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Green Shoots?
New York: May 25, 2009
By John Stephenson

For weeks, economists and market strategists have been talking optimistically about green shoots—the first signs of a turnaround in the global economy. In March, the global economy appeared to be heading over a cliff. But then, rather unexpectedly, some good news appeared on the economic horizon. First, the U.S. Commerce Department began reporting that the American consumer was demanding more than they had previously—an encouraging sign. That was followed by stronger industrial production numbers. And numbers out of India and China suggest that perhaps global manufacturing wasn't dead after all.

But, this past Thursday, the global economic picture became cloudy again, when Standard & Poors (S&P), a rating agency, lowered its medium-term outlook on the triple A rated U.K. government debt from “stable” to “negative.” While the rating agency has yet to downgrade the debt, a move that would cost the government more to finance the outstanding debt, this was the first negative revision of the U.K. 's debt since S&P began rating U.K. government debt. The rationale for S&P's move is a simple one—the massive debts that the U.K. government has incurred to fight the global recession has pushed the U.K. net government debt to nearly 100 percent of national income—an unsustainable level.

The U.K. may be the first large economy to face the prospect of a ratings downgrade, but in all likelihood, it won't be the last. Already, investors have begun to join the dots and have started selling U.S. dollars as speculation increases that the United States could be next to lose its triple-A sovereign credit rating. The market reaction has been swift, with yields rising sharply on long-term U.S. government debt, the U.S. dollar tumbling to a new low for the year, while gold rallied more than 1.7 percent last week.

With governments around the world throwing everything but the kitchen sink at economic crisis—their level of indebtedness has soared. In the United States, as well as in France, the U.K. and Germany the level of government borrowing is approaching, and in some cases exceeding, 100 percent of national income. If rating agencies, begin to get tough with over-spending governments—ratings downgrades of government debt will occur. A ratings downgrade can be a costly affair, since borrowers require a greater interest rate to compensate them for the added risk of the borrower defaulting on its debt.

The likelihood that the U.K. or the United States will actually default on their debts is small. A more likely outcome is that these governments meet their obligations by increasing the money supply. Or, in other words, they inflate away the problem by increasing the money supply so that they pay off their debts with less valuable dollars or pounds. After both the Second World War and the Vietnam war, the U.S. government did exactly that—they increased the money supply to pay down the war related debts and triggered a massive run-up in the inflation rate.

With corporate profits continuing to remain under pressure and jobless claims continuing to rise, the likelihood of a broad-based global economic recovery looks doubtful. As governments around the world, throw good money after bad in an attempt to shore up their sagging economies, the likelihood of a ratings downgrade and a collapse in their currencies increases.

In my view, we are entering an investment period that most closely resembles the 1970s. A period where inflation returned to the forefront, where most market sectors went nowhere over the decade, and commodity producing stocks were all the rage. A potent combination of massive government expenditures and high levels of consumer and government indebtedness have lowered the prospects dramatically for a consumer-led recovery and raised the prospect of increased inflationary pressures within the economy.

Already, gold and the stocks of gold producers have been on a tear. This trend will likely continue, as governments around the globe show no sign of easing-up on the amount of stimulus that they are pouring into the system. For my money, I would look to increase the weighting of gold and gold producing stocks in your portfolio as inflation, and U.S. dollar weakness are about to become more pronounced in the months that lie ahead.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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