The sharp decline in US equity prices during the past few weeks reflects a convergence of several negative factors. The US banking system is still experiencing a large rise in non-performing loans which will create major capital adequacy problems next year. The rise in oil and food prices is producing an upward spiral of global inflation which now poses a greater threat to prosperity of the developing countries than the US recession. The opinion polls are suggesting that the Democrats could win such a convincing victory in both the presidential and congressional elections that there could be a major reversal of the Bush-era policies that were benign for taxation of capital income. The odds are increasing that high inflation and falling house prices could finally trigger a downturn in US consumer spending during the autumn large enough to tip the economy into a recession.

CONTINUED HOUSING PROBLEMS HURTING BANKING SECTOR

The IMF produced a report two months ago estimating that ultimate losses on US property loans could be just under one trillion dollars. Financial institutions have now written off $400 billion of subprime loans. The new data on loans delinquencies suggests that US banks could lose another $200-$300 billion during the year ahead. As the total equity capital of the US banking system is $1.35 trillion, the pending loan losses suggest that many banks could fail and that others will have to significantly dilute their share holders by raising new capital under adverse circumstances. It should not be a surprise that US bank stocks have fallen 27% this year compared to 13% for the S&P 500 or that banks on average now sell for 96% of book value. While the stocks appear to be oversold and could have a technical rally, there is unlikely to be a bottom in the sector until mid-2009.

The latest data from US banks about non-performing loans indicates that asset quality is still deteriorating. The American Bankers Association announced last week that the share of home equity loans now delinquent is 1.1% or the highest since the series began in 1999. The dollar value of delinquent loans is even higher at 1.65%. The June data on mortgage delinquencies is also alarming. The share of home mortgage loans 60 days past due is now 39% for subprime adjustable rate loans, 11.6% for fixed rate subprime loans, 15.5% for variable rate Alt A loans, 6.8% for fixed rate Alt A loans, 2.2% for variable rate prime loans, and 0.9% for prime fixed rate loans. All of these delinquency rates are several times higher than they were one and two years ago. Banks are also experiencing problems with loans to developers. There is now a default rate of 10.8% on $264.4 of loans to residential developers and 3.6% on $280.8 billion of loans to commercial developers. The default rate on $41.3 billion of condo loans is 13.6%.

THE MONETARY CONSEQUENCES OF HIGH GLOBAL INFLATION

The upward spiral in food and energy prices is now threatening to undermine the resilience of the developing countries which have been global growth leaders since 2003. In recent weeks, the central banks of South Africa, Mexico, Brazil, the Philippines, Peru, Chile, Taiwan, Turkey, and other countries have had to raise interest rates in order to restrain inflation. The growth rates of most developing countries had remained at high levels during the first quarter but rising prices for food and oil coupled with monetary tightening will now erode their momentum during the next few quarters.

The markets are very anxious about oil prices because no economist has been successful at forecasting them this year. The International Energy Association produced a new forecast last week suggesting that global oil demand will rise by 0.9% this year and 0.87% next year despite weakness in US gasoline consumption. The IEA then expects demand growth to accelerate to 1.46% in 2010, 1.55% in 2011, and 1.64% in 2012. In this scenario, OPEC’s spare capacity will rise to 5.28 million barrels in 2010 from 2.82 million barrels in 2007 and then decline back to 2.02 million barrels in 2013. The IEA said that oil prices were high because of fundamental supply and demand, not commodity speculators. The projected increase in OPEC’s spare capacity during the next two years suggest that there is a reasonable possibility that prices could correct later this year or next year. But the IEA data suggest that prices will rise again to new highs in three or four years.

THE POLITICAL OUTLOOK IN THE US

The opinion polls in the US have increased the odds that the Democrats could win a landslide election victory this autumn. Mr. Obama now enjoys a double digit lead in some polls. Most pollsters think that Democrats will win 20 new house seats and at least 3-5 Senate seats. Some even think they may be able to gain the 9 seats necessary for complete control of the Senate.

THE PROPOSED TAX POLICIES OF THE TWO CANDIDATES

The markets should be very concerned about the election because the Democrats want to reverse many of the Bush tax cuts which boosted equity prices after 2003. Mr. Obama wants to raise the 15% tax rate on dividends and capital gains to as high as 28%. He wants to raise the top marginal income tax rate back to 40% from 35%. He wants to eliminate the income cap on social security taxes for people who earn over $250,000 per annum. If the Congress were to enact all of his proposals, the top marginal tax rate on high income US citizens would rise from 43-44% to 53-54% or over 60% if state taxes are included. Such tax rates would rival those of Scandinavian countries such as Sweden and Denmark, which are the highest in the world. The Democrats are also advocating a windfall profits tax on the oil industry while opposing Republican proposals to allow drilling on the continental shelf. The Democratic proposals could add to upward pressure on oil prices by reducing US oil production over time. The McCain program would be more benign for the equity market because he would attempt to protect the Bush tax cuts and reduce the corporate income tax rate to 25%. The US corporate tax rate is now the second highest in the world after Japan. As the Democrats will control Congress, it will probably be impossible for Mr. McCain to protect all the Bush tax cuts. He will probably have to accept a hike in the top marginal income tax rate to 40% as part of a larger deal to protect the tax cuts for middle income people. But if the Republicans retain more than 40 Senate seats, he might be able to prevent Democrats from raising the social security tax or capital gains tax.

What remains unclear is whether Mr. Obama will favor so many tax hikes if he actually wins the election. He has raised a great deal of money from wealthy people as well as hedge fund tycoons. His tax program would impose a heavy burden on such people. He also named as his economic coordinator last week, Jason Furman, of the Brookings Institution. Jason’s research program at Brookings had been funded by Robert Rubin. His appointment suggests that Mr. Rubin as well as Lawrence Summers could have a major role in shaping the Obama economic policy next year. While Mr. Rubin supported the Clinton tax hikes on high income people in 1993, he might be reluctant to impose as many tax increases as Mr. Obama is currently advocating, especially if they could produce a large stock market correction. The outlook for Mr. Obama’s economic program should therefore be regarded as tentative. He will certainly raise taxes on high income US citizens but it is unclear by how much.

The Tax Policy Center has recently produced a study of the Obama and McCain tax programs. They found that under current tax policy, the tax share of GDP would fluctuate between 18.3% of GDP and 18.0% during the period 2010-2018. If the Bush tax cuts were allowed to expire, as now scheduled, the tax share of GDP would rise to 19.4% of GDP in 2011 and over 20.0% of GDP by 2017 from 18.9% in 2009.

The McCain program would reduce the tax share of GDP to 17.9% in 2010 and 17.8% in 2013. The Obama program would reduce the tax share of GDP to 18.2% in 2010 and allow it to rise back to 18.4% of GDP in 2012. The total difference between the two candidates would be about 0.5% of GDP during the period 2009-2018. But there would be significant differences in the distribution of the tax burden. Mr. Obama would attempt to lower taxes for people earning under $50,000 per annum while raising taxes on people earning over $250,000. The Democrats perceive that increases in marginal income tax rates will be popular because of widespread resentment over high CEO salaries and the extravagant lifestyles of some prominent Wall Street personalities.

THE US ECONOMY CONTINUES TO TREAD WATER

The latest US economic data confirms that the economy is still growing at a sluggish pace. The purchasing agent index rose to 50.2 in June from 49.8 in May. The purchasing agent survey confirms that the export sector is still sustaining modest output growth in the US manufacturing sector. The May orders data further reinforces this fact by showing that unfilled orders in the durable goods sector rose to $810 billion last month from $706 billion one year ago. The biggest gains were in orders for transportation equipment (+$81.7 billion), machinery (+$15 billion), and computers or electronics products (+$5.5 billion). Firms which do not have a significant export business are far more pessimistic about the economy. The NFIB small business survey, for example, hit a 28 year low during June because of pessimism about the economy and inflation. Small firms plan to reduce their hiring, capital spending, and inventory. The number of firms planning to raise

prices rose to 38% or the highest level since 1981. The number of firms saying high inflation is their most serious problem also rose to 17% from 8% or the highest reading since 1981. The economy continued to lose jobs during June for the sixth month in a row, but the rate of decline continues to be less severe than in past downturns. The economy has been losing jobs at a monthly rate of 73,000 or 0.6% per month. This rate of decline compares to 1.9% during the eight months of the 2001 recession, 2.2% during the eight months of the 1990-1991 recession, and 2.3% during the sixteen months of the 1981-1982 recession.

The recent uptick in the level of unemployment insurance claims suggests there could be larger job losses during the next few months. The unemployment rate could therefore rise into the 6.0-6.5% range by the fourth quarter. In June, it rose to 4.3% from 4.1% for people over the age of 25. The good news is that the weak labor market is restraining wages. The rate of growth in wages slipped to 3.4% in June from 4.1% one year ago or the slowest pace since 2005. It is essential that firms restrain wages because the cost of commodities is rising sharply. The June purchasing agent survey showed that the prices of manufacturing inputs shot up to 91.5 from 68.0 one year ago and was the highest reading since 93.1 in July 1979.

Most analysts have been surprised by the willingness of the households to spend the tax rebates they started receiving six weeks ago. Wall Street is now projecting that real consumer spending could rise by 2.0% during the second quarter. But the risk is high that consumption could falter during the autumn after households have spent the tax rebates. The growth rate of compensation during the past three months has been only 3.2% while inflation is rising into the 5.0-6.0% range. The success of firms restraining wages and protecting profit margins has greatly increased the vulnerability of consumer spending to negative real income growth at a time when households are also experiencing capital losses on their most important asset. The weakness of real income growth creates the possibility of the economy experiencing a double dip during the fourth quarter. If firms also become cautious about capital spending, there could finally be a contraction of real GDP.

GLOBAL CENTRAL BANK UPDATE

The European Central Bank raised interest rates last week because the European inflation rate has risen above 4.0%. But Mr. Trichet attempted to dampen expectations of further tightening by saying that “from here, I have no bias.” His comments reflect the fact that European economic data has slowed sharply after a robust first quarter in Germany. The ECB decision to tighten was also criticized by several governments (France, Spain, and Italy). The ECB is independent and will always attempt to demonstrate its independence, but it cannot ignore the fact that European economic growth is likely to slow to the 1.0-1.2% range this year from over 2.0% last year. Many analysts believe that European growth could be weaker in 2009 than during 2008.

Japan is also unlikely to change its monetary policy this year. Recent data suggests that Japanese growth is slowing while the uptick of inflation is being greeted as a sign that deflation is finally over. The greatest risk of monetary tightening is now in the developing countries suffering from large increases in oil and food prices.

IRAN RISK TO OIL MARKETS RISES

One of the factors which has boosted the oil price is investor concern over a potential US or Israeli attack on Iran. Israel recently engaged in a large-scale air force maneuver which was thought to be a rehearsal for an Iranian attack. Most probably in response, the BBC reports today that Iran has claimed that it test-fired nine missiles capable of reaching Israel, including a new version of the Shahab-3. There is a policy debate going on in Washington. Some senior US officials have recently described Iran as an existential threat to Israel and suggest that Israel

has the right to launch a preemptive strike. At the same time, Secretary of State Condi Rice has been discussing increasing the US diplomatic presence in Tehran. Currently, the Swiss Embassy houses a “US Interests” section, but a $42B natural gas deal between Switzerland and Iran has irritated the US and the Israelis. The Swiss response was that Israel has been importing Iranian oil for years. And an amusing fact: the US increased its exports to Iran tenfold under George Bush. Tobacco leads the list of US exports approved by the current administration.

CHAIRMAN BERNANKE’S LIMITED OPTIONS

The vulnerability of the US economy to rising inflation suggests that the Federal Reserve is likely to leave interest rates unchanged for the balance of this year. The Fed chairman, Mr. Ben Bernanke, has taken a harder line about inflation in recent speeches but he will be reluctant to tighten at a time when unemployment is still increasing and the banking system is confronting a large increase in non-performing loans. Some analysts have suggested he should tighten in order to bolster the dollar but Mr. Bernanke is an economic historian who knows about the history of linking monetary policy to the exchange rate. In September, 1931, the Federal Reserve responded to the devaluation of the British Pound by hiking money market yields from 1.5% to 3.5% in order to reduce gold outflows from New York. Many countries devalued with Britain and the markets feared the US might join them. The decision of the Fed to defend the gold value of the dollar tightened monetary policy at a time when many banks were failing and thus worsened the Great Depression. Roosevelt then reflated the economy by devaluing against gold in 1933. As Mr. Bernanke has written extensively about the monetary policy errors of the 1930′s, he will not raise interest rates to protect the dollar at a time when the US banking system is experiencing a large increase in bad debts.