Asset Allocation and Dumb American "Energy Policy"

The bankruptcy of American "energy policy" supports  two major facets of our asset allocation strategy: (1) underweight U.S. equities relative to global equities because of bad U.S. policy and other unprecedented problems for the nation, and (2) invest aggressively in companies working to solve the energy crisis, which will exist for even longer thanks to America's bankrupt "energy policy" (see our Environment link).

Today's column by Thomas Friedman in the New York Times explains perfectly the vacuity of "energy policy" debate in the U.S.   It's appropriately titled "Dumb as We Wanna Be":

• It is great to see that we finally have some national unity on energy policy. Unfortunately, the unifying idea is so ridiculous, so unworthy of the people aspiring to lead our nation, it takes your breath away. Hillary Clinton has decided to line up with John McCain in pushing to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for this summer's travel season. This is not an energy policy. This is money laundering: we borrow money from China and ship it to Saudi Arabia and take a little cut for ourselves as it goes through our gas tanks. What a way to build our country

• When the summer is over, we will have increased our debt to China, increased our transfer of wealth to Saudi Arabia and increased our contribution to global warming for our kids to inherit.

• No, no no, we'll just get the money by taxing Big Oil, says Mrs. Clinton. Even if you could do that, what a terrible way to spend precious tax dollars -- burning it up on the way to the beach rather than on innovation?

• The McCain-Clinton gas holiday proposal is a perfect example of what energy expert Peter Schwartz of Global Business Network describes as the true American energy policy today: "Maximize demand, minimize supply and buy the rest from the people who hate us the most." Good for Barack Obama for resisting this shameful pandering.

• But here's what's scary: our problem is so much worse than you think. We have no energy strategy. If you are going to use tax policy to shape energy strategy then you want to raise taxes on the things you want to discourage -- gasoline consumption and gas-guzzling cars -- and you want to lower taxes on the things you want to encourage -- new, renewable energy technologies. We are doing just the opposite.

• Are you sitting down?

• Few Americans know it, but for almost a year now, Congress has been bickering over whether and how to renew the investment tax credit to stimulate investment in solar energy and the production tax credit to encourage investment in wind energy. The bickering has been so poisonous hat when Congress passed the 2007 energy bill last December, it failed to extend any stimulus for wind and solar energy production. Oil and as kept all their credits, but those for wind and solar have been left to expire this December. I am not making this up. At a time when we should be throwing everything into clean power innovation, we are squabbling over pennies.

• These credits are critical because they ensure that if oil prices slip back down again -- which often happens -- investments in wind and solar would still be profitable. That's how you launch a new energy technology and help it achieve scale, so it can compete without subsidies.

• The Democrats wanted the wind and solar credits to be paid for by taking away tax credits from the oil industry.  President Bush said he would veto that. Neither side would back down, and Mr. Bush -- showing not one iota of leadership -- refused to get all the adults together in a room and work out a compromise. Stalemate. Meanwhile, Germany has a 20-year solar incentive program; Japan 12 years.  Ours, at best, run two years.

• "It's a disaster," says Michael Polsky, founder of Invenergy, one of the biggest wind-power developers in America. "Wind is a very capital-intensive industry, and financial institutions are not ready to take 'Congressional risk.' They say if you don't get the [production tax credit] we will not lend you the money to buy more turbines and build projects."

• It is also alarming, says Rhone Resch, the president of the Solar Energy Industries Association, that the U.S. has reached a point "where the priorities of Congress could become so distorted by politics" that it would turn its back on the next great global industry -- clean power-- "but that's exactly what's happening." If the wind and solar credits expire, says Resch, the impact in 2009 would be more than 100,000 jobs either lost or not created in these industries, and $20 billion worth of investments that won't be made [and another generation of debt-dependent energy import-dependence---this time dependent on imports of wind and solar instead of oil]

• While all the presidential candidates were railing about lost manufacturing jobs in Ohio, no one noticed that America's premier solar company, First Solar, from Toledo, Ohio, was opening its newest factory in the former East German -- 540 high-paying engineering jobs -- because Germany had created a booming solar market and America has not.

• In 1997, said Resch, America was the leader in solar energy technology, with 40% of global solar production. "Last year, we were less than 8%, and even most of that was manufacturing for overseas markets."

• The McCain-Clinton proposal is a reminder to me that the biggest energy crisis we have in our country today is the energy to be serious -- the energy to do big things in a sustained, focused and intelligent way. We are in the midst of a national political brownout.

Allocation and Africa -- II

We continue to think "Frontier Markets" -- and African markets particularly -- will rise toward the status of an asset class for many investors. This stems from (1) low portfolio-correlation of many African stock markets owing to highly country-specific developments, and (2) the world's race for resources that is increasingly investing in African nations. We highlighted these trends here and primarily here.

A Bloomberg article today highlights the additional drive toward #2, investment in Africa. (It's also suggested in the article that China's model of investment, which does not concern itself with human rights, may still do more good than harm. It this standard continues to be adopted, it could clear-away a major hurdle to African economic that was not possible when America's liberal values predominated in previous decades.)

From Bloomberg: (China Fund May Pledge $1 Billion in African Investment in '08)

• A Chinese fund set up to encourage investment in Africa may commit to spend $1 billion by the end of the year, Liliang Teng, president of the China-Africa Development Fund said today.

  The fund is in discussions with Chinese companies on projects to improve energy infrastructure in South Africa, Mozambique, Zimbabwe and eastern Africa, Teng said in interview at a business forum in Tanzania's northern city of Arusha.

  ``Besides energy and power plants we will also focus on infrastructure, like rail, roads and airports as well as other areas, including agriculture and manufacturing,'' he said.

  The China-Africa Development Fund, announced by Chinese President Hu Jintao in November 2006, will grow to $5 billion and may become bigger depending on its initial results, said Teng. Financed by the China Development Bank, it approved the first investments with four Chinese companies totaling $90 million on Jan. 15, according to a press release on its Web site.

  Sino-Steel Group, the China Building Material Co., Shenzhen Energy Group Co., and the CGC Overseas Construction Ltd. will use the money to develop electricity, construction, and mining projects in Africa, the statement said, without elaborating.

  China's trade with African nations will rise to $100 billion by 2010 from $73 billion last year and $2 billion in 1999, Khalid Malik, the United Nations resident coordinator in China, said at the opening of the China Africa Business Forum in Arusha today. The two-day summit is bringing together 300 trade officials and businesspeople.

  Critics say China's push into Africa for oil and raw materials to feed its growing economy in some cases disregards environmental laws, labor standards and human rights.

  Economist Jeffrey Sachs, the UN's special envoy on the Millennium Development Goals, said the positive impact of Chinese investment and skills transfer to Africa far outweigh the negatives.

  ``What is being promoted is a great increase in business development,'' Sachs said in a taped address.

  To contact the reporter on this story: Sarah McGregor in Dar es Salaam via Johannesburg at 1933 or abolleurs@bloomberg.net

A Long Retreat from U.S. Equities is Continuing

In the last 25 years, Americans have steadfastly increased their exposure the U.S. equities, as the mutual fund industry matured and the cost of investing directly into stocks dropped. In 1980, only 6% of households held mutual funds, rising to 25% in 1990 to about 50% today. And far more people trade individual equities now than in the early-1980s.

That's the type of accumulation of an asset class that limits future returns, because there's less "money on the sidelines" available to drive demand for equities much beyond supply.

This trends are reflected in the following long-term P/E chart (below), which, toward the far right, shows valuations rising sharply from 1981 through 2001 (as investors raised their exposure to the asset class), and then retreating somewhat since then, and still not near a classic bear-market bottom by any means:


For a decade already, many of the world's savviest and nimble investors have owned far less U.S. equities as a percentage of total assets than the typical recommendation of 40-80% advocated for Americans saving for retirement, as referenced here for example. Lately, more of the largest and slower-moving institutional investors are shifting away from U.S. equities, as covered by Pension Risk Matters:

• [D]efined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

Retail investors, usually the last to move en masse, have also begun (but only just begun in the past year or two) to diversify away from U.S. equities, according to the latest fund flow data, and judging from the amount of money being injected into global, commodity and other new ETF varieties.

This process could have a ways to go before U.S. equities bottom, from a long-term perspective. Barclays Treasurer John Porter, being interviewed in Inside the House of Money, says:

• From a financial markets point of view, we're in a range type of stock market with a downward bias. People will become quite disillusioned with the financial markets. At some point, people are going to look to other things, like public service, the Peace Corps, or that type of thing, as opposed to getting an MBA or going into investment banking. These things tend to go in waves."
  

The process of moving toward this notion of a market bottom sounds painful for portfolios. But economic and financial dynamism will prevent a washout. In other words, we think investors will still make money in U.S. equity indices in the next five (+) years, but the trends we discuss above -- and other risks we discuss in previous posts -- will probably keep U.S. index returns in the low-single-digits.

We're overweight cash now, and gradually adding funds to a broad array of asset classes when each of them dips. In the last two months, we've added a bit to Developed Europe equities, Emerging Markets equities, Frontier Markets equities, municipal bonds, and environmental trend-driven equities (rather than high-yielding "real assets," as of yet). We're watching for entry points in Real Estate, U.S. Treasuries and TIPS (Treasury Inflation Protection Securities), and we're hunting for a top-performing and uncorrelated market-neutral equity fund and private equity fund.

Underlying Risks to China (and its Trading Partners) Still Growing

We've been arguing that (1) the Developing Markets' "inflation beast keeps growling" (click and scroll down) due to structural problems such as oil prices and governments' trade and regulatory policies, (2) Chinese equities' still have an adverse risk/reward ratio, and that (3) we probably won't go overweight equities until we see contagion from the U.S. & European financial crisis result in real crisis in some of the Developing Markets (noted throughout this section).

A post from Michael Pettis in "China Financial Markets" supports our overall caution quite strongly. He continues to see the Chinese yuan on a freight train higher (which will increasingly destabilize global inflation, trade, and demand trends) -- and he sees decreasing chances of anyone stopping it. The consequence of a painful revaluation of the yuan would be another major "leg" to the global financial/economic contagion:

• Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think. My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible. I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):
  

• “Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI [foreign direct investment] and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years. If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.”
  

• “From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest. If true, this complicates matters. Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation [a deliberate, sharp strengthening of the Chinese currency, to ward of speculation/"hot money" that it will continue to rise], and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow. The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is. The longer they wait the worse the options become.”
  

• In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows. The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too. I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult. It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust. If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.
  
  

Long Run U.S. Outlook Not Much Improved

It's been a long time (in blog terms) since we've argued for a strategic underweight of U.S. versus non-U.S. assets, but our view remains. America's serial indebtedness, its multi-trillion dollar war in Iraq, its narrowing borders to foreigners relative to its size, its stagnant state of public education, and its increasingly polarizing political tones are the main drivers. In our view, these major negatives slightly counter-balance America's tremendous entrepreneurial power (innovation and access to capital), its information intensity, and its economic diversity.

One of our favorite conduits, NakedCapitalism.com, has just produced a bevy of citations that make us increasingly concerned about the financial risks facing America. A few of the citations:

• An academic paper reviewing several hundred years of world history repeatedly found waves of sovereign debt criss hitting nations that (1) had received very large capital inflows to support very large indebtedness, and (2) existed in a global context of financial liberalization.
• A list of luminaries predicting worse-to-come as result of household and government debt.
• The risks and downsides of a currency losing its reserve status -- "Debasing the Dollar Will Accelerate America's Decline."

It seems that the blog's author, having correctly predicted (repeatedly) a severe financial crisis such as we experienced since late-'07, has now turned his guns on the longer-term fallout from the underlying problems that contributed to the near-term crisis.

There is a best course: America can reign in spending, and can save its way out of its debt. But the cost will be slower economic growth and higher taxes for years. We'd need to see strong evidence that it's happening before giving the nation credit for it, so to speak.

In the next five years, we think more funds (which have led the way already), financial planners, and self-proclaimed investment gurus will cite "world equity" as the core long-term asset allocation, rather than U.S. equities. Of course this shift has already begun to occur, but it has a lot further to go. We think we're still on the early side of the multi-decade "trade."

Another aspect of this "trade" will be the continued outperformance of well-run U.S. companies with superior international growth trajectories.

Chinese Inflation Will Scare Investors More, Then Temper Demand

China's artificially low currency and domestic price control program is one of the world's largest "imbalances." (Of course, it goes hand-in-glove with excessive American credit and borrowing.) Now the world is waking up to those imbalances more than ever, which means securities market volatility remain high while the resolution is pending but uncertain.

Specifically, we see increasing risk of more acute Chinese inflation fear in newspaper headlines, and subsequently some demand moderation in China as the normal function of higher prices finally kicks in. This outlook contributes to our (1) unwillingness to fully re-balance our underweight equities allocation until we see more evidence of "crisis" on some Developing Markets, and (2) unwillingness to go overweight energy now, believing that they're becoming more vulnerable to the global slowdown that's unfolding.

To elaborate, we'll offer a few snippets from Professor Michael Pettis' blog in the past two days. Shortages as a result of price controls are becoming more acute, such that prices will have to rise, which should ultimately lead to a "demand response." This process has been taking far too long, but it may accelerate. From Pettis' post today:

• I had lunch with a senior banker from a major Chinese bank today. He is based in Shenzhen, across the border from Hong Kong in the southern province of Guangdong. Among other things he told me that lines at gasoline stations are getting terrible, in part because a lot of Hong Kong residents drive to the mainland to fill their gas tanks. Gasoline on the mainland is at less than the half global price, so this isn’t much of a surprise. He also told me that he thinks actual inflation is higher than the headline CPI number. That isn’t a big surprise either, I guess.

  Finally we discussed concerns about a coal shortage, and I read in today’s Xinhua a confirming article that claims that coal reserves have fallen to a 12-day supply, which I think I understand from the Xinhua article is a record low level, even less than March’s already-worrisome 15-day supply. The combination of low coal reserves and gasoline shortages means, I think, that it is going to be hard to keep a lid on energy prices. I wouldn’t be surprised to see energy prices, which are controlled in China, rise in the next few weeks, even amid all the worry about spreading inflation.

And from yesterday's post:

• I noted two other interesting pieces today. Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.” They say:

  China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

  …Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

  Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time. Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

China Equities -49% From Peak, But Still Adverse Risk/Reward

We continue to wait for the financial crisis to hit some of the Developing Markets before we'll be more comfortable fully rebalancing our somewhat underweight equity allocations. We see a crisis-of-confidence in some Developing Markets as just one of the signposts that it's safer to raise weightings significantly, but an important signpost.

We see China as the bellweather for our call, and we still see the risks somewhat outweighing reward for a 1-2 year time horizon. One the one hand, its economic dynamism continues in many regards, and its equity market has gotten a lot cheaper, nearly cut in half since its peak, and with P/Es in the low-20s for example. On the other hand, we worry about the effects of China's artificially weak currency, its inflation problem, its opaque financial statements, its immature banking system, its real estate bubble, and so on.

An insightful post by professor Michael Pettis at Peking University adds to our view that the economic slowdown that is spreading around the world could treat the Developing Markets more harshly than is generally believed. First, he details the spike in "hot money" flows to China, which will make it more difficult for China to keep its currency weak and its export machine well lubricated.

Second, Pettis describes why he thinks Chinese companies' financial conditions have deteriorated, perhaps more than the much-reduced equity markets discount. It gets to the heart of our reason for slowly raising our Developing Market weightings specifically, and equity weightings generally, following the selloff since the peak in '07:

• In [the 4/19 edition of the South China Morning Post, reporter Shirley Yam] wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

  Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control. “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks. As she explains in her article,

  This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm. I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

  It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast. Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

  This kind of thing worries me not because I care about the how managers choose to spend and/or waste money. It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity.

  Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years. In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control. The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

  This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).

  Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems. Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside. But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time. This is not a coincidence. It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control.

One Parched Place, Many Major Investment Themes

The following brief Reuters story about the Catalan region in Spain helps demonstrate why we want to own leading companies dealing with water infrastructure, irrigation, agri-biotech, and resource efficiency (see our earlier post for specifics).

The Reuters story:

• Spain plans pipeline to avert Catalan water crisis.
  BARCELONA (Reuters) - Spain unveiled plans on Friday to build a pipeline to relieve drought-stricken Catalonia and prevent Barcelona running out of drinking water, but other regions are up in arms in what media have dubbed a water war.

  The pipeline will take water from the mouth of the Ebro River to Barcelona, the Catalan regional capital. A hosepipe ban has already been in force for weeks and picturesque fountains have run dry in the city, a popular tourist venue.

  The government said on Friday the situation in Barcelona was an emergency.

  "If we don't act, the citizens of Barcelona will be without drinking water in October," said First Deputy Prime Minister Maria Teresa Fernandez de la Vega, speaking at the maiden weekly press conference of the newly re-elected Socialist government.

  Reservoirs in northeast Catalonia are just 20.1 percent full after four years of drought, according to the latest official data, or just 0.1 percent above emergency levels. One Catalan reservoir is so dry that a village has reappeared after being under water since the river flowing through it was dammed.

  Catalonia's department of the environment on Thursday said recent rainfall after a dry winter would only be enough to postpone emergency measures for some weeks.

  WATER IMPORTS

  The new pipeline is not due to be completed until October, however, and Catalonia already has plans to import water to Barcelona by sea beginning in May and by rail in August.

  The plan ends weeks of wrangling between the central government in Madrid and authorities in Catalonia. But it has angered the heads of regional governments further down the Mediterranean coast in Valencia and Murcia, who say they will demand equal access to the Ebro in the Constitutional Court.

  The Socialist government denies favoring Catalonia -- whose regional parties are its allies in parliament -- over conservative Popular Party-led governments in Murcia and Valencia. It says the new pipeline will not deplete the Ebro because it will channel surplus water recovered by installing more efficient irrigation pipes used by farmers.

  "People from Barcelona have the same rights as every other citizen -- not more but not less," said de la Vega. "It's the responsibility of the government to make sure the whole of Spain fairly shares resources that belong to everyone."

  Adding to the government's headaches are protests from farmers in the Ebro delta on whom the plan hinges. Many say they cannot stop irrigating to lay new pipes now that the growing season is under way.

  The delta is known for growing rice, an essential ingredient in renowned dishes from Spain's Mediterranean coast like paella.

  "We don't want to be selfish, but rice is life itself in the delta. The government has had years to act, and now they have acted late and badly," said Rosa Pruna, head of the influential ASAJA farmers' union in Catalonia.

  (Additional reporting by Sonya Dowsett, editing by Mark Trevelyan)

Adding Equity Exposure While "Muddling Through" Crisis

Each day that brings a bit more reassurance that the financial crisis won't turn into a catastrophic melt-down represents a good day for markets, after investors fear the worst for much of 2008.

So, even though we're arguing for being underweight equities until one's semi-annual asset allocation rebalance, we've posted about adding equity exposure gradually, and to gain exposure to major investment themes that should combat the economic cycle and provide high beta if markets turn bullish.

During the week of March 31-April 4, we highlighted the Agriculture theme [specifically agri-biotech Monsanto (MON) and Syngenta (SYT)], the length of the Africa & Middle East theme (TRAMX), and the value of adding some U.S. index exposure (VTI). We also were tracking Water, Solar, Genomics, China, Brazil, Canada and other areas.

This week we extended many of those themes, and are also highlighting Suez (SZEZY - a global utility and water infrastructure company), Lindsay (LNN - a high-tech irrigation equipment company), Itron (ITRI - a global utility metering equipment company), and Origin AgriTech (SEED - a Chinese seed company with substantial "option value"). This week we also saw decreased risk in adding exposure to European (VGK), Emerging Markets (VWO), and Brazil specifically (EWZ).

Allocation and the U.S.-Iraq War

The Achilles heel of U.S. investment prospects isn't its credit debacle but its war in Iraq.

The war's costs are driving the dollar lower (and import inflation higher, including oil), crowding out productive investment, sending interest payments and corporate ownership stakes (and the related technology and dividends) abroad, and driving future tax rates much higher.

These are some of the reasons why we've been underweight U.S. equities for most of the past five years -- though not underweight enough -- and why we'd remain beneath the commonly-prescribed 40%+ weightings for U.S. equities. No other nation in the world bears anything approaching the staggering and wasteful losses that the U.S. will continue to bear until the war ends, and well beyond.

Thus our latest post on the war argued that Bush's latest "defining moment" for the Iraq war was also a defining moment for America. Yet recent fighting hasn't improved matters.

A new book by Nobel prizewinning economist Joseph Stiglitz and Harvard's Linda Bilmes argue that the total costs of the war will be $3 trillion, narrowly speaking in terms of direct costs to the U.S. This includes $845 billion in Congressional appropriations thus far (including the $200b '08 supplemental). What's more, Stiglitz and Bilmes write in The Guardian:

• We are not looking at McCain's 100-year scenario - we assume that we are there, in diminished strength, only through to 2017. But neither are we looking at a scenario that sees our troops pulled out within six months. With operational spending going on at $12 billion a month, and with every year costing more than the last, it is easy to come to a total operational cost that is double the $600 billon already spent.

  Second, we include war expenditures hidden elsewhere in the budget, and budgetary expenditures that we would have to incur in the future even if we left tomorrow. Most important of these are future costs of caring for the 40% of returning veterans that are likely to suffer from disabilities (in excess of $600 billion; second world war veterans' costs didn't peak until 1993), and restoring the military to its prewar strength. If you include interest, and interest on the interest - with all of the war debt financed - the budgetary costs quickly mount.

  Finally, our $3 trillion dollars estimate also includes costs to the economy that go beyond the budget, for instance the cost of caring for the huge number of returning disabled veterans that go beyond the costs borne by the federal government - in one out of five families with a serious disability, someone has to give up a job. The macro-economic costs are even larger. Almost every expert we have talked to agrees that the war has had something to do with the rise in the price of oil; it was not just an accident that oil prices began to soar at the same time as the war began.

  We have been criticised, but for being excessively conservative, for including only $5 to $10 of the $75 to $85 increase in the price of oil since then....

Their article continues:

• With the exception of a few lonely surviving supply-siders, most economists believe that deficits matter, and the huge deficits to finance the war will have their toll in the long run. Deficits matter in both the short run and the long. They help crowd out private investment that would have stimulated the economy far more than the war expenditures; and the reduced investments reduce long-run productivity. With 40% of the funds borrowed from abroad, Americans will be sending interest payments abroad - lowering living standards at home. Finally, even Fed Chair Bernanke (formerly the president's economic adviser) admits that the deficits have reduced the room to manoeuvre - the ability of the government to respond to the looming economic crisis.

  Spending so much on the war has economic consequences, even if you don't think there is any connection between the war and the economy's current woes.

  In adding up the quantifiable costs of the war, it is hard not to come up with a number in excess of $3 trillion. In putting a $3 trillion price tag on the war, we believe we have been excessively conservative - a $4 or $5 trillion tag would be more reasonable. And remember - this is just the cost for America.

The Stiglitz/Bilmes estimate does not seem to count the costs to America of having its leaders so mired in war that it impairs its ability to negotiate in its national interest in many other spheres, while other nations such as China intensively procure access to natural resources, build precious reserves, create new alliances and trade agreements, and so on. Nor can Stiglitz/Bilmes or anyone estimate the cost of millions of Islamic adherents' increased antipathy toward the U.S., the increased potential for anti-American terror acts for generations into the future. (America's increased fear of that potential that has also led it to slowly close its borders to thousands and thousands of extraordinarily talented foreign workers seeking H1-B visas.)

As we wrote in our post "A Defining Moment for Iraq" Is a Renewed Risk for America (and for Financial Markets):

• Failing to help stabilize Iraq now, only months before the troop increase was to be tapered off, could significantly prolong the costs to the U.S. and Iraq, or present a new set of even less-appealing options, such as partitioning Iraq into militarily "self-governed" entities, which could cause a new wave of misery.

Contagion Spreading (and seeds of a US dollar base?)

We have written many times (such as here, here and other posts) that the financial crisis will be landing hard in various Developing Markets, and that inflation (food, fuel, etc) and could be the catalyst in the further "great unwind" of global pressures that have been building this decade.

Our main point in the posts was to say why we remain underweight equities, and that the coming global market selloffs would ultimately take us closer to "the beginning of the end" of the global financial crisis, and subsequently a better time to buy equities -- both globally and in the U.S.

Now, signs are clearer than ever that circumstances are creating the conditions for financial crisis in some developing markets. Acute food inflation, subsequent export barriers that are making matters, worse, food rioting in a half-dozen countries, and increased political risk (for example, note India's nervousness at the Maoist election victories in Nepal) are raising matters to a head. This comes on the heels of years of currency manipulation and hypercredit in certain countries, the slowing pace of trade & financial reform, and of course the continuing U.S. credit bubble implosion.

A Bloomberg update today contains implications that we're closer to cusp of true contagion into Developing Markets. The news may signify only the early stages of a continuing destabilization to the post-2000 trends:

• Rupia Weakens With Peso as Rice Jump Spurs Inflation (Bloomberg, April 14) At the end of last year, rice was selling at $13.865 per 100 pounds, the Philippine central bank had met its inflation target for the first time since 2003 and the peso was the world's second best-performing currency.

  By April 1, rice was surging toward a record $21.60, the inflation rate had almost doubled, and the peso suffered its biggest monthly decline in seven years.

  Record prices for rice, wheat, milk and cooking oil are wreaking havoc with currencies in Southeast Asia, causing a slump in the peso and Indonesia's rupiah. Investors from Deutsche Asset Management to Fortis Investments are dumping their bondholdings on concern inflation will erode returns, putting further pressure on exchange rates. The region has come to depend on strong currencies to contain the rising cost of food and fuel imports.

  ``You can't just rely on currencies to fight inflation, as there comes a time when they have no potential to appreciate further,'' said Nicolas Schlotthauer, a money manager who helps oversee $5 billion at Deutsche Asset Management, part of Germany's largest bank, in Frankfurt. ``Everyone is so complacent about the fact that if there's inflationary pressure, they will let their currencies appreciate. No one thought of potential currency weakness.''

  Currency Reversal

  The Philippine peso tumbled 3.2 percent in March, the most since June 2001. It fell 0.4 percent to 41.750 by the close of trading in Manila, according to data from the Bankers Association of the Philippines. That's a reversal for a currency that gained 9 percent in the fourth quarter, second only to the Armenian dram. In Indonesia, the central bank probably bought more than $2 billion of rupiah, limiting its decline since March 1 to 1.1 percent, according to Oversea-Chinese Banking Corp., Singapore's third-biggest bank. The rupiah slid 0.3 percent to 9,200 per dollar in Jakarta by 5:30 p.m. local time.

  International investors cut their holdings of Indonesian government bonds 3.2 percent in March to 80.7 trillion rupiah ($8.8 billion), according to finance ministry data. Foreign funds sold a net $154 million of stocks in the Philippines this year, helping drive the Philippine Stock Exchange Index down 19.5 percent.

  Deutsche Asset sold all its rupiah debt earlier this year and didn't buy peso bonds because of inflation, Schlotthauer said. Fortis Investments, a unit of Belgium's biggest financial group, expects the rupiah will weaken 3.2 percent to 9,500 per dollar within three months. The firm is ``short'' the rupiah, meaning it is betting the currency will depreciate.

  `Bearish on Indonesia'

  ``I'm really bearish on Indonesia,'' said Didier Lambert, a London-based money manager who helps oversee $4 billion in emerging-market debt at Fortis. ``You will see investor outflows that should weaken the currency.''

  The last time Indonesia's rupiah depreciated due to rising commodity costs was in August 2005, when a jump in global oil prices increased the cost of a state fuel-subsidy program. The rupiah slumped to a four-year low of 10,875.

  ``Subsidies can be very disruptive and expensive for a government to maintain,'' billionaire investor George Soros said in a teleconference from Washington on April 9. Rising food prices may cause ``social and political disruptions,'' he said.

  Emergency Meeting

  The Philippines is urging China, Japan, India and other Asian nations to convene an emergency meeting this month or next on the region's food crisis, Agriculture Secretary Arthur Yap said today. International Monetary Fund Managing Director Dominique Strauss-Kahn said April 12 that ``hundreds of thousands'' worldwide may starve as food costs jump.

  Philippine President Gloria Arroyo said on April 1 she may abandon plans to balance the budget. Two days later, Indonesia widened its 2008 deficit target to 2.1 percent of gross domestic product from an earlier 1.7 percent.

  Food accounts for 49 percent of the consumer price index in the Philippines, the world's biggest importer of rice, and 38 percent in Indonesia, according to Mirza Baig, an economist at Deutsche Bank AG in Singapore. In the U.S., it's 14 percent.

  Indonesian inflation surged to an 18-month high of 8.2 percent in March, breaching Bank Indonesia's target of 6.5 percent. It reached a 20-month high of 6.4 percent in the Philippines, above Bangko Sentral ng Pilipinas's 5 percent target.

  Asian central banks may be able to curb inflation by raising interest rates and seeking stronger currencies because of ``robust'' growth, the Washington-based IMF said on April 9. Excluding Japan, Asia will grow 7.5 percent in 2008, compared with 9.1 percent in 2007.

Allocation and Currencies?

How long before currencies are widely treated as an asset class? The question is crucial because finding new asset classes -- shortly before institutions begin treating them that way -- can be a very lucrative strategy. (For example, Energy commodities have skyrocketed in part because of institutions beginning to treat them as an asset class in the past five years).

Most institutional money managers and asset allocation advisories don't count currencies as an asset class, in that they don't apportion a percentage of their assets exclusively for currency investments. Currency is still a crucial part of all international investors' considerations, but it's usually not treated as a separate asset class by investors other than globally-oriented hedge funds.

Why not? After all, currencies frequently provide a source of significant alpha and uncorrelated returns. And some investors do extremely well in currency investing. For example, in Inside the House of Money, the manager of a significant family investment fund, Falcon Management, says:

• [F]oreign exchange is a whole area of risk premia that none of the real money [long only] funds are earning.
• Back to the smart real money (long-only] funds, Yale has seven asset categories where they look to extract risk premia and Harvard has eleven. The question is, why doesn't Harvard throw in a twelfth category? They should be looking at other uncorrelated markets such as foreign exchange for more sources of risk premia. Once they identify new sources, they can allocate X% and, in a Markowitz sense, run an efficient frontier to come up with what the correct allocation should be. But they don't do it. Asset categories like foreign exchange or options are not thought of as an asset category where risk premia can be earned.
• As a hedge fund, we'll look anywhere for opportunities. The currency markets are a place where global macro hedge funds especially earn risk premia. I can name three risk premia in currencies that I don't think any real money manager has ever attempted to earn on a systematic basis: (1) High yielding versus lower yielding currencies.... 92) Short-dated volatility is too high because of an insurance premium component in short-dated options....(3) Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price....

The Falcon manager, Jim Leitner, notes there's significant value to be extracted from currency markets (indeed many asset classes) over time:

• The large inefficiencies do not get arbitraged out because there's very little capital that actually gets allocated toward extracting value over multiple years. Everybod who's allocating money to hedge funds has monthly or quarterly redemption clauses, which force hedge funds to manage to those liquidity paramaters, and that's not at all the way to wealth.

Things are starting to change, and will probably continue to. The U.S. dollar's precipitous multi-year slide versus other major currencies is forcing more money managers to think about creating asset allocations for currency. Moreover, ETFs tracking currencies are rapidly appearing.

The traditional reason why currency isn't regarded as an asset class is that there's no "expected return." The currencies taken together are a "zero-sum" game, versus other asset classes where everyone can win. But for some investors, active management of currencies are creating consistently strong returns that institutional asset allocators (such as pension funds, insurance companies, charitable organizations, etc) may stop ignoring.

China Equity Market Not Expensive If Real Growth Slows Some

We recently increased our Developing Markets exposure slightly -- via Chinese ADRs -- given signs of the world financial system "muddling through" the crisis period. A "muddle through" is the bull case, and the more we muddle, the lower the chance of the "tail risk" of a major melt-down.

We're still underweight equities overall, and Developing Markets equities specifically, because we don't think we're at "the beginning of the end" of the financial crisis yet. (One thing we're waiting for is a Developing Market financial crisis as a sign that the global crisis has come full circle.)

Nevertheless, a bump-up in our Developing Market allocation via China has a somewhat higher reward/risk ratio than it has for a while, we think. A few helpful tidbits today in an FT Opinion article from Jake Lynch of Macquarie:

• A recent survey of Chinese A-share investors found that 70 per cent believed they were investing in a bubble, matching the perception of most foreign observers.

  The A-share market has been cited, according to a standard calculation, as trading at a price/earning ratios of 70 times. Even worse, 30 per cent of earnings are alleged to come from investment income (that is, stock trading) - in effect, a giant Ponzi [pyramid] scheme.

  Combine the above with a reputation for questionable accounting practices, as well as the threat of $1,300bn of previously non-tradable shares becoming unlocked in the next two years, and it is no wonder that the A-share market is now off about 36 per cent from its highs.

  So is this correction just the first leg of the great unwinding? Not likely.

  In fact, it is hard to find evidence of a bubble at all. Take valuations: the benchmark CSI 300 index is now trading at 23 times 2008 consensus earnings forecasts. This is not cheap, but it is far from what we think of as bubble valuations and below its 10 year average of 30 times. How did we get from a multiple of 70 to 23 with a 25 per cent share price correction? First, bearish commentators were focusing on the smaller but more expensive Shenzhen market and looking backwards 12 months. Second, earnings grew 48 per cent in 2007 and the consensus forecast is for 32 per cent earnings growth this year.

  While 32 per cent seems like an aggressive number given the global slowdown, 7 percentage points come from a one-off tax break and a 25 per cent pre-tax growth rate may be achievable with a mid-teens nominal GDP growth rate - particularly when banks, oil and commodities are the main drivers.

  And what of all that investment income (which would presumably be turning into losses about now)? In fact, the 30 per cent figure was and is misleading as "investment income" contains all operating income from joint ventures and associates. Stripping those out, we found that only 9 per cent of non-financials income was generated by some form of asset revaluation.

  How much can we trust these numbers? More than 70 per cent of the CSI 300 market cap is now audited by the Big Four accounting firms using IFRS: the risk of accounting misadventures is now no higher than other emerging markets.

  The final issue supposedly dooming the A-share market is the unlocking of the non-tradable shares and the threat that the current holders of such shares will flood the market.

  Yet a quick glance at the A shares that have been unlocked since 2006 shows that only 10 per cent were actually sold into the market In fact, more than 75 per cent of the shares being unlocked belong to the government. That they would be sold down en masse is highly unlikely. A much more likely scenario is the one that the government itself gives - that it will control the issuance of supply to continue to foster a healthily developing market.

  Indeed, the increase of share supply is critical for a sustainable market. A shares have historically traded at high valuations because China's ratio of free-float market capitalisation to both GDP and savings remains far below other emerging and developed countries.

  In other words, there is not enough "supply" of shares relative to high "demand" from savers (especially given today's negative real interest rates). Both supply of and demand for shares are likely to rise rapidly in coming years, inevitably resulting in high volatility.

  Does any of this matter for international investors? With 72 per cent of the market cap of the MSCI China already dual-listed in Hong Kong and Shanghai (and the percentages rising monthly) the answer is yes. Hong Kong investors closely watch the price movements of the listed A shares and the recent correction in the A-share market has been an important cause of the MSCI China's underperformance relative to other emerging markets.

  While the A-share market may not yet be at a bottom, it can't be characterised as a bubble that is bursting.

When Are "Food Export Barriers" Simply "Protectionism"?

Despite the cracks in Alan Greenspan's reputation because of the credit bust and regulatory negligence he fostered, it's worth focusing instead on his repeated warnings against erecting barriers to trade. He frequently stated that a resurgence in trade barriers was the one poison he feared most. Today he reiterated those sentiments to the Senate Finance Committee, and how destructive it would be reverse the wealth-generating tide of the past two decades of trade liberalization.

If the rapid spike in food export barriers (part of what's been happening in the past couple of weeks) creates an even larger contagion of protectionism, ill-feelings, and tit-for-tat among nations than it already has, global economic prospects will quickly darken and become more volatile. This article on Asia Business Newswire today points how quickly the risk of protectionism is rising.

(It is also a reminder of how owning the food commodities and commodity-linked securities may become an even more important element in an optimal diversified portfolio.)

• Sydney, Apr 4, 2008 (ABN Newswire) - Across the developing and emerging economies of the world, and in some developed economies for that matter, governments are opting to shoulder some of the burden of higher food prices or try and control their immediate direction.
  
  The efforts are likely to be fruitless and very expensive for the countries involved, consumers and taxpayers.
  
  From India to Egypt governments are slashing import tariffs on foodstuffs and curbing exports, as well as boosting subsidies: all to try and ease the impact of what will be the big story of 2008 and 2009 - the soaring cost of food.
  
  As we reported this week, an exploding price for rice is the latest cause of much government action.
  
  Egypt, India, the Philippines, Vietnam, Indonesia, Cambodia, parts of Africa, Mexico, Italy, China, Russia, Argentina: the list is growing by the day of governments who now see the rising cost of food and all the social and political problems that brings, as far more important that good governance, low debt, the US recession, subprime debt or American foreign and economic policy.
  
  Even in the developed world the impact is startling. Biofuels in Asia, Europe and the US are withering because of rising costs for corn, canola and palm oil. Food riots have happened in Mexico over the cost of tortilla flour. Italians have protested about the sharp rise in the cost of flour for pasta and bread.
  
  Farmers are being blamed in some countries, such as Argentina and parts of Europe; in the US it's causing an explosion in land values and incomes in parts of the country that have been slowly withering away.
  
  The irony won't be lost on Americans that in the midst of a recession farmers and some of the biggest companies in the US (think Cargill and Archer Midland) will be booming, some with record incomes, and much of it (like Europe) subsidised.
  
  Longer term, however, the side-effects of this largesse will be ugly. Forgoing revenues and paying subsidies hurts national budgets.
  
  India, for example, spent $US600 million on rice and wheat subsidies in 2004-05. Given the surge in rice, maize and wheat prices since then, the cost could be up by a third to a half: something approaching $US1 billion, which a country like India can ill afford, even in the midst of its boom (which is slowing anyway).
  
  In the Philippines, the rice subsidy could top the half a billion dollar mark this year, according to the Asian Development Bank, and the country is scouring Asia and the US for around 1.5 million tonnes of rice at subsidised prices because its stocks have run down.
  
  Indonesia which is thinking of banning some rice exports, like China, India, Vietnam and Egypt, may have to pay $US2.2 billion in food subsidies this year, or around 3% of spending by the national government.
  
  That's three times earlier estimates.
  
  Nearby Malaysia is looking to boost rice imports and hitting a wall because the Philippines has been mopping up as much grain as it can get.
  
  Indonesia and many other countries in Asia also subsidise energy costs and they have skyrocketed with the rise in oil prices over the past three years.
  
  Indonesia is thinking of cutting rice exports, even though it will have a surplus this year of around two million tonnes (it imported just over 1 million tonnes in 2007).
  
  Soaring food and fuel prices are driving global inflation. Consumer prices in China hit an annual rate of 8.7% in February, an 11-year high, and reached a 13-month peak in India of 6.8%.
  
  World prices for rice, wheat, soybeans and corn have all increased sharply: rice and wheat prices have doubled in the year - rice is up 30% or more in a week....
  
  The World Bank said this week it considered soaring food and fuel prices as greater challenges to East Asian governments than the financial turmoil in the United States and slowing global growth.
  
  As we said yesterday, it's a similar outlook from the Asian Development Bank.
  
  "The major risk lies not so much in softer growth but in rising commodity prices and accelerating inflation,'' the Bank said yesterday. "Appropriate macroeconomic responses to accelerating inflation are likely to include tighter monetary policy and some exchange-rate appreciation.''
  
  "Indeed, published inflation rates disguise the true extent of underlying inflation pressures due to the presence of subsidies, administrative price controls and cuts in excise taxes," it said.
  
  The subsidies used by many governments in the region to cushion the impact of soaring fuel and food prices are posing a threat to budgets and the bank said that cash handouts to the poor may be a better and cheaper option.
  
  "If governments do not rethink these expensive and inefficient subsidy programs, fiscal costs could escalate sharply and require painful adjustments (or accelerating inflation, or both) later," the ADB said.
  
  "Carefully targetted direct income support for the poor, within strict budgetary limits, might better alleviate stresses, and at much lower cost."
  
  Saudi Arabia has cut import taxes across a range of food products this week, slashing its wheat tariff from 25% to zero and reducing tariffs on poultry, dairy produce and vegetable oils.
  
  On Monday, India scrapped tariffs on edible oil and maize and banned exports of all rice except the high-value basmati variety, while Vietnam, the world's third biggest rice exporter, said it would cut rice exports by 11%.
  
  In Argentina, farmers called off a protest against attempts by the government of President Cristina Fernández to redistribute the benefits of rising commodity prices by increasing export taxes on soybeans and other crops.....
  
  

Slight Increases in Equity Allocation This Week, But Still Underweight

As the "muddle through the credit crisis" hypothesis gained a bit more credibility this week, it made sense to boost equity allocations somewhat, though we remain partial to the underweight argument.

We've tried to raise equity allocations via gaining exposure to diverse major investment trends, including:

• Agriculture - Monsanto (MON) and Syngenta (SYT), two of the leaders in agri-biotech. We summarize the major trends here ("Allocation and Agriculture"). We're also watching two agriculture ETNs: iPath Dow Jones AIG-Agriculture ETN (JJA) and ELEMENTS Linked to the Rogers International Commodity Index - Agriculture ETN (RJA).
  
• Africa & Middle East (a broad fund with some "frontier" market exposure.) See our previous post titled Allocation and Africa.
  
• U.S. - Vanguard Total Stock Market ETF (VTI), a Wilshire 5000 Index tracker - Selloff provided a better probability of a long-term entry point.

We're looking for further opportunities in these areas, as well as some additional ones, such as:

• Water and Industrial Processes - Flowserve (FLS), a leader in pumps, flow control and other flow solutions; sells into a diverse industrial end-market. Suez SA (SZE) a France-based utility planning to separate its diversified global water business.
  
• Solar - FirstSolar (FSLR) may pull back after recent flare-up after CEO's comments that he is in project talks with several large utilities. We certainly believe him -- coal-fired power projects are coming off the drawing boards as expected carbon costs rise, nuclear projects aren't being added quickly owing to NIMBY, and oil/gas/hydro prices continue their uptrends -- but collaborations with utilities may take a while to develop.
• Genomics - Illumina (ILMN), a leader in genetic analysis. Find a brief description of this super-trend here: "New Technologies Spur the Race to Affordable Genome Sequencing," as well as the backdrop for a very long-term view here on combating the increasing risk of plagues using new antibiotics, genetic testing, and anti viral drugs.
• China (PGJ, consisting of 25 ADRs) - 40% selloff from peak provided a more fair discounting of the risks, which we've discussed in several previous posts.
• Energy - SPDR S&P Oil & Gas Exploration & Production ETF (XOP), Vanguard Energy ETF (VDE), or iShares S&P Global Energy Sector (IXC)
  
• Canada - iShares MSCI Canada Index (EWC)
• Brazil - iShares MSCI Brazil Index (EWZ)
• Education - ITT Industries (ESI), a well-managed company at a 40% discount to its peak, and up sharply today after Congress introduced a new student loan aid bill. Good summary of Education credit issue here.

Developing Markets' Inflation Beast Continues Growling

For two days we've cited anecdotes about how the Developing Economies' micro-mercantilist policies to address inflation aren't working, and won't engineer a soft landing (slower, less-inflationary economic growth rates). There will be financial crises along the path to slowdown, and that's why we're not raising our Developing Markets allocation from our current underweight.

Our post yesterday highlighted India and East Asia's widespread policies of limiting exports of inflationary goods (to retain more supply at home), and reduction of import taxes on those goods to encourage cheaper imports. We view these as potentially offsetting policies that don't address the root causes of inflation, namely the rapid growth in credit, currency manipulation in many Developing nations that artificially juices export growth and high import prices, and other policies. A previous post implicates Brazil, too.

Today, a WSJ article makes the same point about Argentina:

• The recent trouble [social unrest[ began not in Buenos Aires but in the provinces, where agriculture is the main economic activity. Farmers rebelled earlier this month when the government announced an increase in export taxes on agricultural products....
• Take, for example, soy beans. The new export tax will be raised to 44% from 35%. But since farmers also have to pay a 35% income tax on profits, the effective tax rate is significantly higher. "The farmer ends up paying essentially a 63% tax on gross income," says Pablo Guidotti, dean of the school of government at Argentina's DiTella University. If the price of soy goes up, Mr. Guidotti adds, the "retention rate" increases until the government can end up taking as much as 95% of any marginal increase in a farmer's gross income.
• In response to the tax increases, farmers have blocked roads in some 300 locations around the country, pledging not to allow their goods to reach markets. The effects of the action have been felt in the capital, where demonstrators have taken to the streets in sympathy for the farmers and against what they say is government arrogance. The strike is now in its third week.
• [President Cristina] Kirchner says the tax increase is a redistribution mechanism, suggesting that growers and ranchers have to be forced to share more of their good fortune with others. But the greater motivation behind the export-tax increase is inflation.
• This government, it seems, will do just about anything to reduce inflation except the one thing that would solve the problem: Let the peso strengthen. It has imposed price controls on businesses; frozen, and then subsidized, energy prices; and prohibited the export of beef. Last year it fired the director of the government's agency for inflation data because she refused to fudge the numbers. Even so, prices rose by an estimated 20% in 2007 and expectations for this year remain high. This would explain the new round of confiscatory export taxes. By discouraging farmers from sending food abroad, the government thinks it can increase food supplies inside the country and damp prices.

To repeat from our post last night:

This is a big reason why we're not adding to our Developing Markets weighting now, and it's also a reason why we're waiting-out the dollar weakness rather than piling-on the shorts. As instabilities and unsustainable policies within Developing Market economies become more apparent (very very soon), the dollar will give more reassuring signals. Financial seizures within Developing Markets will, we continue to believe, signify "the beginning of the end" of the global financial crisis, and a buying opportunity for equities worldwide.