During Armored Wolf’s recent Third Quarter 2010 Forum, one discussion topic focused on the United States – enquiring whether its recovery from recession was stable, based on the internal components driving growth. This question obviously is intimately intertwined with the sustainability of funding the Federal fiscal deficit and there being sufficient demand for more US dollar assets in the portfolios of our foreign creditors.

While not yet officially validated by the National Bureau of Economic Research (those charged with doing so), the US recovery seems to have begun about one year ago. Quarterly GDP numbers, post‐revision, reveal a fairly strong initial rebound in growth during H2 2009, despite what now seems to be a deceleration during H1 2010. Most recently, Q2 2010 GDP registered an underwhelming +2.4% growth rate, significantly less than the robust +5% as recently as Q4 2009. Preliminary component data for Q3 suggests that GDP growth will continue to decelerate in this quarter.

Essentially, we believe the V‐shaped recovery that investors hope for and have largely priced into the US equity market is now losing steam, with the policy stimulus from both fiscal and monetary policy fading and the structural headwinds to growth remaining stubbornly immovable.

Unlike Europe, the United States continues to pursue profligate fiscal policy; the $1.47 trillion Federal deficit this year is expected to remain about the same next year between 9% to 10% of GDP. With slumping tax receipts due to the still weak economy, this requires the US Treasury to borrow about 41 cents of every US$1 it spends.

Congress seems unlikely to grapple with the issue until after mid‐term elections. With new taxes embedded in the recent ObamaCare law and the Bush tax cuts set to expire, current fiscal policy, despite the untoward size of the deficit, is set to generate a negative fiscal impulse next year, barring a pro‐active adjustment by Congress. It remains somewhat uncertain whether the new landscape in Congress after the mid‐term elections will have the appetite for another major fiscal stimulus package. However, even if fiscal policy tightens somewhat as a result of inaction, there seems little appetite by US policymakers to embark upon a fiscal consolidation policy similar to the Europeans.

Monetary policy in the US remains easy as profiled by the Fed’s near‐zero interest rate policy, its current $2.3trillion balance sheet (having grown about three‐fold) and its widely anticipated intention to pursue QEII should risk‐asset markets meltdown or should there be further evidence of a deceleration in growth. So the policy mix in the US is quite different from that of Europe. There seems surprisingly little concern in the US about running fiscal deficits at around 10% of GDP and certainly no political appetite to target the fiscal consolidation goals akin to those like Europe’s 3%.

While monetary policy currently looks similar on both sides of the Atlantic, the future intentions of the Fed and ECB seem more dissimilar. The power of the “doves” in the Fed is growing, particularly with Janet Yellen’s likely imminent appointment as Vice Chair of the Board of Governors. This suggests that it is a 4 question of when, not if, for QEII. Moreover, one has an uneasy sense that the magnitude of another round of quantitative easing may ultimately dwarf the historic first round of QE, assuming markets allow it. Any attempt at QE‐lite is likely to be thwarted by the markets.

There are plenty of structural impediments to re‐attaining trend GDP growth in the US: tight credit markets, consumer de‐leveraging, weak state and local fiscal health, rising home foreclosures, stubbornly high unemployment and a weak recovery in job creation and personal income. Perhaps the one we find most disturbing is the continuing collapse of credit.

The fractional reserve banking system is not currently functioning as it should. Certainly, the 25bps paid by the Fed to the banks for their $1trillion of excess reserves on deposit is an impediment to credit growth. In addition, we believe there is an active credit crunch and perhaps even a liquidity trap both at work, as banks slowly work off the bad assets on their balance sheet and as consumers continue to de‐lever. Since all these structural impediments will take some time to resolve and will impede the economy’s trajectory back to trend growth, this anchors our belief in the likelihood of another stimulus package and the certainty of another round of quantitative easing by the Federal Reserve.

The biggest uncertainty for the US economy is not the intended policy mix going forward, which will undoubtedly be loose, if not profligate fiscal policy and another burst of monetary ease. The latter will be accomplished by maintaining low policy rates, a removal of the rate paid on deposits of excess reserves and perhaps most importantly the purchase of more securities in the open market, once again ballooning the Fed’s balance sheet. These we believe are virtually certain; it is simply a question of timing and perhaps the trigger. What remains less certain is how the risk markets and foreign investors will react to these policies.

With break‐even yields below 2% and rising home foreclosures set to beat those from 2009, there is clear evidence of deflationary forces. As mentioned, credit growth remains negative; to us this is the definition of deflation. Weak price levels are really only a symptom. Yet the current monetary policy team headed by Dr. Bernanke views deflation as the ultimate scourge, thus confirming our view that QEII is a certainty.

Unlike the Japanese experience of the past two decades that has more differences than similarities to the current US situation, we believe ultimately the Fed will be successful in igniting the velocity of money and creating inflation. It seems clear that the banks are reticent to aggressively recognize all the dead weight losses embodied in a significant share of mortgages and other debts on their balance sheets and policymakers in Washington unfortunately seems loathe to force them. It also seems unlikely that we simply grow our way out of this leveraged mess. Therefore, inflation is the only way out from these huge debt levels.

So we see the road to inflation via the alley of deflation. We believe the trigger for QEII is likely to be further evidence of slowing growth, no rebound in credit expansion and further house price deflation. Whether this “slow” trigger is the catalyst or if the risk markets, discounting this scenario, become the “fast” trigger remains to be seen.

We see little value in US Treasury notes with yields at current levels. This is not to say they cannot go lower in the short‐term, however, there is no long‐term value here. We see a more nuanced picture with US equities.

Those companies, mostly blue chips and multinationals, which still have access to bank credit and the capital markets for finance and can target the bright spots in global growth (largely Asia and emerging markets), have been able to not only improve margins but also grow the top line. Other companies have found it more difficult either due to being credit constrained or facing weak final demand in their markets. Thus, whilst corporate profitability has “recovered” we view a growing disconnect between Wall Streets analysts’ rosy forecasts of forward operating earnings and a dichotomous economy that is again slowing.

We prefer to look at other parameters such as cyclically adjusted earnings (for example Shiller’s 10‐year average of net earnings) or average dividend yields to value the US equity market. Using these measures, US equities are considerably overvalued. While that makes us cautious, we also acknowledge the wall of liquidity in the system, which is not being used to extend credit as per normal, however seeks risk assets in its increasingly desperate search for yield. So at the moment we remain neutral with a bearish tilt on the outlook for US equities with a keen awareness that the fully priced market could well suffer once further deflationary forces become evident. We expect US equities to continue to set the tone for global equities, particularly those in emerging markets. While we observe strong fundamentals throughout most of EM, “real sector” decoupling, for the most part, does not translate into financial‐asset market decoupling.

Our biggest concern about the imminent QEII is it impact on the US dollar and to a lesser extent US Treasury yields. The Fed’s attempt to keep deflation at bay and smooth out the business cycle has been their goal since the institution was established in 1913. Largely as a direct result, the US dollar has been secularly weak and cumulatively lost around 90% of its purchasing power since then. We believe QEII will further erode the US dollar’s value. The response of US Treasury yields to QEII is less certain. Whilst one would believe the yield curve should steepen, there will be countervailing forces. The Fed may well target US treasury yields during QEII, trying to affect term interest rates and keep yields modest. It is also quite plausible that QEII will involve larger, perhaps even much larger, amounts of monetization of the fiscal deficit, ultimately with the same objective. Should this unnerve investors, particularly those with either large holdings or significant purchases of new issuance, the Fed may find it difficult to “cap” rates. We would be in trouble if the markets lost confidence in the Fed.

Our view of a weaker secular US dollar is the reason that we believe most commodities, particularly precious metals, crude oil, other energy, foodstuffs and certain base metals will be a very good store of value once QEII is launched. The weak US dollar outlook also attracts us to many EM currencies particularly those of resource‐exporting countries like Brazil, Indonesia and Chile, for example. Also any EM companies that mine or produce the above‐mentioned commodities are attractive.

While we believe the US economy will eventually return to trend growth, the current policy mix is not optimal and probably relegates the adjustment program to the slow lane.