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Dashing the optimists' dreams

China's reserves and purchases of US treasuries
Annualized monthly change ($bn)

We enter the year to a deafening beat of bullishness. The long rally since the lows of March last year has brought US and European equity prices back to 70% of their peak in March 2000. Optimism rules and the consensus is for further upside in 2004.

By mid-year, though, I reckon the message will have changed. Why will this happen?

First, globalization is continuing to destroy corporate pricing power in the US and Europe. Deflationary forces will persist. Indeed, I don't expect the Federal Reserve or the European Central Bank to raise rates this year.

Second, the consumer debt bubble in the the US, the UK and Australia is set to burst. So central bank liquidity injections will deliver diminishing returns. Global economic expansion will disappoint and, with it, corporate profit growth.

Third, the dollar will continue to weaken as foreign funding of US deficits declines, threatening to drive up US treasury yields and destroy the equity rally.

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