Granted, many of these

publications are left leaning, but looking atrecent elections, these messages are clearlyresonating the growing displeasure ofausterity-racked periphery citizens. After


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the summit, newspapers in Italy, Spain,and France boasted how their leaders were

victorious by pushing Merkel into a U-

turn. In fact, Italys Monti made it a pointto claim a double victory over Germany,referencing Italys win in the 2012 Euro-Cup. I do not see these as signs ofincreasing unity in Europe.

While last week was a clear step towardsfiscal union, the meat of the solution wasonce again a prescription for a liquiditycrisis, not a solvency one. Tradeimbalances and austerity policies to correct

them look set to continue, depletingfinancial resources used to attack thesymptoms and not the underlying causes of

the problem. This means that recessions inthe periphery will continue and are likelyto worsen, further inflaming nationalisticsentiment. In my prior thesis update, I

posed the following question: Has psycheamongst the periphery citizenry and

political spectrum crossed the eventhorizon into nationalism? Ironically,

piecemeal solutions designed to buy time toset the stage for a United States of Europeare in fact worsening the crisis by allowingmore time for nationalistic sentiment, and

political parties tapping this powerfuldynamic, to gain strength.

Third, political rifts between Europes topeconomies are blatant and untenable. Astrong political push to relax austeritymeasures and tap bailout funds has yieldeda positive resolution. However, Germanyand other core-countries maintain that they

will require strict conditionality overdispersed funds. Common sense leads me

to disagree with the view that it ispolitically feasible for Germany to reversecourse and grant unconditional bailoutsdemanded by periphery nations.Inevitably, the high-risk event of a

referendum will occur. Furthermore,French President Franois Hollande hasrecently reversed Sarkozys law by

lowering the retirement age citing socialjustice. This policy goes flatly against theGerman prescription for the crisis. Withincreasing economic pressure in the

periphery fanning nationalistic sentiment,odds are increasing against Hollanderelinquishing the fiscal and financialsovereignty that core-countries mandate. Itis clear that policy discord is fatallyinfecting the political unity desperatelyneeded to combat the crisis. Meanwhile in

Italy, we have the new 5-Star Movementgaining momentum as well as the politicalsituation in Greece. In general, thesemovements are introducing the concept ofodious debt into the daily vernacular.

The Bottom line is that discussions for afiscal union should have taken place during

the go-go years of growth prior to the 2008crisis, not in the middle of a deep region-

wide recession, which has spawned asignificant political crisis.

Finally, while the prospect of anotherLTRO always makes for fresh bullishfodder, it is increasingly clear that prioroperations worsened the state of Europes

banking system by infecting banks withtoxic sovereign paper. Furthermore withdecaying political cooperation, I surmise

that a push for another LTRO may welltransform Europes creeping political crisisbetween core and periphery-countries toan acute state. Nonetheless, it is very

possible, even likely, that officials willagain turn to some sort of monetaryintervention to avoid a catastrophe, likelyresulting in a powerful turn in sentiment, ifonly temporarily.


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In conclusion, while recent news fromEuropes summit was well received,focusing on this event neglects the larger

macro trend of increasing discord withinthe Eurozone, which I believe will worsen,until it is put to a euro-wide referendum.Until then austerity, recession, and astrengthening of nationalism look set tocontinue, depressing sentiment andincreasing an already high likelihood of theself-fulfilling prophecy of disorderlyfragmentation. European officials mustmove quicker. Indeed, while Germany may

be getting flak from government officials

around the globe, it is France who holdsthe key to a positive resolution. If Hollandecan embrace relinquishing Frances fiscaland financial sovereignty, other periphery-countries would likely follow suit. AllGermany has been asking for the entire

time is for periphery-countries, which arein need of bailout funds, to sign on thedotted line to confirm their commitment toa true European fiscal union.

In China its becoming clear that anorderly rebalancing from an export toconsumer-based economy will be verydifficult with continued uncertainty inEurope. This leads me to increase the

probability of a hard landing from 40-70%to 50-80% should the Eurozone fragment;however, I am a little more optimistic for asoft-landing if theres a positive solutionand am slightly lowering my probability ofa hard-landing (sans a negative catalystfrom Europe) from 30-50% to 20-50%.

Interestingly despite the ever-increasingdanger of a negative catalyst in theEurozone and continued sluggishness of

the U.S. consumer, Chinese officials stilluse the term fine-tuning to describe theirmacro adjustments to the economy. Use ofsuch a term implies that officials are not

immediately pondering the introduction asignificant stimulus package. I see this two

ways.

First from a long-term bullish view,officials are finally focusing on improving

the countrys economic structure byfocusing more on consumption, animportant requirement for globaleconomic restructuring. Furthermorehigh prices have made real estate out ofreach for the majority of the countryscitizens. It would be imprudent to initiateanother stimulus package, which could

result in a leg higher for the countrysresilient property market, leading toincreased inequality.

A second, more bearish, way to look at thecurrent scenario can be done using asimple analogy. China is mowing the lawn,sweeping the porch, and wiping the

windows while the house next door isburning down. They should be getting thehoses ready to put out a likely fire in theirown home due to plenty of dangerousembers flying from the blaze. I believeofficials have found fiscal andmacroeconomic religion at the wrong time.Theres an elevated probability that theyare behind the curve with regard to fast-moving events in Europe, a slowing globaleconomy, as well as the countrys ownslowdown in fixed-asset investment, whichcomprises roughly 45% of GDP as of 2010according to the World Bank.

Figure 1 on the following page shows thatexports to the EU and U.S. account forroughly 40% of Chinas total exports.Figure 2 demonstrates that Chinas totalexports comprise roughly 40% of its GDPaccording to the U.S. Bureau of Economic

Analysis and Economist Intelligence Unit.


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Figure 1 Source:www.mint.com

Figure 2 Source:www.futureofUSChinaTrade.com


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Indeed one can see that Chinas exporteconomy is under increasing stress due to adeteriorating global economy by looking at

the recent performance of the Renminbi.

Source:WSJ

If growth for approximately 16% ofChinas GDP is compromised due toslowing growth in Europe and the U.S.;

theres an elevated probability of afinancial exogenous shock stemming from

the EU; and growth in gross fixed-asset

investment, which accounts for 45% ofGDP, is falling; it puzzles me that officialswould continue to use the phase fine-tuning.

Obviously if there was an exogenousfinancial shock in Europe, China would

likely respond with another hefty stimuluspackage. I only hope that any stimulus isprimarily aimed at long-term reform toaccelerate the global restructuring process.

Protectionism

In my prior thesis update, I mentioned howthe clouds of protectionism weregathering and could pose a large negativerisk for global trade in the quarters ahead.I covered how presidential candidate Mitt

Romney had (and continues) to bluntlystate that China is a currency manipulator.He recently stated that embracing a more

aggressive stance towards China was thecenterpiece of his economic policy. I alsocovered how U.S. politicians needed to

practice stern patience, that China wastaking the necessary steps and to give themtime. Taking aggressive protectionist policyactions would be the last thing the globaleconomy needs at this point.

Since then my fears have been somewhatalleviated by Romneys position to move

aggressively and open up more foreignmarkets for US exports. However, seekingconfrontation with a future superpower isnot in the best interests of global long-term

prosperity. China remains significantlyunderdeveloped and the future untappeddemand of its consumers will eventually be

the impetus of global long-term growth inthe decades to come. It is in our bestinterests to have an integral part in this

long-term development.

What has recently caught my attention isthe growing tension in the South ChinaSea, which involves territorial disputes

between China and Malaysia, Thailand,Brunei, and the Philippines. It will be

particularly important for the current U.S.administration as well as the next president

to carefully defuse this potentially negativecatalyst. Obviously any resulting negativeevent may spark a stronger wave of tensionand protectionism at precisely the wrong

time. Ill be keeping an eye out for furtherdevelopments here.


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Middle East

I dont pretend to be an expert on Middle

Eastern affairs; however, events there haveme very concerned. My primaryconclusion is that tensions are increasing,not decreasing. Israel continues to openlydiscuss the military option against Iran.Iran doesnt seem to be backing down,despite an oil embargo initiated by most of

the Western world.

Meanwhile, Syria is at the precipice of acivil war, if not already in one. Tensions

between the country and Turkey are at aboiling point and Russia stands ready toassist the Syrians with military weapons to

the chagrin of the West. Needless to say,any negative surprise from this region

would add another negative dimension toan already jittery global backdrop.

Over the Long-Term (1+ yrs)

I remain a bullish fellow in the long-term.The future of the global economy lies inChina. The country is in the slow processof preparing for period of sustainableexpansion. If we were faced with anegative market environment in the comingquarters, Im sure one could find plenty ofdiamonds in the rough in regard to U.S.manufacturing and transportationcompanies. I continue to believe thatChinas stock market has bottomed and itis currently in the retesting phase.

Since my previous thesis update wildcards,such as the advent of protectionism as wellas conflict rocking the Middle East, haveincreased in probability. It is important toremain alert for any developments along

these fronts.

Finally, continued quantitative easing(QE) from central banks, especially ourFed, could set the stage for a period of

worldwide vulnerability to inflation oncethe global restructuring process is nearcompletion.

U.S. Monetary Policy

While many investors expected QE3 to beunleashed by the Fed sometime during the

beginning of the year, I wasnt betting thehouse on it. In the past 6 months, rising 5and 10-yr breakevens further reduced my

expectations for any sort of QE.Surprisingly though, the Fed extended itsTwist operation until the end of the year,despite breakevens remaining at elevated

levels. Perhaps they felt that plunging gasprices were a green light for moreintervention.

In the short-term, the Fed stands ready toinitiate QE3 should we have a negativeresolution in the Eurozone. Excluding thisnegative scenario, I believe the case formore quantitative easing is strengthening.However, the approaching U.S. elections

will likely complicate matters, as any QEwould be seen as politically motivated.Therefore the outlook for QE, absent anegative surprise from Europe is clouded,

but with a bullish hue. The followingpages contain a compilation of the currentbullish and bearish points for quantitativeeasing.


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(QE Bullish): The current FOMC is dominated by doves, most likely supportingfurther easing measures should economic activity continue to underperform. Circledmembers represent this years FOMC.

Source: ReutersAbsent are Jeremy Stein & Jerome Powell; early indications reflect dovish tendencies

(QE Bullish): Though an inexact science, comparing forecasts of the prior 2 FOMCforecasts for GDP, the unemployment rate, and inflation versus the latest prognosesreleased roughly 2 weeks ago show a decline in inflation and GDP expectations along

with an increase in the unemployment rate. Fed officials see slower growth and fallinginflation, a good recipe for additional monetary accommodation in the months to comeshould economic growth continue to underperform expectations.


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Source: Calculated Risk Blog

(QE Slightly Bullish): Market expectations of inflation, such as 5 and 10-yrbreakevens are mostly neutral. However, falling rates of inflation at the producer leveland sub-50 ISM Manufacturing Surveys Prices Received subcomponent increasinglysupport the case for further easing.

(QE Neutral): The Conference Board shows consumer inflation expectations arefalling (though remain historically elevated), while University of Michigans survey

shows expectations trickling lower.

(QE Neutral): The year over year rate for CPI has been declining, reflecting fallingfood and gas prices. However Core-CPI, arguably longer-term in nature, hasremained elevated just above the Feds year over year target rate, at 2.3% vs. 2.0%.Rising rents, due to a lack of multi-family dwellings, will likely keep Core-CPI sticky

to the upside.

(QE Bearish): While I mentioned that gas prices accounted for a fall in the headlineCPI rate, they are still high by historical standards. Furthermore, the prospect ofconflict in the Middle East is always a bullish factor for oil. I recently categorizedconflict in the region as a bearish wildcard in the global outlook. It would beshortsighted if the FOMC wasnt accounting for this unpredictable factor.

The topic Ive begun to focus on is shouldthe Fed institute its third major QEoperation since 2008 what happens after

that?

By glancing at my prior outlooks, one canconstrue my negative long-term view ofcontinued monetary accommodation. Frommy prior outlook: I remain adamant that

this policy is creating a platform for


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powerful unintended consequences overthe longer-term, should the global economyavoid the long-term risk of protectionism.

These policies only serve to distort capitalmarkets and disrupt the process of activelyallocating capital to produce real economicgrowth. The progressing global economicrestructuring is slowly opening thePandoras box of these policies.

Ive recently seen an interestingdevelopment in this regard. None other

than the Bank for InternationalSettlements, what some refer to as the

Central Bank of central banks has recentlyexpressed its concern for rates remainingso low for so long. With nominal interestrates staying as low as they can go andcentral bank balance sheets continuing toexpand, risks are surely building up.

Furthermore, prominent analysts such asPimcos Mohammed El-Erian, have drawnattention to this growing unease, but with anew wrinkle. From a recent FT Alphavillearticle, Pimcos Mohammed El-Erian was

the most recent high profile name to throwlight on the issue. Commenting on theFeds latest decision to extend OperationTwist last week, El-Erian explicitly stated

that lacking fiscal support, solitary Fedactivism would only alter the functioning ofmarkets, contaminate price discovery anddistort capital allocation. Funny how

yours truly said exactly that half a yearago.

So what does this all mean? First, there is agrowing belief among respected analysts

that QE is causing more harm than good,that ultra-loose monetary policy has notbeen the panacea that many expected whenthe Fed began its first QE program in2008. Moreover, loose monetary

accommodation has resulted in increasedinflationary problems in emerging markets.

But, perhaps the most importantimplication of these concerns is thatwithout fiscal stimulus, which is unlikelyforthcoming over the short-term, and if theFed is forced into a QE3 by the negativecatalyst in the Eurozone, the Feds aura ofinvincibility (i.e. Dont fight the Fed)may be at serious risk.

Notice that in every other instance inwhich the Fed announced some sort of

extraordinary monetary easing (QE, Twist,etc.), U.S. growth was either firmlypositive or there was some sort of fiscalstimulus flowing through the economy,

whether it originate here or abroad. Thistime around, the largest economic bloc inthe world is in recession (likely entering adeep recession), China is finetuningmacroeconomic policy, and the U.S.economy is nearing stall speed with nofiscal stimulus on the horizon.

* For readers familiar with the layout of my prior outlooks,I have moved my U.S. dollar forecast to my marketoutlook.

U.S. Government Policy

Since 2010 Ive identified a theme, which Icall Political Frugality where the specterof overblown government deficits wouldmake it politically difficult to pass any

large-scale stimulus package. Political

deadlock has continued, leading to a lackof leadership from Washington as both

parties jockey for position leading up to thepresidential election in November.Persistent consumer deleveragingcontinues to expose the private sector to anexogenous shock, such as a Eurozone

breakup and/or a Chinese hard landing.


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From a bullish perspective, the economyhas maintained positive momentum in spite

of the fading effects of the 2009 stimulus,which I posed would be a challenge.Surprisingly, a weaker global economyduring the 1st half of the year didnt

profoundly affect economic activity athome, until recently. Furthermore andinline with my expectations, politicaldebate has begun in order to reverseautomatic spending cuts set to begin in2013; in addition, Congress voted to extend

the payroll tax cuts as well as

unemployment benefits. Unfortunately andsurprisingly, the extension ofunemployment benefits included areduction of the number of weeks ofextended aid and effectively made it moredifficult for states to qualify for themaximum aid. Reports have surfaced of the

long-term jobless losing their extendedbenefits.

Looking ahead over the short to medium-term, I sense that sentiment towardsausterity is likely to weaken shouldeconomic activity continued to deteriorate.Unfortunately due to the oncomingNovember elections it is unlikely that fiscalstimulus will be forthcoming unlesscatastrophe hits Europe, causing arecession at home. As I stated in my priorupdate, My fear lies in the need fordecisive action from government officials tostep in with fiscal stimulus in case of adownside surprise from Europe or China.

While many (including myself) may call itfiscal profligacy, the likely extension(partial at least) of the Bush tax cuts as

well as the delay of automatic spendingcuts should be seen as a short to medium-

term positive. The economy, as vulnerableas it is and with significant uncertainty in

Europe cannot afford to take a 0.40% hit toyearly GDP as shown in the followinggraph.

Source: ZeroHedge: Goldman Sachs

The fact that government officials arenegotiating to avoid at least partial fiscalcontraction in 2013 tells me that theyunderstand that the private sector remainsfragile. Continued historically loose fiscal

policy would act to offset weak spendinggrowth as deleveraging continues. Ill befocused on news of continued progress on

this front. Note however that a financialexogenous shock from the Eurozone wouldoverwhelm the positive effects of current

loose fiscal policy.

Before you cringe at the notion that Ibelieve that loose fiscal policy is good forthe economy, I want to clarify that kickingthe can down the road is undoubtedly anegative long-term prescription. However,I believe that finding fiscal religion now is

unadvisable. Finding it in the midst of astrong recovery and in turn paring backspending, countercyclical fiscal policiesas Keynes supported, is how fiscal policyshould be handled.

Looking over the longer-term, I believethat government officials will eventually


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address the structural causes of thisprolonged period of economic fragility. Wemay get a giant jobs-based stimulus,

including a government sponsorednationwide university system to retooldisplaced workers as well as largeinvestments in the nations infrastructure,alternative energy, and exports.Unfortunately, well likely need a crisis toget lawmakers to unite as they did in 2008

to pass a program of this magnitude.

Protectionism

Beginning 2012, I identified a potentialnegative trend of the growing tide againstcontinued globalization. Indeed, the WorldEconomic Forum has also expressed thisconcern. The weak foundation of ourglobal economy has resulted in a period ofuneven and uncertain growth as well asgrowing inequality. As a consequence,

trade frictions have increased as politiciansremain under pressure to create jobs athome. I see the rise of protectionism as asymptom of an idiosyncratic problem withglobal trade not covered by typicaleconomic analysis.

To begin, protectionist policies impede theflow of capital, reducing economic profitand subsequent residual funds forcontinued investment. It is wellunderstood that global trade increases totaleconomic production and wealth, as capitalis allowed to flow freely to the highest

wealth creating activities.

Unfortunately with highly unequal wagegaps between countries, private capitalflow and investment has been decidedlyone sided. Investment in China hasincreased significantly, while the U.S.remains struggling to produce strong jobgrowth. Ideally, it would be more prudent

to set up a system of RegionalGlobalization. In this system, the majorityof trade would occur freely but within

countries with similar cost/wage structures.The resources of a country woulddetermine what output could be producedat a competitive advantage.

Regrettably, our highly globalizedmarketplace is currently working toachieve equilibrium between low-wageemerging markets (experiencing wagegrowth) and high-wage developedcountries (with stagnant wages). However

it is pivotal to understand that China istaking matters more seriously. Theyunderstand that an export-centric modelisnt sustainable. Indeed one need only

look at Chinas most recent 5-Year Plan:Some important initiatives of theeconomic rebalancing theme in the 12thFYP include a notional GDP growth rate

target of 7 percent, promoting consumptionover investments and exports, closing theincome gap through minimum wage hikesand increased social safety nets, and arange of energy efficiency targets. It is

very important that U.S. officials continueto practice stern patience so that Chinamay devote more resources to changecourse, instead of worrying about a

pending trade war, which would sink theireconomy.

This has been the source of my concern asRomney has made strong statements aboutactions he will take against China ifelected. While it is prudent to act sternly so

that they feel obligated to move quicker intheir efforts, acting in a threateningmanner would clearly becounterproductive.


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As I expected, when looking at the Intrade charts below, tracking the probability of recession

and Obamas chances of reelection, one can clearly see that Obamas fate is tied to theeconomy.

If ones higher probability scenario calls further economic turbulence, like mine, it would be

prudent to begin wondering what life would be like under a Romney presidency in regard toglobal trade. Similar to souring business sentiment in Europe for a market friendly solutionand consumer sentiment during the U.S. fiscal standoff in 2011, sentiment regardinguncertainty in global trade could result in stalled expansion plans and consequently lowereconomic growth worldwide.

On the bright side Romney has somewhat alleviated my fears by committing himself towardsaggressively opening up other export markets. But as I said before, cooperation with aneventual superpower, if not militarily, then consumer demand-wise, is important to eventuallyseek the long-term benefits of a new world economy.

Thats why Ill be carefully covering events transpiring in the South China Sea. If issues thereare not handled in a responsible and fair manner, they may further increase the risk of

protectionism.


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Confidence

Confidence has become one of the more

important factors to watch. I began to seeconsumer confidence indicators as a truemeasure of actual improvement on MainStreet. Since 2009, markets havesignificantly recovered on an improvingglobal outlook; however, consumerconfidence has remained lackluster.

Inline with my expectations, confidenceimproved as the job market strengthened.Conversely, confidence has begun to

decline as the specter of a Eurozonebreakup fills the newswires.

Confidence is an integral ingredient for a

budding economic positive feedback loop.Continued uncertainty is breaking thecurrent fragile one and the prospect of aself-fulfilling prophecy of global recessionis becoming dangerously real. Its alsoimportant to see if unresolved issuesregarding the oncoming Fiscal Cliff begin

to act as a headwind as well.

On the bright side, plunging gas prices anda stabilizing real estate market are positive

and strengthening points. However, thewave of uncertainty due to theaforementioned bearish factors currentlydominates the landscape.

Inflation

As in my prior outlook, I remain convinced that there are notable harmful risks in theEurozone and China over the short to medium-term. Negative developments here would

trigger a surprise global deflationary episode, similar to the one in 2008. I still worry aboutdeflation instead of inflation.

However, I did not account for our current disinflationary environment (see the 2 nd scenariobelow), which represents continued optimism towards a market friendly solution in Europeand/or a possible soft-landing in China (manufacturing data is not showing a sector falling outof bed). Below are my updated scenarios:

1. Deflation: Eurozone Fragmentation / China Hard landing (Avg. Probability = 50-75%): Aglobal recession would likely occur. Deflation would make a vicious comeback. Along

with falling global growth, another U.S. recession could result in a wave ofrestructured and/or eliminated debt. This scenario could also result in the dreadedJapanese mindset of deflationary anticipation. Consequently falling consumer demand

would sap job creation. Fed would continue QE; however, the key to recovery fromthis scenario would be fiscal stimulus.

2. Disinflation: Eurozone Fragmentation/China Soft landing or Eurozone Fiscal Compact/ChinaHard landing (Ongoing --- Avg. Probability of end result = 25-50%): A disinflationaryenvironment would ensue if one of the two major global risks had a negativeresolution. An uneven global recovery would negatively affect commodities and achronically weak U.S. consumer would translate to a stronger bargaining power of

buyers versus suppliers. However, this scenario would serve as a significant step


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forward in the global restructuring process as well as eliminate growth-sapping debt,possibly resulting in a solid cyclical bull opportunity in medium to long-term.

3. Uncomfortable Inflation: Eurozone Fiscal Compact/China Soft landing (Probability = 5-10%):The U.S. economy would stabilize then resume its recovery. Commodity prices wouldincrease, fueled by a rebound in global growth. Additionally, wage equalization

between China and the U.S. would carry on. Higher wages in China would see morecompanies moving operations back to the U.S. (Manufacturing Renaissance) orsmaller emerging markets to cut down on costs. For years, U.S. businesses have been

trimming fat. To increase production, long-term capital projects would need to takeplace. Improving economic activity in benefiting nations would lead to bottlenecks inmanufacturing sectors. Itll be important to keep an eye on capacity utilization (80mark = budding inflationary pressure).

Due to the Feds myopic policies (QE, Twist, etc), these secular trends would result ina period of persistently high inflation, likely harming economic growth as well as themiddle class and retiring baby-boomers with fixed incomes. This sequence of events

would also be a developing secular bearish headwind for the U.S. Treasury market

(Top?). The Fed would eventually be forced to raise interest rates, thus semi-cappingthe recoverys potential. An example of this environment occurred in 2011 (absentFed rate increases). Higher commodity prices led to increasing inflation and interestrates during the first half of 2011; however, the weak U.S. consumer was unable toshoulder these higher costs and by mid-year the recovery was in jeopardy. Ieventually see this scenario occurring over the long-term, absent a bearish catalystarresting global trade. That is why the Fed must stop extraordinary loosing now.


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Industrial Production

Over the past 6 months, the manufacturing sector has led the U.S. economic recovery and has

outperformed my expectations of a muddle through scenario. However, downside risks that Icovered in my prior update are beginning to affect business confidence. Declining confidenceis currently poisoning prospects of a continuing recovery and must be immediately reversed.

Indeed the sector is in critical danger of contracting the latest reading of the ISMmanufacturing gauge signaled its first contraction reading in almost 3 years. I had been waryof expectations for continued strong growth given persistent weakness in backlogs coupled

with continued uncertainty with global growth. Monitoring the latter is of upmost importancewhen figuring the sectors short to medium-term trajectory.

Despite my increasing bearishness over the short to medium term, I remain bullish over thesectors long-term prospects, once again assuming the bullish scenario of relatively little

protectionism. Future sustainable consumer-led growth from China and other emergingmarkets would fuel a manufacturing renaissance in the U.S. While I dont believe thisscenario is knocking at our door, its progressively getting closer. On the other hand, if

protectionist policies were further embraced by political leaders, the outlook for

manufacturing would be clouded but with upside potential (fracking, shale gas, coal, etc.).The sector would become a significant job creator; however, from an investment view,margins would be continually under pressure due to eventual inflation (see capacity utilizationfigure on prior page)


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Consumption / Borrowing

The consumer has trudged forward, exhibiting the demeanor of a salmon headed back to its

birthplace far upstream. Over the past 6 months, the economy has been in a fragile positivefeedback loop with just enough consumer-demand improving business confidence, thusleading to job creation.However, the near-term risk posed by slowing global growth is depressing confidence andstimulating what until now has been a controlled paradox of thrift (deleveraging). I amcautiously bearish. Consumption growth is suffering significant damage; the national savingsrate is at a 4-month high, possibly beginning a sustained uptrend. While gas prices have beendeclining markedly in the past month, uncertainty in the direction of the global economy is

beginning to dominate consumer sentiment (beware of increasing uncertainty in regard toupcoming fiscal cliff). Indeed, declining purchases of durable goods, such as automobiles, is

a shot across the bow that further ambiguity in Europe is starting to rock the boat. A solutionmust be found soon to arrest declining confidence.

As in my prior thesis update I still remainconcerned of conditions in the MiddleEast. A negative surprise from this regioncould cause a spike in oil prices as well as

add a new dimension of uncertainty to analready tense geopolitical stage.

Medium to long-term, consumption growthis likely to remain weak as the consumer


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deleveraging process continues and wagegrowth remains stagnant. From a bullishstandpoint, we have come a long way in the

process and are likely past its midpoint.Ironically though, Fed-induced lowerinterest rates are prolonging the malaise bydenying retirees higher and safer returns,

leading them to save more present income.Two giant bubbles have decimatedretirement plans over the past decade(again due to the Fed). Baby-boomers

paid a dear price if they took excessivesavings risk by tapping the home ATMmachine and spending far beyond their

means. Then, with the onset of theproperty bust, they became exposed toelevated financial market risk, as drops in

portfolio values has now obligated victimsto alter their expected retirement lifestyleand/ or delay retirement.

Eventually once the consumer recovers,he/she could be faced with persistentlyhigh commodity prices as well asincreasing interest rates (see scenario 3 inmy Inflation outlook).

In case of a negative surprise in theEurozone or China, we may see the

passage of more fiscal stimulus in themedium-term (6 months out to roughly 1

year) as government officials act to stemthe damage of a second recession. Simplyextending Bush-tax cuts or delayingautomatic spending cuts wouldnt beenough. However, should a fiscal stimulus

package be passed, along with likelycontinued loose monetary policy, the

prospect of a mirror image of 2009 couldgain credibility.

Jobs

The labor market continues its slow butvulnerable recovery, as the fragile positive

feedback loop persists. Indeed, I amimpressed at its resiliency. However, due

to increased uncertainty with regard to the

Eurozone and China, businesses arebeginning to pull in their horns. I amcautiously bearish on the expectation forfurther job creation as long as confidence isnot restored. Europe must find a solution.Referring to an analogy that I used in my2011 outlook to explain the labor market:the pre-born baby must be put back into

the incubator soon. Should Europeconvince investors that its latestannouncement is a solid step in the right

direction, then confidence would returnand the labor market would recover.

Longer-term, the feasibility of any self-sustaining economic recovery depends on ahealthy job market. Substantial andconsistent job creation would be a

precursor of rising real wages andsolidifying consumption growth. However,

we remain in a chickenoregg scenario.Before, the use of credit served as a spark-

plug for consumption growth, leading tojob creation, and ultimately creating astrong to positive feedback loop. Thisdynamic has been damaged, but is healing.

The recovery from the 2001 recession wasbuilt on a faulty foundation (no punintended). Rising home values and careless

lending standards increased the supply ofcredit (home ATM), producing artificialdemand. Once the housing bubble popped,credit dried up and construction activitycollapsed; we had a semi-permanentreduction in demand growth. As a result,structural unemployment became a starkcharacteristic of the 2007-2009 recession.

This characteristic is set to linger as apersistent headwind until consumerdeleveraging as well as global economic


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restructuring (China = consumer economy)both enter their end phase, reducing long-term uncertainty. It may also end if theres

significant progress on emergingtechnologies, such as fracking, anexpansion in the shale gas industry, or a

jobs-based stimulus package fromCongress. If I had a kid, Id be guidinghim/her towards learning science orengineering.

Service Sector

The service sector accounts for 80 to 90%

of the US economy. Its performancetracked by the ISMs Non-Manufacturingindex has surpassed my expectations. Inmy prior thesis update I covered howslowing backlogs as well as new orders had

turned me cautious on the sector. While Istill believed that the sectors growth wassustainable, absent an exogenous shock, itsstrong run in the early months of 2012 (6-

month average = 55.46) was a pleasantsurprise.

However, my cautiousness remains. WhileI still believe that growth in the sector isself-sustaining, creeping uncertainty

towards the global outlook risks criticallydamaging its short to medium-term growth

prospects. Theres a high likelihood that anegative event from Europe or China

would tip this important sector of theeconomy back into contraction.

Medium to long-term, lack of substantial

enddemand growth keep hiring activity ata low level, proliferating tepid enddemandgrowth; all in all, this sector will be hard

pressed to find any strong impetus for solidgrowth. On the bullish end, thedeleveraging process has likely passed itsmidpoint; which combined with astructurally improved global economy, will

lead to sustainable growth over the long-term.

Housing

Nationally, home prices have double-dipped. However, this latest decline has been lessforceful than the initial drop beginning in 2006 and as varied greatly in intensity betweencities. As I stated in my prior outlook, a recovery in home prices will increasingly depend on

local conditions. Markets, such as Miami, have recovered much quicker due to theiruniqueness. For example, Miami has lots of ocean front property and is considered thegateway to Latin America. Real estate activity has largely consisted of Latin Americaninvestors.

On the bright side, construction activity has clearly bottomed. High demand for rentalproperties is spurring investment in multifamily real estate. This will act as a steady tailwindfor job creation.

Looking at the bigger picture, we are still faced with a large supply of homes (shadowinventory). Despite increased optimism due to recent good news in regard to home sales,

which I correctly forecast, I am less sanguine than many housing bulls who proclaim that thesector has turned the corner and is on the verge of a comeback. Yes, I agree that the sector is

turning a corner, however, the recovery will consistently underwhelm due to a myriad of


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reasons. For starters, demand has clearly stabilized, but remains tepid when analyzing yearover year rates in the Mortgage Bankers Associations purchase index.

Second, heres a chart that puts into perspective the amount of inventory sitting on thesidelines. It will likely take a couple of years at least to absorb most of it.

Source: CoreLogic


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Third, lets not forget that the U.S. economy is in danger of falling back into another recessionif Europe cannot put its house in order or if Chinas economic growth surprises to thedownside. Another recession would lead to higher defaults, foreclosures, and consequently a

strengthening downward trend in prices.

Fourth, over the longer-term, price appreciation may face the strengthening trend of higherinterest rates, making homeownership less affordable (see scenario 3 in my inflation outlook).

Dont get me wrong, Im all for a housing recovery. However, recent optimism for sustainableprice increases over the coming year seems misplaced. Housing will continue to recover;however, progress will be glacial. From a sentiment standpoint, I remain unconvinced that

prices have hit a secular low. The asset class isnt universally hated yet, except Detroit; Id bebuying up blocks there now in anticipation of a manufacturing renaissance in the years tocome.

(Next Thesis Update: Early January 2013)

Thesis as of Mid 2012

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