….in a far away land (USA), a group of Federal Reserve board members became hopelessly lost in a jungle of economic data. As they thrashed about endlessly, they stumbled upon a cabin. Upon entering, they spotted three bowls of economic porridge on the kitchen table. The first bowl of economic porridge was toooo hot (China). The second bowl was toooo cold (France). However, the third bowl was just right (could that be the USA?). After nine consecutive quarter point increases in the Fed funds rate, it would seem like we have reached that magic “neutral” level in rates. In spite of a tripling of short-term interest rates and a doubling of the price of oil, the economy is perking along at a 3.8% growth rate (first quarter GDP), and unemployment remains a low 5.0%. In addition, tax receipts are up and the projected federal deficit keeps dropping. What’s not to like? If it’s not broke, don’t fix it.

Deja vu all over again? In the 1980s it was Japan that was going to buy up America. Now it is China’s turn. They have already bought the personal computer business from IBM and are on the verge of employing the not-so-busy Maytag man. The biggest foray, however, is one of China’s biggest oil firms, the China National Offshore Oil Corporation (CNOCC), attempting to purchase Unocal for $18.5 billion. As this is a state-owned company, they have unlimited access to funds to outbid Chevron which made the initial bid of $16.4 billion. This has Congress up in arms, not to mention Americans in general, as the perception is that this purchase would severely crimp our oil sources. On the surface this would appear logical. Under the surface several other factors appear.

About 70% of Unocal’s oil and gas reserves are close to Asian markets. The majority of these Asian reserves is gas and is mostly committed to long term contracts. CNOOC has partnered with other oil companies in the past to explore for oil, most notably with Chevron to participate in a project in Australia which would supply gas to both China and the US. This is simply a business decision, and Chevron will have to step up to the plate if they expect to play in the international marketplace. More importantly perhaps are the political implications. Taiwan comes to mind and the fact that if China wants to play in our back yard, they will have to play fair. Ties between the two countries are strengthening and should be beneficial to both sides, and it’s not just China. We need cooperation from all countries so that everyone is able to join the global establishment. Nationalism will not be good at this time. There are many challenges to be met today - the spread of nuclear weapons, diseases, drugs, and terrorism to mention a few. Working together will raise the standard of living across the globe.

Are we still in the throes of deflation? The Fed thinks not as they continue to raise interest rates to fight inflation. Bond traders are not so optimistic about the economy. Their argument being that a weakening economy brings lower long-term interest rates because it reduces demand for credit and inflationary pressures. We continue to believe the economy is just right. However, we may be in the final stages of a long-term deflationary cycle that began in the early 1980s. This cycle may have been extended by the rise of the Chinese economy and the quantity of cheap goods being produced there.

The next bear market? In China’s effort to be the manufacturer to the world and their attempt to reach higher employment levels, they are creating an oversupply of products. Their economy is already showing signs of weakness. A pause here would be healthy for them and the rest of the world.

Random thought for July 2005:
“An appeaser is one who feeds a crocodile hoping it will eat him last.”
- Winston Churchill

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