July 2010 Economic Update

As long-time readers know, in our assessments of economic conditions and their implications for strategic asset allocation and risk management, we use a methodology called "Analysis of Competing Hypotheses", or ACH. The essence of this approach is to identify alternative future economic scenarios, and then seek high value evidence that disconfirms them. We believe that this approach should produce superior insights, as it directly addresses the "confirmation bias" that affects human thinking, and too often blinds us to important changes underway in our environment. More specifically, the confirmation bias is our tendency to seek, notice, and give greater weight to evidence that confirms our existing views and mental models.

Our two current scenarios are based on traditional behavior patterns for complex social systems operating in far from equilibrium conditions. The first is enhanced cooperation and the second is higher levels of conflict. Realization of the cooperative scenario should result in a higher level of stability and predictability in the system's operations, while development of the conflict scenario will prolong and quite possibly worsen the system's instability. More detail about our two current scenarios is provided in the following table:

	Cooperative Scenario	Conflict Scenario
Brief Scenario Description:	More rapid domestic consumption growth in China and cleantech investment demand in North America return the world to a healthy rate of growth, and enable preservation of the world trading system, a reduction in global imbalances, and monetary actions to head off an extended period of high inflation.	Domestic politics prevents an increase in cleantech investment in the United States, and China continues to pursue export led growth while encouraging rising nationalism to limit domestic unrest and the political threat to the current Chinese leadership. This only reinforces growing demands for protection in Europe and the United States.  Weak global demand is maintained by rising fiscal deficits, which are increasingly monetized, leading to much higher inflation.
Key Agent Level Scenario Assumptions
U.S. Middle Class	Resolution of banking crisis, passage of health care reforms, mortgage relief, and a sharp increase in cleantech driven investment spending lead to reduced uncertainty and a shift towards higher savings and lower consumption, without triggering populist demands for protectionism.	Continued economic stagnation, uncertainty, and insecurity lead to more extreme partisanship and the development of strong populist calls for protectionism and income redistribution.
Chinese Peasants	Land reform and economic growth (which provides jobs) boost incomes while a sharp increase in government spending on health care and education limits resentment of Communist Party corruption and economic inequality compared to coastal elites. This minimizes social unrest and threats to continued legitimacy of the Party's governance of China.	Growing unemployment and a sense that government stimulus is disproportionately benefiting coastal and party elites triggers widespread unrest and peasant alignment with disaffected students, urban unemployed, and members of the military. The Chinese government becomes aggressively nationalist in an attempt to channel this anger outward. At best, this triggers a global retreat into trading blocs; at worst, this strategy fails and China descends into fragmented authoritarian regions with minimal central control.
Iranian Youth	Prolonged economic stagnation and rising inflation lead to the removal of President Ahmadinejad and widespread pressure for better relations with the West. Economic self-interest trumps the Revolutionary Guards' ideological opposition to this opening. Moderation of Iran's conflicts with the west and a renewal of inward investment flows lead to increased hydrocarbon production, limiting upward pressure on global energy prices.	Supreme Leader Khamenei ensures that Ahmadinejad remains in power. Repression and emigration are used to limit resistance by younger Iranians to these policies. The country attempts to improve economic conditions via closer ties with China, while maintaining its nuclear program (which could trigger an attack by Israel) and a conflict-oriented policy versus the US that continues to put upward pressure on energy prices.
Key Issue Level Scenario Assumptions:
Overleveraged Consumers	Effective mortgage relief plans implemented in most affected countries, while stronger economic growth maintains income needed for debt repayment.	No effective mortgage relief legislation passed. Instead, rise in bankruptcies and mortgage foreclosures puts continuing downward pressure on housing prices.
Financial System Weakness	Combination of stronger investment and export led economic growth and effective bank rescue plans reduces uncertainty about health of system, and enables sufficient flow of credit to support renewed economic growth.	Worsening economic conditions and failure of bank rescue plans (due to design or political resistance) cause uncertainty to remain high, credit flows to be constrained, and defaults to increase, which all contribute to a worsening process of debt deflation.
International Imbalances	Rising domestic consumption spending in China enables a reduction in export dependence, while U.S. imports are reduced by a shift from private consumption to private saving and higher investment spending and greater exports. This reduces global current account imbalances to a manageable level.	China's continued emphasis on export led growth, at a time when the US is incurring high fiscal deficits (and eventually higher taxes) to maintain global demand, triggers demands for greater protection, which in turn precipitate a dollar exchange rate crisis as other countries move to limit the losses on their foreign exchange reserves. Result is a fragmentation of the global trade and financial system into much less integrated blocs.

At some point, the accumulated evidence against one of our scenarios becomes so compelling that it triggers the development of two new scenarios that we hope capture a significant portion of the range of possible future outcomes for the economy and financial markets. Over the past six months, we have been going through this experience once again, as it became clear to us that global conditions has changed in important ways since our two current scenarios were developed. Here is how we see the situation today:

Key Factors

The leverage problem. The global debt problem now goes beyond the struggles of Anglozone households, the health of the world's largest banks, and the functioning of the fixed income securities and credit derivatives markets. Today it also includes the credit fueled property and infrastructure boom in China (and health of its visible and shadow banking systems), a range of corporate sector issues (e.g., solvency and rollover risk at large leveraged buyouts and some commercial properties, and increasing default risk at small and medium sized companies in the face of weak global demand), and rising concern with government credit risk around the world (e.g., the Eurozone, Japan, U.S. municipals, and even U.S. Treasuries). We have noted in the past that there are basically three ways to solve an excessive debt/income problem: (a) Growth - i.e., an increase in income; (b) Austerity -- i.e., consume a smaller share of income, and devote more cashflow to debt reduction; and/or (c) Default -- i.e., reduce the face value of debt, via exchange offers, debt-to-equity conversion, and/or bankruptcy (for more on the leverage problem, see The Economist's excellent special section on "Is There Life After Debt?" in its 24June2010 issue).

The demand problem. For the last ten years, we have used what we call the Economic Balance Equation to understand and assess aggregate demand conditions. This equation is based on the decomposition of aggregate demand that is taught in a first year macroeconomics class: Aggregate Demand [Y] equals the sum of Private Consumption [C] plus Private Investment [I] plus Government Consumption and Investment [G] plus product and service Exports [X] less Imports [M]. In this framework, Savings equals Aggregate Output [Y] less the portion of it that is consumed [C]. Extending the framework further, the sum of the Private Sector Balance [Savings Less Investment] plus the Public Sector Balance [Taxes less Government Consumption and Investment] always equals the External Balance [X minus M]. Dynamically, any change in one of these balances must be offset by a change in one or both of the others. For example, in many countries the global economic crisis has caused the private sector balance sharply increase (as households and companies spent less and saved more). By definition, there were only two ways to offset this: a decrease in the public sector balance (i.e., rising government deficits) and/or an improvement in the external balance (i.e., a reduction in the deficit or increase in the surplus, depending on the starting point). However, a change in the external balance of one country implies that one or more countries is willing and able to make equal and opposite changes in their own external, private and public sector balances (e.g., willing to accept a larger external deficit and larger private sector deficit). If this is not the case, then the external adjustment route will be closed off, and increased public sector deficits must bear the full burden of adjustment.

Finally, any Public, Private, or External Imbalance (essentially, a net positive or negative cash flow over a given period of time) also represents a change in financial either issued (in the case of a negative balance) or purchased (in the case of a positive balance). These stocks of claims accumulate over time, and, when they reach a critical threshold (e.g., our Debt/Income ratio) impose a constraint on the size of the negative balance that can be run by the Private, Public, and/or External Sector. This is the key feedback loop to the leverage problem. For example, the ability of the U.S. household sector to run a negative balance is hindered by its already high debt/income ratio, and by the fact that weak aggregate demand conditions have made the future path of the "income" term of this ratio -- i.e., private sector income growth -- much more uncertain. In the public sector, Greece provides an example of how a country's ability to stimulate the economy through government deficit spending becomes sharply limited once a critical debt/income threshold has been exceeded. Finally, the emerging markets debt crises of the 1980s usually reflected a "sudden stop" to countries' ability to run external deficits once their external debt/export income ratio passed a tipping point. Similarly, in the years preceding the current global crisis, questions were repeatedly raised about other nations' continued willingness to accumulate U.S. dollar debt to finance U.S. external deficits whose size was unprecedented as a percentage of GDP.

The following table shows Deutsche Bank's projection for how different balances will evolve between 2009 and 2011. To better understand the aggregate demand problem, we have converted the change in these balances between 2009 and 2011 from a percentage of national GDP to a percentage of global GDP (using the most recent IMF estimates of 2010 purchasing power GDP). (See pdf version)

This table highlights a number of key points about aggregate demand in 2009. First, it was heavily dependent upon deficit spending by governments, as evidenced by the negative public sector balances. Second, it also highlights the dependence of aggregate demand in China on the willingness of other countries, particularly the United States, to run government deficits (the U.S. ran an external deficit that largely offset China's external surplus). The next two tables describe Deutsche Bank's projection for how key balances will look in 2011, and the changes they will represent from 2009. Essentially, these tables paint one version of what the cooperative scenario could look like if it came to pass: (see pdf version)

In this table, negative changes on the private and public balances contribute to demand, as do positive changes on the external balance. As you can see, the key elements in the cooperative scenario include (1) an expansion of private sector demand in the United States and the rest of the Anglosphere (based on some combination of a recovery in household sector consumption and/or an increase in business investment spending); (2) a reduction in the U.S. public sector deficit; (3) a significant increase in private sector demand in China (logically via higher household consumption, as private sector investment spending is already extremely high); (4) a reduction in the size of China's external surplus; and (5) an increase in the rest of the world’s external deficit.  The end result of these changes is shown in the next table: (see pdf version) 

The obvious issue is what happens if all these changes don't happen as expected. Suppose business investment doesn't increase in the United States? Suppose household spending doesn't increase in China? And suppose the Rest of the World doesn't accept a large change in their External Balance? What will support global aggregate demand in this case? Can governments increase their deficits by a sufficient amount given their already high current debt levels, and, in some cases (e.g., the U.S.) growing political resistance to deficit spending on a level that is unprecedented in peacetime? As you can see, it is very easy to envision a scenario in which global aggregate demand declines -- the double dip recession that has been the subject of so much commentary over the past month. This brings us to the next critical issue.

The deflation/inflation problem. When households and businesses can no longer pay their debts, the collateral supporting those loans is usually seized and sold by lenders to limit their losses. When lots of loans go bad all at once, the resulting collateral sales place severe downward pressure on asset values, as we can see in the U.S. housing market today. Realization of loan losses also depletes banks' capital, causing them to be less able to make loans. At the same time, households and businesses become more reluctant to borrow and spend, as the outlook for demand, employment and income all become more negative. This often causes businesses to cut their prices in an attempt to generate sales and at least cover their variable operating costs and avoid bankruptcy. Eventually, falling asset values and prices for goods and services show up in government price indexes, and the existence of deflation becomes official. Once this happens, a profound psychological change can take place, as evidenced by the deflationary trap that Japan has been in for much of the past twenty years. As most debt contracts are not indexed to price level changes, debt service burdens can become heavier if wages and employment are cut, and income decline. Spending may also sharply decline, as households and businesses attempt to make up for declining incomes by postponing expenditures while prices decline and goods and services become steadily cheaper. In the context of the Economic Balance Equation, the result is a sharp rise in the private sector balance, which must be offset by either higher government deficit spending and/or an improvement of the external balance, via higher exports and lower imports. However, in a globalized world where economies are highly interconnected, there may not be other countries willing to accept offsetting changes to their external balance. This places the whole onus of breaking out of the deflation trap on domestic fiscal and monetary policy. At some point, private domestic and foreign investors may either cease or sharply curtail their purchases of government debt. This forces the government to print money to finance its deficits, which should eventually result in both higher inflation and a government debt crisis of some type -- e.g., default and restructuring that occurs formally via negotiation or informally via prolonged inflation that reduces the real value of government debt held by private investors that is not indexed to inflation. Indeed, this is a pattern that has repeated throughout history, as Reinhart and Rogoff have shown in their outstanding book, This Time Is Different: Eight Centuries of Financial Folly. At some point, the combination of the leverage, demand, and inflation/deflation problems can trigger another issue:

The legitimacy problem. We view this issue at two different levels. The first is the belief by a given nation's citizens or subjects in the legitimacy of the global economic system -- e.g., the current arrangements for the flow of goods and services, capital, labor and information across the borders of nation states. Our basic rule is that systems that lack adequate institutional mechanisms for balancing the interests of different parties, and especially winners and losers under the current arrangements, will eventually be regarded as illegitimate and forced to either put those institutions in place or retrench to a less integrated manner of operating. The second legitimacy issue concerns citizens' or subjects' view of the legitimacy of the institutional arrangements within their own nation. Throughout history, domestic legitimacy crises have been associated with populist political movements, major institutional changes, and in extreme cased, with varying degrees of civil unrest and violent regime change. In the United States, the middle class is the center of gravity for the legitimacy problem, which reflects not only the most recent crisis, but also the accumulated tensions created by many trends that preceded it (e.g., the widening income gaps between top earners and everyone else, the gap between public and private sector workers, the widening gap between the Wall Street-Washington elite and the rest of the nation, etc.).

In China, the situation is more complex. In addition to the rural peasantry, the evolving situation has also increased the importance of the views of urban workers (who are becoming more restive in their desire for a better standard of living), affluent middle class (who would be most damaged by the collapse of the current credit and property market bubble, and whose conspicuous consumption may rile urban workers) and the military (whose interests would be threatened by increasingly chaotic domestic conditions in China). Finally, the views of the German middle class are critical to the continued legitimacy of the Eurozone.

In addition to these four key problems, we also continue to believe that three "wildcards" could also dramatically affect whether the cooperative or conflict scenario develops in the future. The first is the evolution of future events in Iran. The second is the continuing evolution of the influenza virus, and whether H1N1 and/or H5N1 become capable of causing a large number of deaths around the world. The third wildcard is whether we have, as some assert, reached the peak of global oil supply. If this is the case, and if cost-competitive substitutes are not quickly commercialized (e.g., bio transportation fuels from algae or bacteria), any increase in the rate of global demand growth could be quickly choked off by a sharp rise in petroleum prices.

Where We Are and Where We're Headed

The four critical problems we have identified -- leverage, demand, deflation and legitimacy -- are not independent. In fact, a complex series of feedback loops flows between them, which suggests that future events will emerge in a manner that is both non-linear and hard to predict. That said, it is easy to find evidence that the cooperative scenario is not developing.

First and foremost, there are few signs of accelerating domestic demand growth in the three nations that have run the largest current account surpluses: China, Japan and Germany. The absence of increased domestic demand in these countries implies a continuation of relatively high (as a percentage of GDP) external deficits by the United States, undermining the benefits to the public sector balance that would otherwise be generated by any reduction in the size of the U.S. private sector surplus (i.e., by more business investment spending). GE CEO Jeff Immelt's recent observation about the growing difficulties faced by western firms doing business in China -- "I am not sure that in the end they want any of us to win, or any of us to be successful" -- cuts to what we see as the heart of the matter. China has a long horizon memory, and plays a long horizon game. Regarding the former, when Western nations held a strong advantage over China a century ago, they pressed it. We should not be surprised to be on the receiving end of such treatment when the shoe is on the other foot. Nor should we be surprised that China does not appear to be in any great rush to bail out the world economy, and nations, particularly the United States, that it sees as threats to its ascendant power. Their actions are quite consistent with the famous precepts of the great Chinese strategist Sun Tzu: win without fighting, and strike where the enemy is most vulnerable. In so far as China takes any actions to increase global demand, we believe it is and will be due to domestic political considerations -- the need to maintain the economic growth and social order that are critical to the popular legitimacy, power, and survival of the Chinese Communist Party (particularly in the lead up to the 2012 leadership transition).

To be sure, China is facing a range of difficult domestic issues, including a credit and property bubble, the collapsing demand for its exports (e.g., due to the sharp Eurozone economic slowdown) and the unpredictable consequences of its one-child policy (e.g., increasing nationalism in a nation where young males outnumber young females, rising labor unrest and demands for higher wages, and the challenge of paying for a rapidly ageing population -- the famous four grandparents, two parents, and one child dilemma). And it is not clear whether the West has more to fear from a China that continues on its current path, or a China that is beset by rising domestic crises and nationalist anger at foreigners for causing them. But for our purposes, neither outcome appears to be consistent with the development of our cooperative scenario. Moreover, we have seen precious little evidence of Western governments aggressively tackling the structural impediments to higher domestic economic growth rates (e.g., education reform, improved infrastructure, better control of spiraling health care costs, etc). Instead, we repeatedly see well-organized special interest groups (from environmentalists to the coal industry to teachers unions, etc.) blocking these initiatives. While Mancur Olson years ago predicted just this outcome (in his book, The Rise and Decline of Nations), we take no pleasure in his foresight, for it almost certainly implies more suffering and conflict than needs to be the case.

If the demand problem cannot be solved, then higher economic growth will not alleviate the leverage problem. In the United States, we do not believe that prolonged austerity is a viable alternative. Let's start with government deficits. The current political deadlock in many states over how to get their budget deficits under control provides an indication of just how hard it will be to implement prolonged austerity at the federal level (see "Public Rejects Variety of Options for Fixing State Budgets" published by Pew Research on 28June2010). At the household level, we believe that a number of factors work against the ability to sustain prolonged austerity. First, we have seen few signs of a resurgence in religion in the United States. In our view, prolonged austerity can only work when the people asked to experience it can place it in a larger moral framework -- i.e., a classic creation-fall-redemption story that characterizes most major world religions. Second, we have not seen secular belief systems, like the environmental movement, gaining enough traction to offset the decline in traditional religion. Given this lack of moral context for rejecting conspicuous consumption -- and feeling good about doing so -- and the continued widening of income differences in the United States (which stimulates "keep up with the Joneses" consumption desires), we conclude that prolonged austerity is unlikely to be a viable path for the nation to follow. That makes some type of default -- formally via restructuring and bankruptcy, and/or informally via a period of prolonged high inflation -- as end result of the path we are on.

Granted, this will not happen right away. Time and again, we have been surprised at the ability of complex adaptive systems, even under great pressure, to resist tipping over into the region of chaotic operations. But unless something fundamental changes, we believe this is where we will eventually end up. In the future, we expect to see accelerating strategic mortgage defaults, bankruptcy filings, and credit system crises around the world. Indeed, this is already happening. For example, the Wall Street Journal recently noted that all the reduction in U.S. household debt/income ratio that has occurred since the first quarter of 2008 has been due to defaults, and not higher savings -- i.e., more austerity ("Number of the Week: Default, Not Thrift, Pares U.S. Debt", 12June2010). Another recent report found that "nearly one in five mortgage defaults are strategic" (see the article with this title in the 28June2010 Wall Street Journal). The good news is that, as has been the case throughout history, extinguishing debt will lay the groundwork for renewed growth. The bad news is that we will have to experience a lot of pain to get to this point.

Unfortunately, the sequence of events described above also seems consistent with a growing threat of deflation and a Japan-style extended period of economic stagnation that should eventually culminate in the aggressive monetization of government debt, and a sharp increase in inflation that will only be reduced when the excessive leverage problem has been resolved. While Ben Bernanke, when he was a professor, was one of the world's leading experts on deflation, the fact remains that we have far less policy experience with successfully avoiding and reversing deflation than we do with avoiding and reversing deflation. Unfortunately, it looks like we are going to close that experience gap.

In our minds, the greatest uncertainty surrounds the question of how these economic developments will affect legitimacy, and the unpredictable results that could follow. The forecast in which we have the greatest confidence is that, as has repeatedly happened throughout history, the current highly open and integrated global economic system will not survive the crises that lie ahead. We remain convinced that we will see a return to a "bloc-based" system, organized around three competing centers of gravity: the Anglosphere, Continental Europe, and the Sinosphere. Interestingly, we believe that the UK in particular would strongly benefit from this development, as it would reduce uncertainties about how it will address its leverage problem. We also strongly suspect that India and Japan will choose to align themselves with the Anglosphere in this system. For example, a recently published study by the Pew Global Attitudes Project compared different nations' views of China. In the United States, 36% had an unfavorable view of China, while 49% had a favorable view. In India, this ratio was 52% unfavorable, 34% favorable; in Japan it was 69% unfavorable, 26% favorable. Similarly, people in different countries were asked if they viewed China as a partner, an enemy, neither or "don’t know." In the United States, the partner/enemy split was 25%/17%; in Japan, it was 32%/20%; and in India it was 32%/44%. Interestingly, in the case of Russia, the results were very much in the other direction, with a 29%/60% unfavorable/favorable split, and a 49%/13% partner/enemy split.

We are far less sure of how the economic consequences of the conflict scenario will affect the perceived legitimacy of domestic institutions and leaders. On the one hand, the headlines suggest trouble ahead, from declining support in Germany for the Eurozone, to Rasmussen Reports' recent finding that "68% say the political class doesn't care what most Americans think" (Rasmussen 15Jul10), to worries that weakening economic growth, and eventually the collapse of the credit/property bubble, will cause splits among the Chinese elite (for example, see "Will the Chinese Communist Party Survive the Crisis?" by Minxin Pei, published in the March 2009 issue of Foreign Affairs) and or a spike in frustration among the upwardly mobile Chinese middle class (see The Myth of the Social Volcano by Martin King Whyte). On the other hand, unwinding the Eurozone would be an extremely difficult undertaking, and, in the case of China, many other nations have shown how maintaining the loyalty of the security forces, along with the leverage provided by modern surveillance technology, can enable regimes to remain in power long after they have lost any popular legitimacy.

In the case of legitimacy issues in the United States, a recent article in National Affairs made some important points. In "Populism, American Style", Henry Olsen begins by noting that, "although classical populism has varied according to time and place, it has generally taken the form of a morality play in four acts. In the first act, the masses come to feel like powerless victims, left helpless against the onslaught of an oppressive 'other.' In the second act, often following a crisis, that ‘other’ is defined by a popular leader as an implacable enemy -- one who has no concern for the welfare of the people, and whose actions are motivated by selfishness and greed. In the third act, the leader proposes a solution: The people must use their numerical advantage to seize control of the state. In the fourth and final act, that power is used to take back from the enemy that which rightfully belongs to the people, without regard for the enemy's consent or rights."

However, he goes on to note that the history of populism in the United States has been different: "First, successful populist movements tend to characterize the American people not as helpless victims, but as honest folk dispossessed of their right to achieve prosperity and happiness through self-improvement and hard work. As such, American populists seek not a charismatic leader who will bring them order and justice, but rather a re-opening of the avenues to self-advancement and self-reliance. Second, the 'other' in American populism tends not to be vilified as an implacable enemy without rights. Instead, he is an adversary: one who might be corrupt or acting unjustly at the moment, but still a fellow citizen who retains his basic American goodness, is capable of redemption, and is secure in his rights. Third and most important, effective American populists generally do not seek to take the enemy's property to redistribute it to the people. Instead, they argue that if the government is once again made responsive to the electorate -- by placing the populists in power -- the people will again be able to help themselves. Sooner or later, the populists usually develop a policy agenda -- and it is typically a case for using government to advance self-reliance or enable prosperity and growth. These distinctive elements of American populism recur throughout our political history."

Last but not least, when it comes to the wildcards, we observe that relations between Iran and the rest of the world have significantly deteriorated over the last three months, and that military action now seems to be more probable than it was while the Obama administration was attempting to achieve a diplomatic re-engagement with the Ahmadinejad regime (e.g., see "Iran Could Spring a Nasty Surprise" by Simon Tisdall in the 15July10 Guardian, and Joe Klein's "An Attack on Iran: Back on the Table" in the 15July10 Time). As we have noted in the past, open hostilities with Iran would likely lead to a spike in global oil prices, which could easily tip the world economy into a new recession. On the oil supply front, any increase in global economic demand will soon run up against the fact that oil reserves that are recoverable at today's prices are limited (see, for example, "The Status Of Conventional World Oil Reserves -- Hype Or Cause For Concern?" by Owen, Inderwildi, and King). The result will be sharply increasing energy prices that, in the absence of new energy breakthroughs, will limit the effective rate at which global demand can grow. The wildcard aspect of this that we do not believe that world financial markets have fully priced in the implications of this constraint. The final wildcard is the continuing evolution of the H1N1 and H5N1 influenza viruses, even though much of the media apparently considers this story over. Unfortunately, the evolution taking place appears to be headed in more dangerous direction that is making H1N1 more deadly, as can be seen in the early evidence from this year's southern hemisphere flu season. Again, the potential exists for this to turn into a nasty economic shock this autumn and winter, when influenza season peaks in the northern hemisphere.

Let us conclude with a review of what our outlook implies for strategic asset allocation and risk management. At the regime, level, as we have repeatedly noted in recent months, we believe that markets have been underestimating the probability of a return to the high uncertainty regime, as well as how long that regime may last. In terms of global currencies, given the stresses on the Eurozone and Japan, it seems likely that higher uncertainty will result in a strong inflow of assets into the U.S. Dollar, and, to a lesser extent, the Swiss Franc and Canadian Dollar. While this will be good news when it comes to financing high U.S. government budget deficits, it will not be good news for the U.S. Dollar exchange rate (which could sharply appreciate), export growth, and employment. As such, this inflow into the USD will put further pressure on China to increase domestic household consumption demand, and, if this is not forthcoming, accelerate the reversal of globalization and transition to a world of competing blocs.

Rising uncertainty should also lead to rising prices (and falling yields) on Canadian government bonds, German Bunds (government bonds), and perhaps Scandinavian governments too, though for USD-based investors gains on the last two will to some extent be offset by exchange rate losses. In contrast, the exchange rate gains on the USD/CAD could well be positive. Within the government bond sector, real return bonds will benefit to some extent from further declines in real interest rates; however demand for them as an inflation hedge will wane, at least for now. On the other hand, demand for longer maturity governments should increase, as fixed income markets become more convinced that we must proceed through a period of deflation before high inflation can occur. In credit markets, we expect to see prices for lower rated instruments fall as perceived default risk increases. On the other hand, prices for issues with superior credit risk characteristics should increase. Higher uncertainty should also generate rising interest in commercial property investments, particularly in those regions (e.g., the Eurozone) where this asset class has been a traditional refuge in times of trouble when capital preservation is paramount. In the United States, commercial property could benefit from an inflow of capital; possibly offsetting this, however, will be the negative impact from rising commercial mortgage backed securities and collateralized loan obligation defaults (see Pimco's new report on its "U.S. Commercial Real Estate Project").

Worries about preserving the real value of capital could also lead to an increase in the price of other vehicles for gaining direct exposure to real assets, such as timber and oil and gas funds, particularly those that offer a regular income component and are based in politically safe regions (e.g., Canada, the U.S., Australia, Germany, the U.K., Scandanavia, etc.). On the other hand, we expect futures-based, long-only commodity index products to suffer, as declining economic growth reduces demand for the underlying products (i.e., causing more downside spot price surprises), while the structural imbalance between futures buyers and futures sellers continues to cause many futures curves to be contangoed, and consequently roll yields to be negative. On the other hand, investments in futures-based volatility funds should benefit from rising uncertainty. The outlook for gold funds is more mixed. Gold prices should benefit from rising uncertainty in the Eurozone and China; however, the most important upward price pressure would come if and when investors lost confidence in U.S. government securities as the most liquid and secure refuge in times of trouble. It seems to us that this loss of confidence is inevitable, and will arrive when investor demand falls and aggressive monetization of the debt begins, and the probability of much higher inflation sharply increases. However, we are much less certain about the timing of these developments.

Finally, our expectations for the future do not bode well for equity markets. There are, however, some possible exceptions to this, including stocks of large, well-managed and conservatively capitalized companies that can both absorb shocks and benefit from them by exploiting consolidation opportunities, and, perhaps, selected emerging markets like India and Brazil. On balance, however, we believe that the world's equity markets face a high risk of a "lost decade." Finally, we believe that the implications of our outlook for uncorrelated alpha strategies are mixed. The spike in uncertainty should work to the benefit of the best global macro managers, though set against that may be increased restrictions on their ability to easily redeploy capital between different nations' financial markets. Equity Market Neutral should continue to be a viable strategy, so long as managers are careful to hedge out their directional market exposure. Currency strategies may fair less well, as they become more of a one-way bet (i.e., hold the USD) and the ability to move capital between markets becomes subject to more constraints. Arbitrage strategies may suffer as historical relationships between asset returns are undermined by rapidly evolving political and economic changes. Finally, equity long/short strategies typically have a net long exposure, so their returns should be hurt by substantial equity market declines.

Let us conclude with a word of caution. We face a world in which the term "unprecedented" has become commonplace. In our view, this leads to three imperatives for investment managers and their clients. The first is the need to move away from relative performance goals, and to replace them with a clear view of the real rate of return that must be earned in order to achieve one's long-term financial goals. In a highly uncertain world, relative performance will increasingly be driven by chance and accident. In relatively calm periods, this has always been a very difficult game even for the most skilled to win consistently; in the coming years, it will become even more difficult, and getting the big question -- asset allocation -- right is likely to be even more important. The second imperative is the heightened need to employ forecasts based on different methodologies, and to combine them to improve the accuracy of one's views in the face of high uncertainty. We have no monopoly on insight; the smartest thing our readers can do is combine our forecasts with those produced by other organizations. The third imperative is to focus on becoming more agile and adaptive as the necessary complement to a decline in expected forecast accuracy during a period of high uncertainty. In practice, this means paying even more attention to avoiding over-optimism, overconfidence, the confirmation bias, and the all-too-human tendency to avoid facing up to decisions that aren't working out and quickly cutting one's losses. We strongly agree with Seth Klarman, when he says, "we are big fans of fear, and in investing it is better to be scared than sorry."

| Table: Fundamental Asset Class Valuation and Recent Return Momentum | July 2010 Issue: Key Points | This Month's Letters to the Editor: Why the mix of .70 Plum Creek Timber and .30 Rayonier to Implement Your Allocation to Timber, instead of CUT ETF; How Do I Use Your Global Asset Class Valuation Analysis?; and Could you please clarify what you mean in your monthly Equity Valuation Analysis by "Low Demanded Return" and "High Demanded Return"? | Feature Article: Understanding and Predicting Uncertainty Shocks, Part 2 | July 2010 Economic Update | Investor Herding Risk Analysis | Global Asset Class Valuation Updates Detail through June 30, 2010 | Product and Strategy Notes: New Analyses on Gold as an Asset Class and Financial Advisers' Corner | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast |