Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. China Offers U.S. the Sincerest Form of Flattery. The world is truly mobile. Cars, trains, planes, phones, texts, video all connect the world actually or virtually. You can be there, or almost be there, with a similar visceral feeling. But as news events stream off the wire and markets respond, I would still prefer particular places and spaces that are my true domain versus a substitute (such as an office in an airport lounge, or wireless connection at a hotel).

Gathering resources and organizing decisions can be done remotely, but should as often as possible be done from a dispassionate and quiet place. This is all preamble to the sense I had this past week as the Chinese raised rates. Many thanks to James Chanos for his candor and insight on China.

In a seemingly causal reaction, silver and gold slipped along with the markets as they digested the newswire data: “25 bps higher as the Chinese take the market by surprise.” Causal? Anything but. What we witnessed was several markets reaching inflection points and needing a catalyst to move them on in their short-term trends – or, alternatively, to reverse course.

Reverse course they did. The dollar jumped like a patient zapped by a defibrillator. Gold and silver plunged along with the Dow, which saw greater than 90% of all volume on Tuesday as liquidation. What does it mean? Do the Chinese now hold life and death in their hands, and determine the direction of all markets?

While we can only venture guesses on the meaning of market action, we can clearly say that the Chinese are not in control. The correlation is spurious and the turning points merely coincidental.

The Chinese have an inflation problem. Raising rates (as modestly as a ¼%), may be the first of a series of measures to try to deal with a dollar-driven inflation problem. Frankly, the problem is anything but unique to China, as other countries around the world also maintain dollar pegs. As we in the U.S. debase our currency, it forces dollar-pegged currencies to devalue in lock-step to maintain the peg.

The unfortunate reality is that, as rates rise in a ZIRP world (zero – or nearly zero – interest rate policy), affected currencies gain attractiveness, which can set off a cycle of asset and currency inflation as hot money comes in from the income-starved investors of the U.S. and Japan.

This brings me to the main event in China. The current regime is split between the central party, which prioritizes the conservative approach of the five-year planning cycle, and local party officials, who have found the opportunity to create fortunes harnessing other people’s money in land-development schemes.

These lower-ranking members of the party are creating opportunities through LGFVs, or local government funding vehicles. These are the equivalent of the structured investment vehicles (SIVs) and special purpose vehicles (SPVs) set up by banks in the 2005-2007 period here in the U.S.

Many in the central party believe 25-50% of these LGFVs to be losers from the start. Nevertheless, these development projects, once funded, can be repackaged as trusts (from original loan status) and sold to retail investors. The investments that are not or cannot be repackaged are held off-balance-sheet by Chinese banks, at least until 2011.

These are games we’ve already played in the West. A property bubble is present in all China’s coastal cities, not unlike ours (although we’ll build a house on any other available patch of sand as well – think Arizona or Nevada). Last year alone, 5.8 billion square feet went into development in China, with vacancy rates already spanning 12-17% in major cities, and rising. Construction spending is equal to 60% of GDP.

Here I thought China had an export-oriented economy. As it turns out, the appetite for commodities there is feeding a building frenzy (skylines of high-rise condos look strangely familiar). That is great news for Australia and Brazil as long as the bubble grows. But, should it pop … the noise will be heard and felt around the world.

The underlying issues remain the same. Global inflationary trends are present in the face of monetary policy makers doing all they can to get the global and local economies back into full swing. Neglected is the fact that “full swing” was an artificially high status, and truly a high-water mark moment in trade and cooperation.

Gold and silver continue to garner interest from individuals across the globe concerned about the unintended consequences of policies instituted in major capitals. The dollar, bouncing from electric shock treatment, remains moribund – if not already terminal. And the G20 leaders pretend to understand the issues of our day and prescribe solutions, which time and again remain merely prescriptions or morph into dissolutions.

You might think we are saying, “the more things change, the more they remain the same.” But things are changing. The asset-preservation and profit equation exists for those that see the changes and align themselves accordingly.

This year should finish with a bang. Perhaps that bang will be the popping of the Chinese real estate bubble or the U.S. bond bubble – or a cork, as we see gold rise toward inflation-adjusted highs and we toast the new year with curiosity regarding what 2011 will bring.

2. What Will the Fed Opt for? We are bankrupt as a nation even as I write. The only question the Fed needs to address is: How fast does it want the necessary currency, economic, and fiscal adjustments to manifest themselves? Promoting hyperactivity in commodity prices, as it has done in the last several months, would lead to a rapid deterioration in economic conditions, which would for all intents and purposes be unfavorable for all.

Instead, we suggest the Fed opt for a more “balanced deterioration,” and therefore waive a massive QE2 effort. The reduction of $4.693B in the Fed’s balance sheet (ending Wednesday), the Chinese interest rate hike, and the near 50% dissention among Fed governors may be an early indication of this change in perception that now rules Wall Street.

At the next FOMC meeting on Nov 3rd, we will find out whether QE2 is in fact a done deal. As we discussed last week, we are of the mind that Wall Street has taken Fed policy too far, forcing a swath of commodity prices to all-time highs. To the average eye, all things have done well to some degree, whether stocks, bonds, or the emerging markets. However, this is a relative game; no economy has done well when commodity prices have outpaced productive assets for a sustained period of time.

Judging by this round of earnings reports from JPM, Citi, and BofA, the banking sector is still floundering, as there appears to be no revenue growth. Profits, if any, are due to accounting reversals, such as loan loss reserves. One would think that massive Fed monetization of bank Treasury holdings would have found its way to lending, but it hasn’t. Instead, that money is headed into the markets in the form of speculation.

Now, if the banks know they aren’t lending, they also know the economy isn’t going to produce meaningful growth. And if there is no growth, then perhaps a commodity, especially one excluded from economic activity, makes sense to own – or so goes the theory.

The problem though, is that this appetite for commodities can become self reinforcing; Fed easing leads to higher commodity prices, which leads to further economic declines, which leads to more Fed easing, and so on and so on. Unfortunately, there is no real solution to our economic and fiscal condition, unless we reverse time and prevent the manias from happening in the first place.

Have a wonderful weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO