Deflation looms, Asia booms
Last time we bluntly said it was “not the time to relax” and that the biggest risk for investors was complacency as there was a wide range of risks which could trip up markets. Among others, we highlighted the risk of Government bond yields rising in the US and UK and fringe European states due to worries over rising debt; the actual outcome has been rates rising sharply in fringe Europe (as expected), but falling in the US and UK (not expected).
Government debt, sovereign debt, has moved centre stage. This is what history tells us should happen following a banking crisis, because the unsustainable debts of banks and consumers is taken over by the state - and then the state finds them unsustainable! (see web of debt).
If there is one lesson to take away from the last few months it must be that sovereign debt is more than just a parochial Greek issue or even just a European one. It certainly includes the UK (the recent Emergency Budget was the beginning of the painful, but necessary, adjustment), the US and Japan.
History tells us that recessions associated with financial or banking crises are prolonged, that banking crises tend to lead to sovereign debt crises, and they in turn to currency crises. This pattern has added potency now because it is not an isolated problem, and takes in a large part of the globe.
We also know that following financial crises, typically founded on too much debt, there are some years of adjustment as debt is repaid, and this takes steam out of the economy, and is deflationary.
Money is also taken out of the economy as governments act to reduce their sovereign debt, by cutting their expenditure and raising taxes. Again this is deflationary.
deflation looms
In simple terms deflation is a period of falling prices, which on the face of it sounds attractive. But in reality a prolonged period of deflation is dangerous - think of Japan for the last 20 years and the US in the 1930s. Confidence, already fragile, falls further, purchases are put off or postponed, profits fall and unemployment rises, prices are cut to attract buyers, then purchases are postponed (why buy today when I can buy cheaper tomorrow?), and a vicious circle gets underway.
Governments will do whatever they can to avoid such a deflation trap. Interest rates are already very low, so they need to be more inventive. More printing money or quantitative easing should be expected.
As you know vast sums have been pumped into the global economy already, and normally this would cause inflation; the problem is that other than leaking out into financial markets (up sharply since March 2009), vast sums are stuck in the banks, and not flowing through to the wider economy, as the banks are too timid to lend and their customers are lacking the confidence to borrow.
So if even more money is pumped into economies, will consumers and businesses rush to start borrowing? (assuming action is taken to force the banks to lend).
History informs us hugely, but not as to when or if such action by governments might spark the wider economy into life. Until that point the only obvious call is that each such initiative will trigger more sharp, but temporary, rises in financial markets.
Eventually this pattern of events will change (albeit not imminently), the period of adjustment for economies and markets will be over, and then you will need to switch your investment strategy - the cautious strategy of a deflationary period must be replaced by an aggressive investment into the stock market and property to benefit from inflation.
All of this means that you need to be flexible and dextrous (see Adjust to changing times). Right now our Model Portfolio (click here) reflects signs that significant parts of the global economy are slowing, with signs of deflation emerging.
“flash crash” lessons
We need to pay attention to what happened earlier in May. As the Greek debt crisis moved to a crescendo we also encountered the so-called “flash crash” on 6th May, when the US stock market fell 10% in 20 minutes. It is still unclear what caused this, but it doesn’t appear to have been a technical hitch nor a “fat finger” problem, where a trader typed too many noughts into his trading screen.
So it was probably a bizarre coincidence of people wishing to sell at once, creating a short term panic. Nonetheless it is instructive to see what went up during this period.
The dollar strengthened due to its safe haven status, as did Treasuries, and even UK gilts attracted investors. Gold went up (safe haven?) while other commodities fell (for fear of falling demand as economies began to slow again). The corporate bond market displayed signs of extreme stress, in particular bonds issued by banks were difficult to sell, and the market for new issues dried up. In contrast the highest quality corporate bonds attracted buyers, and improved in line with gilts (see Corporate Bonds party is over).
Gold is a narrow market which has enjoyed a ten year bull market, and you should be wary of jumping on such a bandwagon, where the history of gold is littered with obsession and greed.
But for gold, what went up in early May will inform our judgement when/if the markets come under more prolonged and intense pressure.
company finances in good shape
While sovereign debt is a serious concern that hangs over economies and our investment choices, many businesses in the US, Eurozone, and UK are in good shape, in contrast to their governments. This is a relic of the early 2000’s downturn when companies began to reduce debts accumulated in the booming 1990s.
We hear many analysts saying that this is very positive, as “historically” companies with cash will spend it and employ more people. But the history to which they refer is the last 20-30 years when there was barely a recession worthy of the name - we are now in a very different environment. History can add value to analysis, but choose precedents with care.
history tells us...
Acknowledging the need for care, history inevitably plays more of a role in analysis when we are either in rare or unprecedented times; currently bit of both.
The challenge is for us to unlearn much of what we have learnt and were taught in the last few decades. From the peak in stock markets of 1999/2000 history implied that we should have endured a sharp bear market and probably a recession - we endured the former but not the latter. Then from March 2003, when the UK stock market had lost 50%+ of its value, a recovery began both for the markets and the economy.
But that recovery was built on the soft foundation of easy credit, and from 2007 this began to crack. It now appears that the recovery from 2003 might be no more than a positive interlude in a longer period of ongoing adjustment - what we’d call a secular bear market. Here’s where history helps again.
Research suggests that secular bear markets last 16 years on average, so if it began in 2000 it might end in 2016. History also suggests periods of austerity, to get debts down to more manageable levels, last 5-6 years, pointing towards 2014. These are only averages, but they inform us that we should stay very alert for a while yet.
As such we should also be wary of markets that appear “good value”. A secular bear market will tend to move share prices from being very expensive to very cheap - and that isn’t where we are now.
Asia still booming, & other positives
Concerns will persist for a while yet over the indebted nations, yet Asia still booms (and despite China trying to take the steam out of its economy).
Asia is not immune to a renewed global downturn, as we explore here. But as a long term source of both capital growth and growing income the prospects are undimmed.
In addition the US$ and Treasuries should make money for UK-based investors in uncertain times, as should the highest quality corporate bonds, and the better absolute return funds, all of which are considered in more detail through this edition.
(Taken from TopFunds Guide July 2010)