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Back to The Future

September 18, 2006
Stephen Martin

Stephen Martin

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Many comparisons to times past are being opined lately. First, we have the comparison to the seventies with the rising commodity prices, inflation and stagflation fears. Secondly, we have comparisons with the mid nineties where a soft landing was achieved creating the so-called goldilocks economy of strong non-inflationary growth. However, I see more similarities with the thirties era.

First of all, let's look at the comparisons to the seventies. There is no doubt that we have a commodity boom now as we did then. In fact, I am in the camp that believes we are likely in a secular bull market that will last 20 years. This does not mean we will not experience cyclical declines within this longer-term trend. The big difference between now and then is in the measurements of inflation. So far, the massive rise in commodity prices has had little impact on final prices. Part of this is explained by increases in productivity. Further to this is that real wages have been falling in the developed world. China and India have been exporting deflation. This is in marked contrast to the seventies when rising wages created the important catalyst for an inflationary spiral. Most measurements of inflation are at low single digits compared with double digits in the seventies. Furthermore, this slight increase in inflation comes after the first geo-synchronous economic growth in nearly 20 years and following a massive infusion of liquidity by major central banks. There is some concern that China is about to export inflation. This might be the case if it were not for two important facts: One, is that central banks around the world, including China, are sponging-up liquidity in an effort to control growth. However, China is attempting to reign-in infrastructure spending and the U.S. is attempting to reign in the consumer. This might be ideal if the countries were to switch their growth components so that the Chinese consumer and U.S. business spending picked up the slack. This won't happen...not in the short run. This brings me to the second fact...it is more likely that China will flood the world with cheap goods as it's own economy slows to maintain capacity and employment. This will happen at the same time U.S. consumer demand slows. Again, this is a deflationary (or if you prefer, disinflationary) impact.

Comparisons to the mid nineties are more common. This is the soft-landing scenario. The main premise to this argument is that central banks are successful in reducing inflation expectations and reducing growth to a sustainable non-inflationary level, often referred to as NAIRU (Non-Accelerating Inflation Rate of Unemployment). Once inflation, as interpreted by the central bank, is under control, interest rates could be lowered and this would extend the business cycle. Initially, interest-sensitive investments would out-perform but the overall environment for the capital markets would be positive. However, this focus may be ineffective when inflation pressures appear to be exogenous and transitory. The risk is that, for the U.S. at least, the FED does not get the right signal to begin lowering rates in time to keep the economy above stall speed. There are several important factors that differentiate the current environment from that of the mid-nineties. The current economic expansion was fuelled by a massive liquidity injection which ended up in the real-estate market. More specifically, rising house prices has directly or indirectly fuelled U.S. growth. One cannot over-estimate the link between house prices, U.S. consumption and global growth. Much of this growth was built on debt. The U.S. consumer and Government are more leveraged than they have ever been post World War II. Even if the FED were to lower rates, it is likely to be too little, too late for the housing market and therefore the economy. The current indicators are that house prices in the U.S. are already falling for the first time since the Great Depression.

The comparisons to the thirties are more appropriate in my opinion. A deflationary spiral brought on by a collapsing housing and stock market are exacerbated by high debt levels. As in the thirties, people will sell because they have to and not because they want to. A negative wealth effect also contributes to a change in consumer sentiment. Banks will be tightening lending standards even if interest rates decline. Those who can get credit may not feel the need to do so as there is no reason to take on risk when prices are declining. Another comparison to the thirties is the rise in nationalism. The stock market crash of 1929 set the stage for the Smoot-Hawley Tariff, introduced in the early thirties, and precipitated a tit-for-tat protectionist wave around the World that saw global trade decline each and every month during the thirties. Globalization is in the news these days but what worries me is that most of the news tends to focus on its shortcomings. Furthermore, scant attention was paid to the recent collapse of the Doha round of WTO talks. This may be the biggest non-event of the year. No one can deny that protectionist sentiment is rising around the globe. Protectionism will continue to rise as the increasing polarization of ideologies combine with slowing economies to create an "us vs. them" sentiment. The post war period of ever increasing globalization may be coming to an end. The U.S., once again, is where direction in the global economy is determined. I would anticipate sentiment to be translated into legislation in a shortsighted attempt to correct imbalances and protect U.S. jobs.

The short-term indicators are positive for the capital markets. A decline in energy prices and the prospect of a peak in interest rates are supportive. Furthermore, geopolitical risks seem to have gone from boil to simmer in the past few weeks. While earnings growth is slowing, the market P/E's are within normal ranges. On a technical basis, some of the key market indicators, notably the DJIA, are approaching all time highs. The longer-term trend for commodities and related investments looks positive. Oil in particular will likely trade to a low of $50 bl as demand erosion trumps supply concerns. This is likely to be short-term in nature and oil is still in a long-term secular bull market, which could see a rise to $100 bl during the next economic cycle and/or on heightened geopolitical concerns. Natural gas had a quick burst in July, as I had anticipated but has collapsed in spectacular fashion since August, which I had not anticipated. I proposed a pair’s trade, long Paramount Energy Trust and short Canadian Oil Sands Trust that has returned more than 8% since first proposed in August. I will likely close this position before the end of the year. I still like NYMEX gas relative to oil, but gas is more volatile so it is extremely important to get the entry and exits right. No doubt, energy related investments including coal, nuclear, solar, etc. will do well in the long-term.

The intermediate-term risk to capital markets is great. I still believe that a hard landing for the U.S. economy, and a slow-down at best for the global economy, is in store. The bond market seems more likely to be sending the right message relative to the stock market. The U.S.$ will likely resume its downward spiral in 2007. This may give a boost to commodities priced in Dollars. Of course, gold should shine in this environment. U.S. exporters should do well but my concern is that increasing trade barriers would not be positive for importers/exporters. Health care stocks, bonds and other interest sensitive investments should do well. Defence budgets are rising everywhere and I think that defence stocks should continue to do well. True growth stocks will do well but one must be really selective. I would avoid cyclicals (including those masquerading as growth stocks) for the time being. If the signs of a soft-landing appear there will be time to switch out of defensives and interest sensitives. The British Pound appears to be a beneficiary in flight-to-quality scenarios particularly where a weakening U.S.$ are concerned. The Euro, while still a young currency, may also benefit, particularly due to the yield differential as rates in Europe are still biased upwards.

Finally, I would stay on top of developments to the four major risks I have outlined previously: WAR, PLAGUE, DEFLATION and NATIONALISM. All are real risks and while perceptions fluctuate, these risks continue to grow and are not fully appreciated by investors. If these risk perceptions were to change we could be in for a rocky adjustment.

About the author:

Stephen Martin
Stephen L. Martin has published articles, studies and research on investments over 20 years and has appeared on national television and radio. He currently works for Fairfax I.S., a private U.K. based investment bank. The views expressed are his own and are not representative of his employer.

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