Boeckh Investment Letter

Excess liquidity will continue to act as a tailwind for equities, commodities and non-dollar currencies well into 2011. Deflation will dominate in the short term; the inflationary threat is probably further away than most investors expect. Gold is expensive relative to the inflationary outlook. Fixed income markets are heavily influenced by government intervention. While it is likely that continued intervention will succeed in depressing bond yields below market levels, even a modest increase in inflationary expectations would undermine these actions. We recommend shortening duration.

This special report by George Magnus, a senior economic advisor at UBS Investment Bank, takes a look at some key economic and investment issues regarding emerging markets and China. Magnus, who has just completed a book on emerging markets, argues that while EMs have boomed in recent years, there are a number of unresolved problems which suggest the past may not repeat, and investors must be careful.

Proponents of gold base their arguments on predictions of eventual monetary ruin, a dollar collapse and high inflation. The bond market, however, is far bigger and more sophisticated than the gold market, and it indicates that inflation expectations are nonexistent. Bond yields are far below their long-run equilibrium levels and if anything, are forecasting deflation and possible stagnation. The huge disconnect between gold and bonds should serve as a reminder to gold bulls to tread carefully, unless they are sure that the bond market has it wrong.

That the U.S. is in a dangerous debt situation is hardly a secret. Yet nothing will be done about it any time soon. Politicians, now back from their holidays, are focused on securing reelection. Republicans are moving further to the populist right. Cutting deficits has once again taken a back seat to spending and minimizing taxation. There is a rapidly escalating Greek-style debt-to-GDP scenario unfolding, along with all the consequences that go with it.

Capital preservation is of critical importance in this volatile, highly uncertain world. Within that conservative context, Boeckh has been relatively bullish on risk assets. The time has come to add another layer of caution to portfolios. The S&P 500 may well remain in an extended trading range, but we may be much closer to the upper boundary than the lower. Seasonally, we are heading into a period when markets tend to be weak, and some important declines have occurred.

Slow growth, high unemployment and weak inflation will keep interest rates very low in the short term. Rising government debt levels and heavy reliance on monetary ease from the Federal Reserve, however, suggest rising risks of price inflation later on, possibly much later. The current period of low long-term interest rates should thus be thought of as an extended base-building period for higher rates down the line. Investors should maintain a diversified portfolio, shifting equity exposure to defensive, non-cyclical sectors, and build positions in cash and safe sovereign debt.

This commentary features a piece by Brian Reading, former advisor to the Bank of England, former economics editor of The Economist magazine and founding partner of Lombard Street research service, on what should be done about massive fiscal deficits and spiraling debt-to-GDP ratios. Reading argues that no amount of exchanging domestic imbalances within the U.S., UK and other deficit countries between the public and private sectors can prevent a resumed recession. The prerequisite for sustained global recovery is increased consumption in Eurasia and a reversal of payment imbalances.

Economic recovery in the U.S. and elsewhere has slowed rapidly and forecasts are being downgraded accordingly. The massive stimulus packages stopped a self-feeding downward spiral, but they have given us only an artificial recovery. Government tax revenues will be disappointing and expenditures will remain elevated. A fragile economy, however, should not push investors away entirely from risk assets. High levels of risk and uncertainty argue for continued focus on wealth preservation and sound diversification.

This letter contains a special feature by George Magnus, senior economic advisor at UBS Investment Bank, on the coming negative change in global demographics. The world population is aging rapidly and the proportion of retired to working people is rising sharply. While these are slow-moving forces compared to, say, banking crises, they are powerful and inexorable trends that cannot be 'fixed.' Rather, we, and governments, must adjust to them, and investors must pay attention to their complex investment implications.

This commentary provides an asset allocation framework for investor?s portfolios that reflects our macro view, concerns about the general riskiness of the financial world and a variety of issues that go into the asset allocation process. In general, we continue to be positive on risks assets in the context of our continuing focus on wealth preservation and diversification. Probabilities favor a recovery in stock and commodity prices rather than an extended bear market.