Investment Themes: The Big Picture

Given the incessant noise in the markets, it's worth standing back periodically and trying to take a coherent top down view of the structural themes that will drive markets medium term. As Confucius might have said had he been a Chinese day trader (are there any left?), there's no profit without perspective. I suspect that we have, in responding to the credit crunch, crossed a generational inflection point in the trade off between inflation and growth, as important in hindsight as the heroic battle of the Volcker Fed in the early 1980's in defeating inflation. This time growth has won out, but there will be a price to pay. I'll leave the last word to the great man himself:
'The current period reminds me of nothing more than the early 1970's'
Paul Volcker, ex Fed Chairman, April 8, 2008.

Bonds: Government bonds in general, particularly Treasuries, are at the end of a 25 year Bull run, and will now suffer sustained under performance as commodity driven inflation becomes structurally entrenched, a trend exacerbated by the negative real interest rate strategy of the Fed to address the credit crunch fallout (although I suspect US rates are at or very near bottom and will reverse within 12 months). With the headline CPI already hitting over 4% in the US and Europe, recent yield levels of sub 3.5% on 10 year Treasuries will quite possibly not be seen again for a generation. The disinflation windfall we enjoyed from China's entry to the world economy is now fast reversing as local demographics force manufacturing wages higher, and indeed accelerating wage inflation is now a theme globally (apart from investment banking). Southern China and Eastern Europe are both seeing 20-30% plus annualised wage rises. Far from being a safe haven, the riskiest place to invest right now is long duration fixed income.

Equities: Markets reached an important cyclical low in January, and re-tested it in March post the cathartic Bear Stearns implosion which I saw as a buying opportunity (see post). The MSCI world index is up 8.3% since hitting a 17 month low on March 17. The credit crunch in the financial sector will be largely addressed by the end of the year, through a combination of massive balance sheet re-capitalisation, and large scale mortgage security swaps by central banks. However, the damage done to the structured finance market and tighter regulation means that bank lending ratios, earnings and dividend growth will remain constrained for years to come, probably reducing trend GDP growth globally by 1-1.5%. Deleveraging will be the big theme for the next couple of years for companies way beyond the financial sector, as financial risk throughout the global economy is permanently priced higher. Balanced against this is the growing influence of SWF's (with assets of over $12trillion by 2012, see previous post), strong corporate balance sheets ex financials, plus generally favourable cyclically adjusted valuations (although profits as a share of GDP have almost certainly peaked as wage inflation becomes an issue). Although positive medium term, I would expect a final leg to the bear market imminently, driven by earnings downgrades to the consumer exposed non-financials and further stress in the credit system. The US should outperform Europe as multinational American companies benefit from their hugely boosted competitiveness, and US financials are better discounting the crisis. Most emerging markets look overvalued at present, but are in a structural bull market driven by globalisation, commodity prices, and a long term infrastructure boom, and are a buy on major setbacks. India and Brazil look like the best long term bets based on corporate governance and demographics. It is generally cheaper right now to seek exposure to these markets via US and European multinationals with large revenue exposure.

Commodities: The bull case for commodities can be summed up simply: soaring demand meets inelastic supply. For a host of structural reasons, the resource industries are struggling to meet demand at any price, faced as they are with a huge shortage of key equipment from rigs to dumper trucks and skilled personnel (for instance after a 20 year bear market the average age of a geologist or mining engineer is mid 50's); just about every major new project in energy and mining has been delayed and gone massively over budget as a result, pushing the marginal cost curve for resources inexorably up. However bullish the medium term fundamentals, the massive weight of money now flooding the commodity markets via ETFs and pension funds has caused a bubble to develop in many markets, particularly energy (where demand destruction is now apparent) and precious metals (where a dollar rally as I expect would undermine a key investment rationale), and this will burst sooner rather than later. Charts for many commodities from rice to oil are showing an accelerating parabolic trend which is usually a technical trend ending feature. Expect a 20% plus correction in the near future (already underway in Gold) and related resource stocks and heavily weighted markets to suffer as a result.

Real Estate: The credit driven boom in property was global and so is the fallout, but local economic and market fundamentals as much as the credit crunch (which will abate by end 2008) will determine the scale of the downside. Those markets with the greatest housing supply response to the recent price boom now face the greatest downside, notably the US, Spain and Ireland, all of which drove housing starts to historic highs in 2006. The UK is fundamentally better underpinned, despite media doom mongering, by a chronically inadequate supply of new housing, at levels 70-80% lower per-capita than say Ireland or Spain (see previous post for details). The US residential market prospects are best illustrated by charting the aggregate volume of adjustable rate reset mortgages over the next 2 years, lagged by 6 mths (chart courtesy John Hussman); as is evident, the worst is yet to come in terms of the volume of potential defaults and foreclosures over the next 12 mths as US mortgage bills soar, so claims we may be through the worst for mortgage exposed banks may be very premature. Commercial property in the US could surprise on the downside also, having been remarkably resilient so far to the economic slowdown, and this is being reflected in a surge in related credit swap spreads.

Currencies: The US dollar will surprise on the upside over coming months, as US interest rates bottom and growth expectations stabilise. The Euro looks very overbought against just about anything else, and while the US slowdown is 'in the price' for the dollar, investors are ignoring the fact that much of Europe from Italy to Spain is sliding into stagnation if not recession, reflected in soaring spreads on local bonds over German Bunds (see post). A sustained rally by the Dollar would have profound implications for many other markets, notably commodities which have behaved as a leveraged 'anti-dollar' in recent months.

Key themes this blog will return to again and again are:

1. The Limits to Growth: Global GDP growth will be increasingly constrained by chronic resource and infrastructure shortages after decades of underinvestment, from power capacity (see post) and commercial agriculture to technically skilled labour. There is no easy fix to these constraints, and they will both restrain headline growth and drive inflationary pressures; renewable energy and nuclear for example, while attractive investment opportunities, suffer huge manufacturing capacity constraints of their own. Investing in these bottleneck areas will be a shrewd strategy.

2. Demographics are Destiny: Many countries from Japan to Germany are now facing a huge change in consumption patterns and economic dynamism as their population structure passes a tipping point in terms of age cohorts, as expressed in the crucial ratio of under 18's to over 65's. Japan is all our futures in this sense, as the first developed country to go 'ex-growth', and evidence of radically changing consumption preferences is emerging; both the automotive and housing markets are entering a secular slump, for example. Significantly, two of investor's favourite emerging markets, Russia and China, are if anything in even worse shape; Russia is facing a population fall of 20% over the next 40 years. The number of new entrants to the labour market in China will fall from 23m currently to 13 m by 2020; the median age of the US population is and will remain lower than that of China (or Europe). I'm bearish on Chinese growth prospects for this and many other reasons (see previous post on China). The chart below relates to Japan, but is broadly applicable to most of the Northern Hemisphere countries (Italy or Spain would look even worse, the US far better because of Latin immigration).



On this analysis, Brazil and India offer much better long term growth prospects than Russia or China, and the US as the best placed developed nation demographically will outperform Europe into the foreseeable future.