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There are two major trends in place that set the stage for world economics in 2011. The first is China’s continued rise.

Although the U.S. remains the most powerful economic force on earth, China will soon be replacing Europe as the second most powerful economic force. China’s power is not built on sheer size alone: indeed, China’s statesman-like behavior during the current economic crisis in U.S. and Europe has highlighted its maturity and greatly enhanced its image. China’s willingness to bailout Europe and the U.S. through the purchase of bonds is a sign that they are preparing themselves to take the next step in becoming the world’s second most powerful economic force. Within 20 or 30 years they may even eclipse the U.S. but they must make many more correct decisions before that takes place.

The second major trend going into 2011 is the rise of inflation.

Inflation is already a problem in the emerging world as demand for better diets and more goods and services have pushed prices up. This inflation is gradually being exported to the developed world, which will experience greater inflation in years to come.

Prediction #1 — China Demand Will Be A Key To Global Growth In 2011

Most of the popularly accepted predictions about China were wrong in 2010. We expect this to be the case again in 2011. In 2010, many predicted that Chinese exports would be slow. Actually, export growth showed a 30% increase. Predictions of 6% GDP growth turned out to be too low. China’s GDP grew about 10% in 2010. Predictions of low growth of commodity imports into China were also too low. Commodity imports turned out to be increases of 10% to 40% depending upon the commodity (coal, copper, iron ore, etc.).

In 2011, China will continue to import massive amounts of goods, especially raw materials (coal, copper, iron ore, gold, nickel) and foods (wheat, corn, soybeans, and rice). We expect China’s GDP will grow at a rate of about 9% or 10% in 2011, not the much lower rate that uninformed pessimists are predicting. Rises in interest rates will not stop this growth, because interest rates are well below the actual inflation rate.

India and other emerging powers will also import large amounts of grains. Keep an eye on food prices worldwide as they may continue to rise.

What does this mean to investors? Companies that provide resources to China, India and other growing nations or companies that mine raw materials will continue to be an attractive investment area in 2011. However, commodities have been rising and we believe that some commodities could experience a temporary price decline soon.

Gold may also correct, but we believe gold will do well longer term. In gold, as in other commodities, we plan to take profits as prices spike up, and use dips as an opportunity to buy. After a correction, we plan to repurchase commodities, materials, and foods. There has been no change in our long-term view; we see inflation on the horizon in years to come.

Investing in Chinese stocks may be wise after the current correction runs its course. The potential negative will be capital controls on foreign investment. If further controls are implemented, Chinese stocks will have a mediocre year. We will wait to see what develops.

If investors are interested in investing in China, we recommend holding quality companies traded in Hong Kong or Shanghai. We do not recommend Chinese stocks traded in the U.S. or other exchanges outside of Hong Kong or Shanghai unless they simultaneously trade in China.

Prediction #2 — Europe’s Banking And Sovereign Debt Crises Will Continue

The question is how will the Europeans deal with their future banking crises?

In 2011, we foresee economic crises in Portugal, Spain, Belgium, France, and Italy, and continuing problems in Greece and Ireland. These countries are susceptible to going into crisis if:

1) they have large debts maturing and has to sell new bonds to pay off old creditors, or

2) investors will realize how deeply underwater European banks are on their investments in the sovereign debt of European nations.

Either of these events will set off a decline in the Euro and Euro bond markets. This will cause investors to move into stronger currencies including the (only slightly less dangerous) U.S. dollar.

Banking crisis after banking crisis will be met by wave after wave of Quantitative Easing [QE] by the European Central Bank and by the U.S. Federal Reserve. The U.S. has supported (and will continue to support) European banks when they need liquidity by buying assets from European banks. The purpose of these actions by both the European Central Bank and the U.S. Fed is to avoid a worldwide liquidity squeeze.

Whether [QE] is a wise political or economic tactic is not for us to say. We are of the opinion however, that [QE] will set off a liquidity wave that will push many markets higher, but drive down the Euro and U.S. dollar over the longer term.

We expect [QE] to be continuing from Europe, Japan and the U.S. over the months and years to come. As the prescient Jim Sinclair has said it will be “[QE] to infinity”. He may exaggerate to make a point, but he is correct; there will be a huge amount of liquidity added to the world financial system.

Prediction #3 — Bonds Will Remain Vulnerable

Investors should not buy long-term bonds. If you are a short seller, sell U.S. and European bonds short. Municipal, U.S. Government agency, and corporate long-term bonds are not attractive. Three big negatives that will make bonds unattractive.

1. Cost-push inflation is a problem in Asia and Latin America, and is on its way to the U.S. Those who hold bonds with maturities over 5 years should consider selling. In Europe and other poorly managed areas, long-term rates will rise due to sovereign risk. In the developed world, rising cost-push inflation will push interest rates higher.

2. U.S. states and municipalities have been grossly irresponsible; they have overpaid employees and wasted taxpayer money. The taxpayers will not tolerate this any longer. Many municipalities and several U.S. states will file for bankruptcy in 2011 and 2012. The reason for this action is that in bankruptcy, they can renegotiate contracts that they have made with government employee unions. In many cases governments pay salaries and benefits far in excess of comparable non-government workers and offer retirement ten years earlier than comparable non-government positions.

3. Investors hold too many bonds and not enough of other asset classes. After a quarter century bull market in bonds it is now time for redeployment out of bonds and into other asset classes such as stocks and commodities.

It is too early to say with certainty, but we are potentially entering a 10-year bear market in bonds; long-term bonds and municipal bonds are most vulnerable.

As a result of the recent decennial census, north central states are losing seats in the U.S. Congress and the Texas region is gaining seats. This is positive for conservative voters. Texas and other southern states will pick up a number of seats in the house in the next election. This, along with the fact that there were many fiscal conservatives elected to Congress in last month’s election means that the new U.S. Congress, which will be seated in January, is not going to want to spend the capital to support state bailouts.

What does this mean to you? Do not hold long or intermediate term bonds of any of the following issuers: the U.S. government or its agencies, municipalities, counties, and states, corporations in the U.S. and major European nations. If you need income, we suggest that you consider income generated from dividends of companies which produce commodities, or look for high quality commercial real estate.

Prediction #4 — Markets Will Be Volatile; Equities May Offer Some Good Buys On Dips

Attractive countries include: the U.S. Canada, Germany, and Columbia. Hold onto India and China if you already own them. If not, wait for a correction in the short term before buying.

If you are an equity investor and can undertake the risk of holding equities, we recommend the above countries for investment. Many global equity markets have had a good rally over the last few months. We would not be surprised to see market corrections develop in early 2011, possibly in the winter or spring. Be alert to take profits should a major correction begin. After a correction, we will reestablish long positions in several other countries as well as in those mentioned above.

Prediction #5 — Currencies Will Be Volatile

The Euro And U.S. Dollar Are Not Attractive Because European And U.S. Banking Systems Still Have Problems

China pledges to support the Euro zone. China, quite intelligently, has been buying Portuguese debt and putting pressure on Europe to act more responsibly. They will obtain many import export relationships as a result of their behavior, and they are seen as taking the role of senior statesman. The Chinese commerce minister said, ”We want to see if the EU is able to control sovereign debt risks and whether consensus can be translated into real action to enable Europe to emerge from the financial crisis soon.” This is another example of how the U.S. is very gradually losing its power as the world’s most important financial nation, and New York as the world financial center.

Our Recommendations

Investors should continue to hold gold for long-term investment. We have been bullish on gold since June 25, 2002, when it was selling at about $325 per ounce. In our opinion, it will move to $1,500 and then higher. Traders should sell spikes and buy dips.

Food and food-related shares remain a favorite of ours and we believe that oil-related investments hold promise. We have been bullish on grains and farm-related shares since late 2008 and bullish on oil since February 11, 2009, when oil was trading at $35.94 per barrel.

For long-term investment, we do not like the U.S. dollar, Japanese yen, British pound, or the Euro. As we mentioned in our September 14 th letter, we like the Singaporean, Thai, Canadian, Swiss, Brazilian, Chinese, and Australian currencies. We suggest using pullbacks in these currencies as an opportunity to establish long-term positions.

Those familiar with China and India know that it is not the cost of capital (interest rates) that determines whether economic growth continues, but rather the continued availability of capital. Bank lending will not dry up in India and China. We are bullish on both countries but if you do not own them wait until we see if the nations institute capital controls (which would decrease their attraction). We also remain bullish on Colombia. In Colombia’s case, it is due to the very low valuation of Colombian stocks.

In summary, investors should continue to hold shares of growing companies in India, China, and Colombia. We have been recommending these markets since September 14, 2010.

We believe U.S. stocks can rally further. Our reason for becoming more bullish on U.S. stocks on September 9, 2010 is that over the longer-term, liquidity formation through [QE] will create demand for many assets, including U.S. stocks. A correction of 5 to 7% could occur at any time, we would use the correction as a buying opportunity. As mentioned two weeks ago, we also recommend Canada as a country for investment.

A summary of our current recommendations can be found in the table below: