NEW YORK (KWR) November 22, 2005 -- With gold approaching $500 and silver holding $8+, there is a tendency to wonder whether the long awaited “end game” is now before us. We share a bearish posture, particularly in respect to U.S. equity markets. However, before adjourning to the bunker in anticipation of massive social and economic breakdown, it is important to note the odds favor a more protracted adjustment than the possibility things will spin quickly out of control.
While one cannot totally discount the potential for a crash and major spikes in volatility or dispute the excitement forecasts of this kind provide, recessions are far from everyday occurrences and depressions even rarer events. Reality tends to be much more mundane and there is little incentive on the part of the world’s central banks and political leaders to allow the global economy to slide into a massive meltdown.
So what is the outlook moving forward? The trick for global economic policymakers is to maintain stability as they steer the world away from its excessive dependence on the U.S. economy. The U.S. has substantial economic problems – a massive current account imbalance, a sizeable though falling fiscal deficit, a lack of household savings, and a consumer on his last legs. As a result, one has to ask how the US can continue to progress with an exhausted consumer and cooling housing market.
The pressures of economic globalization also make it highly unlikely the U.S. and other developed economies will be able to achieve the productivity gains they need to sustain a cost structure and standard of living that is so much higher than that of the developing world. Over the long term, the US simply cannot maintain its position as the consumer of last resort. This means the Federal Reserve and corporate and public sector managers cannot rely indefinitely upon ever-increasing real estate and other asset values as well as other questionable financing vehicles that enable Americans to accrue the ever-higher levels of debt needed to feed their voracious propensity to consume. Other than hoping there is sufficient room to keep pumping up the bubble and hope it does not blow, the only real option is to shift demand to Asia. In particular, this includes the trio of China, Japan and India as well as other economies in ASEAN (Association of Southeast Asian Nations).
What is the worst-case scenario? Our biggest worry is that central banks over-react to inflation risk by raising interest rates to the point where they kill off growth. In the United States, the Fed could overshoot raising rates, sending an already retreating consumer into a tailspin and making the downturn in the housing market a rapid plunge as opposed to a more orderly retreat from its current heights. Translated into real GDP growth, this could result in a slowdown in the first half of 2006, followed by a steep decline in the second half of the year, setting the state for an actual recession in 2007. It would also, despite their far better fundamentals, at least over the short term, cause panic and fear in Asian and other markets that are believed to remain highly correlated to the US. In our view, however, while we do not doubt this sell-off would occur, the surprise will likely be how quickly these other markets then recover while the US shows at best more lackluster performance.
Fortunately, there are whole legions of people around the world – rising out of poverty or shifting from a predominantly export orientation -- who are only too happy to “catch the American disease” that manifests itself in the aggressive accumulation of material possessions. This is not to suggest the U.S. will no longer remain an extremely important market, but rather the most important drivers of marginal growth will occur offshore. In unit terms, China alone is already said to constitute a larger market than the U.S. for steel, TVs, refrigerators, radios, motorcycles and cellular phones. If one adds in India, Japan, Korea, ASEAN, Central Asia, Africa, Latin America and the rest of the developing world it appears inevitable that the US portion of global market share will decline on a percentage basis though not as radically as a demographically challenged Western Europe.
Indian credit card usage, for example, rose from 4.3 to 9M from 2000/3 and ICICI bank alone issued about 100K cards every month in 2004. Only 53M people – less than 5% of India’s population -- are estimated to have mobile phones. Indonesia’s mobile market is also growing dramatically -- at a 70%+ compounded rate over last six years – yet still has one of the lowest penetration rates in the region. The US would be hard pressed to show similar demand growth in any sector. Even in terms of luxury goods the US no longer remains dominant. Japan now represents the market that defines the profitability for many luxury goods manufacturers and retail chains. Some analysts even forecast the luxury product market in China will be larger than the US in five years.
This is not to suggest a seamless transition or the absence of extreme anxiety and tension along the way. Additionally, over time it may even be possible we will see the dramatic readjustment predicted by analysts such as Richard Russell whereby the price of an ounce of gold ultimately exceeds that of the Dow Jones index. Rather it is to recognize that whatever adjustment occurs, investors are likely to be better served by strategies that focus on the greater probability of a John Maudlin-like “muddle-through” protracted adjustment than the expectation that a new era of hyperinflation, end of fiat currencies, breakdown of law and order and other aspects of life as we know it lies right outside our door and is ready to commence at any time.
Perhaps the most important reason an abrupt adjustment will not take place is that it is not in anyone’s interest -- save perhaps a few highly-leveraged speculators. While developing and developed markets around the world -- will ultimately move to decouple themselves from an excessive reliance on U.S. demand and the vacillations of Wall Street that are still the norm -- this will take time. To do so prematurely, therefore, is equivalent to economic suicide.
While we are not big fans of the PTB “powers that be” argument – if for no other reason than it is impossible for the bureaucracy and consensus needed to carry out all the machinations accorded to them in total secrecy for decades or centuries. That said, - it would be a great mistake to underestimate the capacity of central bankers and key economic policymakers to maintain the subterfuge longer -- given that aside from a few major breakdowns -- they have done so for centuries. As highlighted in our previous article entitled Do Security Concerns Influence Asian Central Bank Holdings?, it is also worth noting that aside from economic concerns, it is potentially destabilizing in a political and security context as well.
What is the bottom line? For those who predict that foreign buyers are likely to suddenly abandon treasury securities, they must recognize this is not only a US problem but a global one -- as Asia and other markets remain very dependent on the US both as an export market and an element within the global security environment. That said, it is clear these economies do see the writing on the wall and are making every effort to promote this adjustment as well – i.e., building up the domestic component of their economies and shifting resources -- not so much away from US --but to allow a multiplicity of focuses.
What does this mean for investors? It depends on the time frame and ones individual circumstances. Over time, the underlying trends are hard to dispute. The entry of large numbers of new people into the world economy will help to ensure strong demand for commodities, energy, and other resources for the foreseeable future. Furthermore the strong growth that will be seen in emerging markets that possess positive demographics and that are just starting to develop consumer-oriented cultures offer far better potential for appreciation than the US. In addition, Japan and other markets that are now in the midst of achieving the benefits of corporate/economic rationalization also have an advantage as the benefits are before them rather than the US where they have largely been realized. Finally, as seen in the recent comments by a Russian official, the growing need for central banks to diversify away from the US dollar as a reserve currency almost necessitates increased demand for gold over time. This innate demand is further accentuated by troubles in Europe that diminish the potential for the Euro to act in this regard.
Therefore, those who have strong stomachs and can afford to simply buy and hold are probably best advised to scale into positions that will benefit from these trends. Those who are a bit more aggressive can take on and trade around core positions, lightening up on strength and buying back with weakness.
The key point, however, is that while the train has certainly left the station, there will be starts and stops and …… one needs to resist the urge to leverage up every time things get hot and everyone starts crying “to the moon” and doing high fives in the newsletters and message boards, only to then get shaken out on the inevitable downturns. On the other hand, if one is able to hold ones nose -- those gut-wrenching moments which are only likely to increase in volatility, are more likely to be buying than selling opportunities – so long as the underlying trend is maintained.
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Keith W. Rabin is President of KWR International, Inc. and Scott B. MacDonald is Senior Managing Director at Aladdin Capital and a Senior Consultant at KWR International.
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