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    - Interim Update 6th July 2005

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Is a rising oil price inflationary or deflationary?

Interestingly, both the inflation and the deflation camps routinely portray a high and rising oil price as being supportive of their respective cases. Those who are anticipating ever-increasing amounts of inflation, for instance, argue that the higher cost of energy will ripple through the economy and push up prices across the board, whereas those who believe that deflation is imminent argue that the higher cost of energy will restrict the abilities of consumers and businesses to borrow and spend.

As usual, most participants in the debate talk as if inflation were an increase in the general price level and deflation were a decrease in the general price level, thus making the entire debate rather meaningless. Inflation and deflation are purely monetary phenomena, so a rising oil price is neither inflationary nor deflationary. It is simply a rising price. The effect that this price rise has on the economy will, in turn, be determined by the actions of the central bank.

For example, in the situation where the central bank is taking steps to reduce the rate of growth in the money supply then, all else being equal, higher prices for energy will have to be offset by lower prices in some other part of the economy. In this situation it is reasonable to say that the rising oil price could have a deflationary effect because under such monetary conditions, and with total private-sector debt already at a very high level, it is probable that less money will be borrowed into existence in the future. But all else is never equal and it's distinctly possible that any reduction in private-sector borrowing stemming from rising energy prices will be offset by an increase in public-sector borrowing.

Now consider the example of a rising oil price in an environment where the central bank is working to increase the rate of money-supply growth. In this case the central bank will effectively be monetising the increase in the oil price and there will likely be no associated reduction in borrowing/spending. It wouldn't, however, be reasonable to say that the rising oil price was inflationary since it would be the central bank, not the oil market, that was driving the increase in the money supply and the economy-wide reduction in the purchasing power of money. 

As things currently stand the Fed is acting to REDUCE the rate of money-supply growth in the US, so the high/rising oil price will potentially have a deflationary effect. We say "potentially" because, thanks to the continuing housing-related borrowing frenzy associated with long-term interest rates languishing near generational lows, it hasn't YET had a deflationary effect. Of course, if the high cost of energy did start to have a significant deflationary effect then the Fed would do an about-face and begin to work towards increasing the money-supply growth rate; so even in this case the probability of deflation actually occurring would be extremely low.

Greenspan's last days

...the Fed isn't likely to do anything different simply as a result of Greenspan being in his final months as Fed chief. However, we expect that the transition to someone new will have an adverse effect on financial market confidence...

Alan Greenspan's term as a Federal Reserve governor ends early next year, so unless a special arrangement is made to allow him to stay longer there will be a new Fed Chairman in about 6 months time. This raises the following questions: First, does Greenspan being in his final months as Fed chief have any implications for US monetary policy over the remainder of this year? And second, what will be the effect on the financial markets of the transition from Greenspan to someone new?

There's a school of thought that Greenspan, concerned about how he will be remembered, will do whatever he has to do to ensure that the US economy and stock market appear to be in good shape on the day he hands over the reins at the Fed. We don't have a lot of time for this view, though, because history won't judge Greenspan's 18 years as Fed chairman based on how things look on the day of his retirement. More to the point, we doubt that Greenspan believes that his legacy will be determined by how things look on his final day. Therefore, it's not reasonable to expect the Fed to be any 'easier' over the coming two quarters than would have been the case if Greenspan were not retiring early next year. In fact, we think it's more reasonable to argue that the Fed will be 'tighter' than would otherwise have been the case because Greenspan will know that he won't be the one responsible for cleaning up the mess resulting from the collapsing of multiple bubbles. But it's most reasonable, we think, to expect the Fed to behave in a way that is consistent with its traditional modus operandi; in particular, to expect Greenspan and Co. to persist with their rate-hiking until either a) the Fed Funds rate has reached what they perceive to be 'neutrality', or b) the stock and/or commodity markets cave in.

Our view, as you know, is that the stock and commodity markets will cave in long before the Fed reaches what Greenspan and his cohorts consider to be a neutral Fed Funds Rate.

Further to the above, the Fed isn't likely to do anything different simply as a result of Greenspan being in his final months as Fed chief. However, we expect that the transition to someone new will have an adverse effect on financial market confidence and that this will cause the Fed to be more accommodative during 2006-2007 than it might otherwise have been. The reason is that additional uncertainty is likely to be generated by having 'the devil you don't know' at the helm of the Fed, especially if downward trends are already entrenched in the stock and commodity markets.

The high probability of there being a new Fed Chairman early next year actually meshes very well with our 1-2 year outlooks for various markets, particularly our view that a new bull market in the gold sector will get underway late this year.

Evidence of falling growth

An important component of our intermediate-term outlook is that there will be a ramping down of global growth expectations during the second half of this year and much of next year. This lowering of growth expectations should initially be evidenced by declining prices for cyclical commodities such as the industrial metals and later -- most likely beginning in the final quarter of this year -- by considerable strength in counter-cyclical investments such as gold and gold shares.

As things stand today global stock markets are refusing to buckle and are therefore not yet confirming the intermediate-term outlook summarised above. However, significant support for our bearish outlook on economic growth is coming from other markets and indicators. For example, the chart at http://www.investmenttools.com/futures/bdi_baltic_dry_index.htm shows that the Baltic Dry Index -- an index comprising the ocean-going freight rates on 11 major shipping routes -- has now fallen by around 60% since last December's peak. This crash in freight rates is no doubt partially due to an increase in the supply of ships, but it's unlikely that such a precipitous fall could have occurred unless there had also been a pronounced reduction in global trade.

In general, industrial metal prices have also begun to support our view. The below charts, for example, show that there have been significant downward moves in the prices of aluminium, nickel, zinc and lead. Copper is now the lone 'hold out', probably because it is a speculative favourite of hedge funds. A daily close below US$3,000/tonne in the 3-month buyer's price for copper on the LME (London Metal Exchange) would be a clear sign that an intermediate-term peak was in place in the copper market.











The last piece of evidence we'll mention is the recent drop in the Australian Dollar relative to the euro. A$/euro, a chart of which is included below, tends to move with the US stock market and with global growth (the A$ is widely perceived to be a growth-oriented currency). It is generally quite volatile so taken in isolation the plunge that has occurred over the past fortnight is not necessarily significant, but taken alongside the weakness in metal prices and the on-going decline in the Baltic Dry Index it constitutes additional evidence that the downturn we've been anticipating is underway.


The US Stock Market

Current Market Situation

If the market continues to decline over the next few weeks then a bullish divergence will become possible, but only if the Dow drops below 10,000 while the NDX holds comfortably above 1400.

Over the past several years the divergences that have occurred between the Dow Industrials Index and the NASDAQ100 Index (NDX), whereby a move to new extreme for the year by the Dow was not confirmed by the NDX, have turned out to be important. For example, the below chart shows that there have been two such divergences over the past year -- a bullish divergence in October-2004 (point A on the chart) when a move to a new low by the Dow was accompanied by a substantially higher low by the NDX, and a bearish divergence in March-2005 (point B on the chart) when a move to a new high by the Dow was accompanied by a substantially lower high by the NDX.

If the market continues to decline over the next few weeks then a bullish divergence will become possible, but only if the Dow drops below 10,000 while the NDX holds comfortably above 1400. The point is, if such a divergence does occur it will be a good idea to exit, or at least to reduce exposure to, bearish positions. In fact, if such a divergence occurs we will seriously consider entering some trades on the 'long' side. By the same token, there would be no reason to reduce exposure to bearish positions if a drop below 10,000 by the Dow WAS confirmed by the NDX dropping below 1400.


The market is yet to tip its hand as far as what we can expect over the coming weeks in that a rebound to test the June highs looks almost as likely as a drop to test the April lows. A daily close below 10,250 in the Dow would, however, shift the odds in favour of a drop to test the April lows.

By the way, there was an interesting divergence on Wednesday between the oil price and the prices of oil-related equities. Specifically, both the AMEX Oil Index (XOI) and the Oil Service Index (OSX) were weak in absolute terms and relative to the S&P500 Index even though the oil price surged $1.70 to a new all-time high. The major oil producers are no doubt going to announce extremely strong earnings results later this month, but it's quite likely that these results are already factored into current stock prices and that the good earnings news will be taken as an opportunity to sell. We don't want to read too much into a single day's action, but perhaps yesterday's surprisingly weak performance by the oil shares was due to some traders anticipating just that (a sell-off later this month in the wake of good earnings news).

Gold and the Dollar

Gold Stocks

The below chart shows that the AMEX Gold BUGS Index (HUI) has spent the past 14 trading days oscillating within a 10-point range. We suspect that an upside breakout from this range would quickly be followed by a move up to 210, but not much more than that. And as noted in previous commentaries, we would consider a close below 192 to be a clear signal that the rebound was over and that the next downward leg had begun.


Gold stocks continue to perform quite well relative to the gold price and we haven't yet seen any solid evidence that a rebound peak is in place. About the only short-term bearish sign that we're aware of is this week's drop below support by Newmont Mining (see chart below). A pullback in NEM to test June's upside breakout would have been par for the course, but the stock has dropped a bit further than it ideally should have done. We wouldn't, however, put a lot of weight on NEM's minor breakdown in the absence of a close below 192 by the HUI; or a close below 90 by the XAU; or significant weakness in gold stocks relative to the metal.


Current Market Situation

Last year's peak of around 92 has been, and continues to be, our target for the FIRST upward leg in the Dollar Index's rally (see chart below). We expect that this target will be reached within the next 6 weeks. Support at just below 89.5 should hold during any near-term pullbacks.


Below is a daily chart of August gold futures.

Despite the fact that gold stocks still appear to have the potential to move to new rebound highs over the coming days/weeks it looks like a rebound peak is already in place for gold. If this proves to be the case it will be a strange turn of events because the gold sector of the stock market tends to reverse downward, or to at least show relative weakness, PRIOR to significant peaks in the bullion market.

Critical support for August gold lies at $417, but given that the gold price has just fallen by $20 in very quick time we'll be surprised if a break below this support happens within the next 1-2 weeks. However, we continue to expect that this support will be broken and that gold will trade below $400 before it embarks on the next major advance in its long-term bull market.


Update on Stock Selections

The managements of Aflease Gold and Uranium (JSE: AFL, OTC: AFLUY) and Southern Cross Resources (TSX: SXR) are planning to merge the two companies to create SXR Uranium One, a company that will be listed on the Toronto Exchange under the symbol SXR. Although the merger will be carried out by SXR issuing 0.9 of its shares for every Aflease share -- the equivalent of 9 SXR shares for every Aflease ADR -- it is effectively a takeover by Aflease of the smaller SXR because Aflease shareholders will end up owning 83% of the new company. If everything goes according to plan the merger will be complete by October.

This merger provides a way for Aflease to obtain a listing on a major North American market (it currently only trades on the horrid "Pink Sheets" market in the US) and a way for Aflease to obtain easier access to equity financing as it works towards bringing its huge South African-based uranium project into production. As far as we can tell, though, it's an expensive way to achieve these ends because the assets that SXR brings to the table don't appear to be worth what Aflease is paying for them. What SXR brings to the table are the fully permitted Honeymoon project in South Australia with its 9.3M-pound uranium resource and potential production of 880K pounds/year, the Goulds Dam project in South Australia with its 12.3M-pound uranium resource (4.4M pounds indicated plus 7.9M pounds inferred), and a few early-stage exploration projects in Australia and Canada.

In a press release issued to announce the companies' plans it was pointed out that the merger terms were based on current market prices, but in our opinion current market prices were under-valuing Aflease and over-valuing SXR.

Further to the above we think that having Aflease listed on the TSX is a significant positive, but that the deal, as announced, is a better one for SXR shareholders than for Aflease shareholders.

We still like Aflease as a long-term investment, but as a result of this planned merger and a soon-to-occur US$20M financing we would not be buyers at the current price. Instead, we'd prefer to wait for a pullback to around US$6.00 before doing any new buying.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
www.lme.com

 
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