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Tandemonium
David Coffin and Eric Coffin

The dual themes of continued weakness in western financial centres and on-going strength for commodities due to eastern growth is now well established. Debate has shifted to how these will play out against each other over the next few quarters. Since we have suggested making cash for the last four months, the question for us is when and where to redeploy it.

Debt bundles are being pushed into longer term sections of bankís asset sheets. This is to forestall calling them write-offs, even at the cost of reducing cash positions and forcing new equity infusions, which at least recognizes the impossibility of marketing CDO paper.

At issue is whether auditors are willing to see stale dated goods moved from inventory to asset categories, wholesale. This was supposed to be liquid paper, and many bank clients who bought it on the premise of being readily redeemable regardless of covenants buried in the fine print. It wonít take many writs based on overly confident cover letters or emailed assurances by bankers before auditors fear signing off on any value for CDOs. But it gets worse.

Underlying debtors are glomming on to the reality that their sub-prime loans may have wonky ownerships, and how they might benefit by that. CDO, or CMO (collateralised mortgage obligations), are weak on who actually holds title to assets borrowed against. There is already a court ruling in the US stating that since clear ownership of the mortgages canít be shown, owners of CMO containing them cannot foreclose. If lenders canít foreclose on the houses meant to guarantee loans, how can the loans be assets?

This ruling in late October, from a judge in Ohio where foreclosures have been large, can still be considered isolated. But of course any new precedent is inherently isolated. Should you be thinking "legal gimmickĒ, try another perspective. If mortgage ownership is unclear, solvent borrowers might begin wondering if their payments are actually going the right place. Putting loan payments into T-bills while such issues are cleared up, at least if Ohio claimant Deutsche Bank is involved, may become tempting.

Not all CDO is weakly papered (from the lenders perspective), but it will take a lot of expensive eye strain to ensure which do work as they are supposed to. In short, a mess that has written off only a few $100 billion, little more then a typical cycle write-off on just the sub-prime mortgage, will continue locking up the debt system for a while yet.

The valuation issue will take most of the early year audit season to sort out. While this is happening there could also be a rush to foreclose on anyone who is in default. That is the only way to secure the assets, and since most of the CDO mortgages defaults will be handled by brokers specialising in the field they will be inclined at any rate to shoot first and question later.

While the debt issue gets uglier the Fed and some other central banks will be wrestling with the trade-off between beating down inflation with high rates and fighting off a property-deflation based recession with low ones. The housing market is too large a part of the US assets base to let it drag the economy into full blown deflation. So we expect the flood of US paper to support low interest rates to continue.

Hopefully that flood would help the US government get a handle on its own debt spending. But given how little notice this concern (as opposed to tax levels) is getting in the presidential run up, that hope may well be in vain. Add to this understandable concern about the role of the US in world affairs, and both the psychology and mechanisms for a serious downturn in the US economy are in place.

From this come calls for much lower base metal prices, by some. Those calls may be enough to push them lower one more time. However, we continue to view Asian demand as a fundamental underpinning for metals. If fear pushes equity markets into a heavy bear mode every thing will drop. But metals will recover as quickly as anything.

Itís also worth remembering that for all its reputation as low tech and low growth the extractive sector has been and will continue to be one of the best profit generators in the market. With ďtraditionalĒ high earnings sectors like financials coming apart resources stocks should get more love than skeptics assume.

This cycle has been different from its predecessors and there is no reason to think that changes just because the US economy stumbles. Yes, the US is the world's largest economy but US wealth creation this decade has been centered on services, finance and real estate. All of those sectors are already getting clobbered. That doesnít automatically negate growth elsewhere.

Debt has underwritten a lot of US consumer spending. Americans cutting back spending will hurt, but it should be less painful than previous cycles. If the money flows were all one way - US generated funds buying foreign goods - the knock on effects would be worse.

Developing nations are lending America the money to buy their goods. They donít want to lose the orders, obviously, but the US current account deficit should require less external funding if spending slows. Those funds do have opportunity costs for developing economies. The money can be put to use elsewhere. Many developing countries have done a better job at finding new markets and developing internal demand than they get credit for. This will help cushion the blow from weaker US spending.

The credit crisis is a world wide problem but itís focused in the US. Banks in all developed countries will have losses but hopefully not enough to freeze their operations in most regions. Some areas like Britain and Spain look vulnerable since the real estate markets there got just as nutty as those in the US.

World growth will slow somewhat but the worst of it will be in the US. We continue to view employment growth as a key statistic. The weakness of the December reading has increased our caution. With Wall St messing up so spectacularly the US consumer is being called on yet again to save the day. Employment growth has been weakening for some time, but a 5% or even 6% unemployment rate could still support some spending growth, as long as the fiscal environment is supportive. This assumes that central banks do their bit as we comment on below.

The Ted Watch

Markets moved from the Fed Watch to the TED Watch in the past couple of months. The TED spread tracks the difference in yields between US Treasuries and Euro inter-bank spreads. The spread widened alarmingly in August and then again in December as a new wave of bond defaults surfaced.

As we noted in the past couple of issues, the root cause is mistrust by banks of each other and the opacity of the whole structured credit market. No one knows whoís holding the hot potato and they donít want to find out the hard way it is them.

There were so many funds clamoring for higher coupon paper until mid 2007 that Wall St. started using whatever credits it could get its hands on before simply making up its own in the form of credit default swaps and other derivatives.

Many companies that wrote these derivatives or wrote insurance on bonds, often in the form of default swaps, are undercapitalized. They may find new funding but who would be crazy enough to put money into them at this point? Weíre in for several quarters of bad news from financials as they work off excesses and each new wave of write offs gets admitted to.

A series of new forms of credit debacle creates the potential for the sort of credit contraction no one wants. Recent credit injections by centrals banks loosened up the inter-bank markets a little but they will need to remain vigilant.

The Bank of England was the first, along with the Bank of Canada, to start the December rate cuts. The Fed seemed behind the curve until mid-December and the ECB is still suffering some denial, not withstanding the late December credit injections.

The ECBís Jean Claude Trichet is worried about inflation and no one would disagree itís a growing problem. That problem pales in comparison to a true credit contraction though. If banks stop lending the potential impact is far more serious and central bank cuts at that point would be close to useless. Japan made that mistake in 1990 and it took 15 years to exit the deflationary spiral that followed.

The Fed and most other central banks have woken up and we expect them to cut rates and continue injecting credit as long as necessary. This is likely to promote further Dollar weakness, on top of that expected from a slowing US economy.

The greenback will bounce if it looks like the US dodged the proverbial bullet and restarted growth. Even in that case however the continued profligacy of the US government will weigh on the greenback. If the ECB gets stubborn and raises rates it will just weaken the Dollar further though we think they would be foolish to do it. There are times you simply have to accept the risk of inflation and this is definitely one of those times.

This monetary backdrop is supportive of commodities and precious metals in particular. This is already a banner year for gold and weíre only a few days into it. Gold will have it own pullbacks but we expect it go higher still before 2008 ends, perhaps as high as $1,000. Silver will move with it, particularly since its own doldrums seem to have ended.

As noted, base metals will be prone to losses until traders are comfortable they have seen demand bottoming. We do not think that will take that long to occur. If the BRIC countries growth rates donít falter it will happen sooner than most predict. The market turns several months before economic stats make it official and commodity buyers in the most affected sectors of the US starting cutting back 18 months ago.

The short version of this monthís convoluted message is that resource stocks will outperform the market this year, and gold and silver stocks will outperform other resources.

Precious metals stocks didnít fare that well in the past 18 months. Costs were rising and traders were holding off until they saw another up leg in the bullion price. Well, that up leg is here now and precious metal stocks again have leverage.

While it might seem contradictory to focus on speculative stories in a teetering market we think it makes sense. Its not realistic to expect resource, or any other, stocks to defy gravity in a full on bear market. The greatest potential for a large market fall comes in the next few months. Barring that, speculative discovery stories should have legs.

Remember that there is no real shortage of liquidity or money looking for a home. Thereís a shortage of ďhomesĒ that donít look like they will cave in. In liquid markets, traders gravitate to winners, especially winners in sectors that have some buzz. That nicely defines discovery companies in precious metals exploration with gold aimed at the $1000 per ounce mark.



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