I have received quite positive feedback on this Journal so far, while a handful people did not want to be bothered. Fair enough. But a friend of mine expressed his view that, while he found it informative and quite readable, he thought the Journal was “alarmist”.

Which reminded me of the old saying that if you’re calm while everyone else is panicking, you don’t understand what’s happening! No one is panicking at this time (just so we’re clear on this point) but globalisation has made the world economy highly interdependent. You may not like to take excessive risks, but your life may be severely affected by risks other people may be taking.

As I see it, one of my primary objectives is to provide information, and context, as I see it. Whether you agree with it, and chose to act upon it is purely your prerogative. But you should understand and assess risks rationally, and then plan your investment strategy accordingly.

Let’s do a quick summary of where the things are at and again, I’ll focus on the US, because when it sneezes, we all catch a cold.

FIRST THE GOOD NEWS

The US economy has seen quite remarkable growth in the last three quarters (8.2%, 4.3% and 4.4% respectively). The Fortune 500 (the top 500 companies in the US by sales) has reported record revenues and earnings in 2003, reaching sales of $ 7.5 trillion and earnings of $ 446 billion. The employment market is showing strength, which was the last remaining concern according to many economists.

The International Monetary Fund (IMF) expects global economic growth to be robust, achieving 4.5% GDP growth in 2004 and 2005, according to their World Economic Outlook, April 2004. Global trade, investment, production and confidence are all rising. It does mention certain risks, such as global imbalances, the US current account deficit and rising interest rates.

China is a growing giant, with the government trying to slow down the economy! The South Asian countries are benefiting from their investments in China (particularly Japan, Taiwan and Korea), at the risk of becoming marginalized in the long run, and losing domestic jobs to Chinese labour.

Let me be clear. Most sources of information that you will come across that help us form our views will highlight the positive things. That is the nature and bias of the financial reporting industry. Most sources of information are snippets, they do not provide adequate context and look at data that is monthly or quarterly. But it is essential that, to form a balanced view and make judgments, that you understand the risks. It is these that I believe are not spelt out adequately.

I can see why pointing these out may makes me look alarmist, but the potential magnitude of the risks do alarm me and you must take these into account. My suggestion that you allocate 5-10% of your investments into commodities still means that you have to figure out how to invest the other 90-95% safely!

I derive my concerns from my analysis and from some well-known investors and analysts. Warren Buffet, Sir John Templeton and Bill Gross are globally renowned fund managers who are concerned about the state of the US equities and bond markets. Analysts such as Stephen Roach of Morgan Stanley and Marc Faber are openly calling for the US economy to fall apart.

THE CHALLENGES

US DEFICITS:

With its record breaking federal budget and current account deficits, the US is sucking savings from all around the world to finance its consumer-oriented lifestyle. The IMF has issued a warning that these deficits threaten the global economy, unless they are reduced.

Each year, the US government borrows (on top of what it ‘earns’ i.e. its GDP) an amount equal to the combined GDP of the GCC countries, plus another 20%.

They have no hope of paying back their debt, which will continue to grow, due to the scale of their social welfare state and future obligations. What does this mean for those financing the debt? What does it mean for the US $, which relies on the creditworthiness of the US Government? What does it mean for the GCC investor, whose currency is linked to the US $?

Things take time to unfold. Or, as Yoggi Berra would say, “It ain’t over till its over!” But this risk has to be part of your planning for the future.

US ECONOMY:

Last week, US durable goods orders fell for the second month in a row, and jobless claims rose. Despite the scale of the stimulus provided (multi-trillion dollar tax cuts, the lowest interest rates in 45 years and a corporate friendly government), the US economy continues to show signs of weakness. If the recovery stalls, it will have nasty global repercussions.

DERIVATIVES:

The joker in the pack, derivates are securities whose price is based on another (underlying) investment. They include futures, options, warrants, swaps, etc. They can be highly complex in nature, and entail a high degree of risk. The global derivative position is estimated to be $ 150 trillion (about 15 times US GDP).

A primary danger to the US economy is the rise of interest rates, due to the high level of corporate and consumer debt, and its negative effect on the booming real estate market. Federal Reserve Chairman Alan Greenspan warned on June 8 that the Fed was ready to raise interest rates more rapidly than the market anticipates, should inflationary pressures intensify.

80% of derivatives are estimated to be interest rate based. The danger with derivatives is leverage. Traders can assume huge positions that are multiples of their actual investment, through margin trading.

Even if you get it right, there is counter-party risk, the chance that the other player makes a large loss and defaults. If the defaulting party is sizeable, then all its other derivative contracts are at risk or perceived to be so. A stampede for the exit, combined with high leverage within the system, can create a domino effect, putting even solvent players at risk. This is why Warren Buffett calls derivatives the Weapon of Mass Destruction.

We saw how things can get out of control, with Nick Leeson at Barings and Long Term Capital Management. LTCM almost brought down the US financial system, and the derivative exposure is much higher now.

Next time someone whispers in your ear, “Psst, wanna buy an Exotic Swap?!”, I hope you have the strength to refuse!!

HEDGE FUNDS:

This bit may be important for GCC investors who have money in hedge funds. Forbes, in its May 24, 2004 issue, featured Hedge Funds on its cover, as the “Sleaziest Show On Earth”.

These are funds that do exotic investing, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to set aggressive investing goals.

It used to be that you had to be an accredited investor (someone with liquid assets over $ 1 million) to invest in hedge funds and minimum investment requirements used to be $ 100,000.

During the Internet era, a friend of mine was talking about how his driver in Pakistan had invested in a Nasdaq stock. This was in 2000 and it turned out to be an accurate predictor of the carnage to come.

It is a sign of a market top when your newspaper guy or shoeshine boy gives you market tips, all the stockbrokers are now driving Porches, etc. So when I heard that Carrefour was partnering the sale of hedge funds in its supermarkets with a $ 5,000 minimum, it sent up a danger signal for me.

Hedge funds, in theory, should help stabalise markets by finding arbitrage opportunities and correcting imbalances. But, in fact, they have ended up creating enormous volatility, due to a trend-following, herdlike mentality and, as Forbes reports, there are rampant abuses due to minimal regulatory oversight.

The 6,300 funds in the US (900 of which are less than 1 year old) manage $ 800 billion, before employing leverage. While their holdings equate to 3.6% of total US equity and corporate debt, they trade so frantically that they generated 12% of total brokerage commissions last year, according to Sanford Bernstein estimates.

10% of hedge funds became defunct last year, according to Hedgefund.net. 35% show no date for their last audit. Kroll Associates reports that 15-20% of fund managers that they do due diligence on show up as not having the college degrees or job titles they claim to have.

Finally, despite significantly higher fees compared to mutual funds and a greater risk profile, hedge funds have under performed both the S&P 500 and the Lehman Brothers’ intermediate bond index for the six years through 2002, according to TASS, the industry’s largest tracking service.

But what about those exotic returns many hedge funds they claim to have achieved? According to TASS, there are many fund managers who start up several funds. When they report, they only report results for the winners and completely drop the funds that are under-performing. TASS reports that half of the 3,600 funds it monitors do this!!

Why is there still such a systematic lack of integrity, after the impact of the fraud at Enron, Tyco, WorldCom, etc.? Congress passed the punitive Sarbannes-Oaxly Act to punish corporate wrongdoing, but how can the system tolerate such abuse?

To answer that, look at Dick Grasso, the former CEO of the New York Stock Exchange. He was paid $ 140 million as part of his deferred compensation package last year. This was on top of the $ 12 million he took as regular compensation in 2002, which represented 43% of NYSE profits. New York Attorney General, Eliot Spitzer, has sued Mr. Grasso for recovery of over $ 100 million, citing that the overall package of $ 188 million (Grasso dropped $ 48 million under pressure) was “excessive”, “rigged” and “illegal”.

So the head of the NYSE is being sued for pushing a compensation package through a handpicked Board in a manner characterised by "the lack of proper information, the stifling of internal debate, the failure of board members to conduct proper inquiry and the unabashed pursuit of personal gain resulted in a wholly inappropriate and illegal compensation package."

Remember, it was his mandate, as NYSE’s head, to ensure that member firms comply with regulations and promote strong corporate governance. Ethics flow from the top down.

REAL ESTATE AND THE STOCK MARKET:

Low interest rates have fuelled a surge in US real estate and stock market valuations. The recession in 2000-2001 was very mild given that it followed the largest bubble in the history of the world, and the reason was that the US consumer kept spending.

He was helped to do so by the wealth effect of rising housing prices and a rebound in the stock market. This was enabled by easy credit arising from the Fed’s accommodative monetary policy and extremely low interest rates. If interest rates spike, and spending slows due to high debt levels, then a major correction in the housing and stock markets may well cause a recession.

OTHER:

I won’t go into all the other potential challenges, such as: rising oil prices which have typically led to US recessions; Iraq and the threat of worldwide terrorism; the imbalance in global trade and the threat of trade embargoes; SARS and other potential epidemics; the future wars that may be fought over diminishing global oil and water reserves; global warming, etc., etc.

As Yogi Berra said, “You can observe a lot by watching.”

This is a challenging period in our lives, whether you are paying attention or not. So, at least keep reading with an open mind and see if my suggestions warrant any action on your part, to safeguard your assets. Do not, for a second, believe that if any of these risks materialise, that it will not affect you.

Investing in commodities can help mitigate these global risks. Am I alarmist? I don’t think so. Why, should I be?

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