it's a war out there, nothing to do with iraq

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    Good article from Alan Kohler, also from todays AFR...fills the bloody great hole in Trevor Sykes thread bare gold analysis.

    There is also a good article by Barrie Dunstan under the Smart Investor column ..all in all a good day to buy the Financial Review...

    It's a war out there, and it has nothing to do with Iraq
    Feb 8

    Investors should ignore the debate over whether to bomb Baghdad. It's nothing but a distraction, except for this: if markets rally when the matter is resolved (either with bombs or without), as they probably will, it will be a chance to sell.

    Equities have not fallen because of uncertainty over the fate of Saddam Hussein. As absorbing and worrying as the round-the-clock belligerent speeches and stern doorstop interviews are at the moment, they are a minor factor in the return of the bear in January.

    The main driver is growing and justified alarm about the macro-economic environment and, in particular, about how companies are going to grow their profits.

    In Europe, the Bank of England unexpectedly cut interest rates on Thursday to the lowest level since Winston Churchill was prime minister (1955). The stockmarket fell. Germany has returned to recession and European companies generally are being squeezed by the rising euro.

    In the United States, 2002 productivity growth was reported on Thursday to have been, at 4.7 per cent, the highest since Harry Truman was president (1950). Real interest rates there are already close enough to zero. Fiscal policy is pumping hundreds of billions into the economy, including through the removal of double taxation of dividends. Yet the Dow Jones Index has fallen 11 per cent since mid-January in a savage three weeks of selling.

    In Australia, the economy still looks strong despite some signs that spending is trending down. The housing market has peaked, but a boom in non-residential construction is rapidly picking up the slack. And there is no sign yet of a collapse in real estate values to undermine confidence.

    Yet the stockmarket rally that began in October has been wiped out and Assirt figures for managed fund flows in the December quarter show it was the worst month for seven years - down 39 per cent on the September quarter and 71 per cent below the inflow of a year before.

    Investors are in retreat.

    The reversal of the Christmas rally has not been caused by war drums. As Bridgewater Associates showed in a newsletter on Friday, even the rises in the prices of oil and gold are part of an average 20 per cent rise in all commodity prices over the past six months. Gold and oil have each risen about 20 per cent - right on the average.

    In fact, it's all about deflation, or more specifically the squeeze on profits following a loss of corporate pricing power as a result of a chronic post-bubble mismatch of supply and demand in the industrial world.

    Corporations are on a treadmill: they need the best productivity improvements in half a century just to stand still. Demand is weak and prices are falling because household balance sheets are in the process of being restored and capacity, still high from the overinvestment of the bubble years, has been inflated by the entry of China into the world trading system.

    Gerard Minack, of ABN Amro in Sydney, says that for the international competitiveness of US corporations to be restored, they need "just enough" US dollar weakness and "just enough" cost cutting - not too much of either.

    The currency fall needs to be big enough to work, but not so large as to suggest that the global capital tap has been turned off. That would be a sort of doomsday scenario for the US economy.

    And cost cutting needs to be enough to offset the effect of competition and price deflation, but not too much that higher unemployment and lower incomes put consumer spending under too much pressure.

    This double Goldilocks scenario, says Minack, is possible but unlikely. "Everything needs to go just right." More likely is another year of sub-par growth and more pressure on profits.

    In Australia, things superficially look better but may, in fact, be more dangerous. The factors in the US that triggered the past three years of low growth, recession and bear market - overcapacity, high debt and low savings - are now present here. The savings rate is effectively zero (not counting superannuation, which is a flaw in the measurements), consumer debt is very high and Australia's open economy is exposed to global excess capacity.

    Real estate values still look likely to have a soft landing unless interest rates increase, which is very unlikely. But it wouldn't take a property crash to produce a long period of low growth - or even a recession - in Australia.

    In fact, those who are watching the real estate market to forecast the economy are missing the point: values need only to stop rising, which has probably already happened, for consumer spending to be affected.

    Every 1 per cent rise in the savings rate reduces gross domestic product by two-thirds of a per cent. Savings will probably have to increase from zero to about 4 per cent (it used to be above 10 per cent) to restore household balance sheets.

    If that happened quickly, it would produce a recession. If it took longer than that, it would mean low growth for a few years - which is what has been happening in the US (including a shallow recession in 2001).

    Meanwhile, the risk of global deflation is rising all the time. Some now put it at 50 per cent. Policymakers - central banks and, increasingly, politicians pushing fiscal policy - are not getting any traction on an economic road that is slick with debt.

    The central question for global investors and economists is when policy will achieve traction. The optimists believe the policy stimulus will - must - have an impact soon. The pessimists think it will take longer.

    The economic furnace won't be kindled in Europe or Japan, that's for sure. Japan's Economics Minister, Heizo Takenaka, told the World Economic Forum at Davos that the Japanese economy was two years away from a revival - two years! - and domestic demand in Europe has collapsed again, leading to Thursday's desperate rate cut in the UK.

    The hope of the world is the US, which is pretty ironic considering that in many quarters, Europe especially, the US is seen as being the opposite of the hope of the world in geopolitical terms - herding it towards a disastrous conflict with Iraq and Islam in general.

    Indeed, as he tries to disarm Saddam Hussein, George Bush is just as energetically attempting to revive the US economy, so far with about as much success.

    And the reason the market is flagging is not because he might succeed in the first aim with bombs but because he may not succeed at all, at least for a while, in the second.
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