Tuesday, January 9, 2007

Themes for 2007

“I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared” - Thomas Jefferson

The second half of 2006 was one that was very interesting for observant onlookers. On the surface there was little indication of anything spectacular. But digging a little deeper has created some curiosity in what the following year will bring. This entry will deal with the signals we have been given and what effects they will have in ‘07.

Where did all the liquidity go?
Westernized countries have, not just recently, but since the end of WWII, undergone a long phase of economic growth, fuelled by the monetization of assets and the positive effects globalization has had on our standard of living. This growth has been accelerating at a fantastic pace due to improvements in technology, communications and transportation. Unemployment has been historically low, even with more women entering our workforce, and disposable incomes have been rising (more for the few than the many.) This has all happened over a post-war period when our population has been young and robust. As a result, inflation has been a common theme throughout the world as the supply of money grows along with our productivity.

However, much of the inflation we have experienced has failed to show up in the balance books of first world citizens. Indeed, we have recently seen price appreciation in commodities (by extension some food products) and energy, the price of homes (rent prices have failed to follow thus far), and for Americans the cost of Medical Insurance has escalated to the point that the bills themselves can make people sick. But we have also experienced lower prices for many things like electronics (computers for $500), appliances, communication devices, transportation (Vancouver to London for $500 tax-in!), and for the most part our taxes are much lower than previous generations (depending of course on where you are from). These differences in expenses for the average western person come pretty close to evening themselves out. Wait a second though. The money supply is growing at a rate of close to 10% in much of the westernized world (and even faster in some developing countries)! Where is this money going? The answer is complex.

Debt servicing, investment in future growth, and most importantly; speculation.

The Speculative Bubbles

1) Real Estate
The mother of all speculative bubbles. In my researching of previous manias like the Tulip Mania of 17th century Holland, the South Sea Bubble, the Mississippi Scheme, the Railroad Schemes and speculative episodes in stocks through the late 20’s and 90’s of the US stock markets, many parallels can be drawn in the psychology of the people involved. That is, people falling over themselves to buy, bidding wars, people buying on insane amounts of leverage and of course the popular, media sponsored belief that prices only go up.

Calling for the housing bubble to pop now is like predicting that Pompeii will be buried by a great volcanic explosion - it has already happened, and debating whether or not it will happen wherever it has not been felt as of yet (like Vancouver) is a waste of my precious time. The only questions that pose any interest to myself are “how far will it go before hitting bottom” and “what effect will it have on our economy in general.” Any number of answers to the first question could hold water. Property is after all, an asset and holds intrinsic value. It’s price cannot fall to zero. However, with the perfect storm of specuvestors getting nervous and selling their highly leveraged properties and summer home(s), adjustable rate mortgages resetting at higher rates than during original financing, and large volumes of supply still coming through the pipeline, the RE market could become a bloodbath. Other issues could become important such as the degradation of lending standards, mortgage fraud, appraisal fraud and poor building practices. I would not be surprised to see nominal home values return to their pre-boom prices. This would involve a 60-70% correction in areas involving the most speculation and 20-40% in areas that have experienced little. How long could this take? In my opinion, the air will be let out quickly in North America, Australia, New Zealand and the UK and slower in Europe. Some will draw lines with the Japanese housing meltdown and it’s now 18 years of steady deflation. Japan is not a good comparison with much of the west; they are a tiny island nation with a relatively large population. They had a supply shortage. There is no shortage of land in Canada, the US or Australia, therefore the run up has been more speculative by nature as opposed to supply and demand driven.

What effect will this have on the economy? Considering the world’s largest economy has been literally propped up with the inflation of this bubble after the tech crash and are now propping up the housing bubble with equity withdrawals to use on spending, I foresee a sudden crash in the value of homes as potentially catastrophic for the US economy and by extension the Canadian economy (80% of exports to the US.) Asian powerhouses (China and Japan) and the Tigers (Singapore, Korea, Malaysia, Taiwan) that rely so heavily on exports to the US will also need to transform their economies to become less export driven. How able are they to make a rapid shift towards domestic growth? A sharp decrease in consumer spending caused by an equity shortfall would bring about new consumer habits in the west that I don’t believe governments, corporations or the average person are prepared for.

Knowing that the money supply includes the value of all assets outstanding, what effect will the collapse have on the now unpublished M3? In 2002 The Economist noted that 54% of all assets held in developed economies were residential and commercial real estate. At the time that amounted to 60 Trillion dollars. I don’t have the time or desire to find an accurate current number, but would estimate that it is approaching 90-100 Trillion, and is likely closer to 60% of total first world assets. Now that we have an understanding of how large this bubble is, what happens when it pops?

Contraction of the money supply is what happens.

2) Equities
Stock exchanges around the world are at or near all time highs. The inflation of the housing bubble was apparently a good thing for corporate profits. Business expanded rapidly to accommodate for all sorts of associated requirements, and consumers basked in the glory of increased equity and showed it at the new shopping mall around the corner. Is this growth sustainable? Sadly not.

The US economy has wedged itself into a tiny box. It is now entirely dependent on consumer spending to maintain positive GDP growth. And that consumer spending is entirely dependant on growing home equity. If the average worker was experiencing double digit growth on his/her paycheque, things would be different - they’re not. Current stock valuations are already a little overpriced, trading around 18x earnings. On a historical basis, stocks trade much lower. It seems that economic growth has ingrained itself so deeply into the craniums of investors, that even with earnings hanging on the balance of home equity they are ready and willing to put up their money at these valuations. Not only are stocks trading at a premium to earnings, but future earnings growth is still expected. For the life of me I cannot figure out why. Corporate executives don’t know either, because they’ve been bailing in record numbers.

Stock prices of late have been maintained for a number of reasons. First and foremost is M&A activity and speculation of activity. Contrary to popular belief this is a very bad sign. We hear lately that companies are “awash with cash”. If I was an executive, my first priority if I had a lot of cash would be to expand business internally. I would attempt to grow my market share by marketing my product/service to a new part of the population. I would invest the money in research and development to bring new products to the market. I would reward employees by paying them more and attracting more talent to my company. Only if I could not do this, would I look at taking another company over and paying a premium for the market share that they have. Failing that, I would resort to the most wasteful of all business operations - I would buy back stock to support the share price. Corporate executives are tipping their hand, and have been doing so for a few years now. There is no room for further growth.

So what happens when all artificial methods of maintaining earnings growth and stock prices are exhausted? Eventually, the market becomes aware of the change and earnings expectations are restated. As a result the stock is revalued lower. A good example would be Whole Foods, who in November restated their growth expectations from 12% growth to 6%. On this news, the market revalued the stock downwards by 30%. What would be the reaction to not just earnings growth being lowered, but lower earnings altogether? 50%? 60%? 70%? Perhaps we now have a better understanding of how speculation in future growth is rampant in the valuations of equities. And since we know that those growth prospects are very minimal for most companies, we know the fate of the equity markets in general. Not good.

So what happens when the 30 Trillion (my conservative estimate based on the same economist article mentioned above) in first world equity markets begins to erode in value? More contraction of the money supply.

3) The Derivatives and Bond Markets
Ah, yes. Where money is made. The last estimate I saw of all outstanding derivative contracts stood at 370 Trillion. To be clear, that figure is not reflective of actual money or even credit. But it gives a good general idea of the magnitude of speculation and hedging in markets that most people don’t even know exist.

I don’t believe that hedge funds are inherently bad. I don’t believe that hedging is bad either. It can be a viable way of managing risk and allows for using a responsible amount of leverage to achieve profits for investors willing to take on more risk than most. However, when funds begin to stray from A.W. Jones’ 3 principles hedge funds are meant to operate under (to utilize leverage, to short the market and manage risk of the underlying position, and to pay the manager 20% of profits) they pose a risk to the financial system with the amount of money they are playing with.

Recently Amaranth Advisors, managing 9 billion of their accredited investor’s money, got burned on a natural gas spread play. They lost 6.5 billion on the one trade. Early in 2007 we have seen some volatility in the commodities markets. Has another fund lost billions on the price of copper or oil?

Perhaps one of the most concerning signals of increasing volatility is the narrowing gap between yields on junk and A rated bonds. Investors seem to be oblivious to the meaning of the term “junk” and why a bond may deserve such a rating. For example, a Mortgage Backed Security (MBS) may be made up of a few hundred or thousand home loans whose dependence lie on the sustaining of the housing bubble. The sub-prime mortgage dealer packages these loans and sells them to Fannie Mae who repackages them and sells them to investors looking for a yield higher than ‘investment grade’ bonds. These investors may be a hedge fund manager for example, who uses the equity to leverage himself on futures contracts for oil. If the homeowners default on their mortgages, the junk bond becomes worthless and the hedge fund manager is left with a leveraged position on a volatile futures contract, potentially resulting in the loss of billions of dollars.

The incestuous nature of the debt markets will eventually come home to roost. The stability of our market is dependant on homeowners to pay off ever-increasing amounts of debt. This is what economists refer to as systemic risk.

Another matter of concern in the US bond market is the inverted yield curve. That is, short term rates being higher than long term rates. Historically, when such has occurred it has been a leading indicator of coming recessions. The more protracted the curve, the higher probability of recession. The inversion began in late summer. It’s predictive powers usually come with a lag of 6-12 months, putting a recession highly probable for Q2 or 3 of ‘07.

So what of this contraction of credit?
One may ask, what does it mean for me? Traditionally a contraction in the money supply is characterized by falling prices and oversupply of consumer goods and assets as people try to avoid bankruptcy by paying off debts. As a result, cash is generally the best asset class. Goods are cheaper and bargains are had.

Forgive me Sir John Templeton for saying so, but “it’s different this time”. To an extent anyway. With the recent advent of globalization, global wage arbitrage and the prolonged development of numerous carry trades with investors seeking higher returns, cash may not necessarily be the best investment in a deflation. Not for North American investors anyway.

Prospects for lower growth in the US economy will not be met with kind reactions from those holding the many trillions of dollars in assets abroad. These dollars coming home will not have nearly the effect of credit destruction from popping asset bubbles, but in the foreign exchange markets it’s effects could be monumental on the value of the dollar relative to other currencies and to gold. What I am suggesting is increasing domestic demand for dollars and decreasing foreign demand.

A practical example of this easily happening can be explained by the following:

A Dutch homeowner who works as a carpenter in Rotterdam is trying to pay of his debt with other means because the housing slowdown has decreased the amount of work for him in the Netherlands. He took out some of his home equity in 2004 to invest in a predominantly American growth mutual fund. He did this because of the attractive returns compared to similar European investments. Now that the US is officially in a recession, he thinks it’s a good idea sell his dollar denominated mutual fund and convert it to Euros in order to pay off debt.

Less foreign demand for cash.

At the same time, a real estate agent from Sacramento, California is also having trouble managing her finances. She quit her job as a teacher in 2001 when she bought her first home. Luckily, she got in before prices got hot. Business had been great for 4 years, and finally she took part in a condominium development near the riverfront. She bought three units in the pre-sale and they are just nearing completion. However, the values have fallen off by about 20% since she purchased two years ago. She now has over $800,000 owing on the empty condos and is trying to sell all three for what she thought would be an easy profit. To add to her problems, her husband has lost his job at Ownit Mortgage and is now working at a car dealership for a third his normal income. Since she hasn’t sold a property in 6 months, he now has the only income even though they are both technically employed.

More domestic demand for cash.

But the Fed will simply lower rates like last time…
If any economist agrees on the above information (fat chance, eh?), they will likely point to the fact that last time the US economy was at risk of deflation (2001) the Federal Reserve abruptly loosened lending rates which sufficiently stimulated the economy (and as a result put us where we are today.) Because it worked last time, they will do it again. To that I have a number of objections:

First is the Fed’s effectiveness. Since the last round of rate loosening and subsequent rescue of the economy, there has been an aura of godliness surrounding the Federal Reserve Board of Directors. If the last reinflation of the US economy is strictly a result of low interest rates (and nothing to do with cheaper consumer goods, lowering corporate expenses due to wage arbitrage and communication costs, and heightened world trade, etc) why did rate cuts not have such magical powers in preventing previous recessions? Additionally, the Fed is a reactor not a leader. Their only ability is to react to the numbers and set rates accordingly. If they lower rates too fast, too soon, they will put at risk the carry trade and will then have to deal with potential runaway inflation. Therefore, they have to wait until a contraction of credit is apparent and then ease rates. Or so people think…

Second is the bank’s willingness to lend at such low rates. What possible benefit is it to them to lend money at such low rates of return, when there is nowhere left to invest money other than in the repayment of debt (which they are already earning higher rates on). Why would they lend money to carpenters, real estate agents, or other mortgage brokers when they know their ability to post future income may be jeopardized? The answer is they won’t.

Thirdly, what American is able to take on a higher debt load? Are those that resisted the temptations of cheap credit last time going to all of a sudden refinance their home mortgage with a 200k ATM to spend frivolously? Are there a new generation of highly skilled young workers with 6 digit paycheques ready to plunge into the stock market? Are there foreigners lining up at the door to invest their money in American companies because they offer higher returns than companies operating in Sao Paulo, Hong Kong or Mumbai? No, no and a resounding no.

Lastly, is an observation regarding the health of the US dollar. In 2001, when rates were cut from 6.5% to 1%, the US Dollar Index fell from around 120 to it’s level of long term support at 80. The Index is currently hovering around 84. If the Fed were to lower rates again to 1%, they would be inviting the dollar to drop below it’s long term support line and enter unchartered territory into a proverbial freefall. To do this is to jeopardize dollar hegemony - the US government’s biggest political weapon. Won’t happen, not intentionally anyway.
Lowering interest rates will have very little affect on a contracting credit environment in the US. It risks destroying the dollar as the currency oil is denominated in and with it the only advantage the US government has left in it’s crusade against “terror”. The prospect of such an intentional occurrence by the Fed seems absurd.

So with this information at hand, I will try to explain what I feel we should expect in 2007 and beyond with respect to asset classes. I have already stated that I believe an accelerated housing crash is upon us, and as a result consumer spending - the largest driver of the US economy, will be negatively affected. Considering such a large premium for future earnings growth is priced in to current valuations of stocks, I could foresee any realization of lower earnings growth causing an outright panic in global equities markets. Here’s how I see other asset classes performing in
2007 and over the remainder of this decade:

Developing Economies
I touched on the subject earlier of the Asian economies needing to shift from export driven economies to domestic driven. Many commentators when confronted with the prospects of a recession in the western economies seem to think global growth will simply be picked up by the Chinese, the Indians and other developing economies where the west left off. They again point to Japan as an example of a growing third world country that became industrialized and eventually graduated to the status of a first world nation. However, this was done by Japan on a gradual basis. Quality of living for the Japanese was earned by consistent economic growth from the early 50s through to the end of the 80s. What they did not have to deal with was an abrupt shock to their export market. Japan’s troubles have been gradual, as increasing competition from the mainland squeezed corporate profits. Looking at a 20 year chart of the Nikkei demonstrates this.

It is true that China has made massive investments in infrastructure, education and natural resource extraction. Regardless, much of this investment has been towards maintaining competitiveness in exports. It could take years for governments and populations to shift from an export/manufacturing economy to a more knowledge-based/balanced economy. I believe that the long term trend for the Asian economies is positive and will remain intact, however there will come a time when they will be challenged to show resiliency. Only once they have demonstrated this, will they be allowed to continue to make gains that we have become used to early in this century. Literacy rates of only 60% for the Indians will have to become a thing of the past and environmental degradation will need to be reversed or at least dramatically slowed.
Although I believe a correction is in order for the larger of the developing economies in Asia, I remain optimistic on the prospects for some of the smaller ones such as Singapore and Malaysia. After traveling through these countries last year I was impressed by the sophistication of their educational institutions and the human capital that is being generated by them. I believe that in a correction in the Asian economies these will be the most resilient and will lead the way in growth thereafter.

Japan could prove to be the big winner in an Asia slowdown. Their relative safety provides a better investment than China or Korea for investors looking for global exposure.

Growth is energy and energy is mostly oil. In an environment where global growth is slowing, demand for oil will decrease. We have already seen how much the “terror premium” has knocked off the value of oil (over $20 from it’s Israel/Lebanon peak in the summer of $78 to where it sits now at $55.) How much of oil’s value lies in expectations for increasing global demand? Whether you believe in peak oil or not (I do), slowing economic growth is negative for the price of oil. There are many factors that could serve as support, such as production cuts by OPEC, the US attacking Iran, Russia cutting off supply to Europe, etc. It is useless to speculate on such issues because they are in the hands of madmen, not us. So we can only go with the information we have, and that is that slower growth pushes the price of oil down. What we also know is that our supply of oil is limited. Even with slower growth or slightly negative growth, we will be using oil at a rate far beyond even what was used 10 years ago. This will become apparent during the world’s next round of economic expansion. When OPEC is asked to increase production, but cannot deliver. Only then will peak oil rear it’s ugly head and send prices into triple digits.

It is my belief that we will see oil priced at $35-40 at some point in 2007 on lower growth prospects. This is barring any socio-political events that cannot be predicted with any accuracy.

By extension, alternative energies such as nuclear that are, in effect, leveraged to the price of oil should be affected adversely as well. The price of uranium rose in a lagging manner after oil, and I suspect it will fall in a similar manner. There has been a lot of speculation over the price of U308, which to me signals that there is potential for a major correction. Hedge fund buying of the metal in physical form could easily be released quickly causing a run to the exits. I like uranium investments with a spot price of $30 or so. Anything above that is overly speculative with today’s oil price and destined for a nasty correction.

Precious Metals
Ahh, the safe haven. Gold is money. Something, unlike anything else, whose intrinsic value has remained relatively constant over time. It is a hedge against instability in the banking system. No portfolio should be without it in my mind. But over the last decade, with investors seeking higher returns it has been neglected. Priced in currencies other than the USD it has performed very poorly. It is, however, volatile. So owning gold may be a bit of a rollercoaster for those who own it. It should be viewed as more of an anchor in a portfolio, but most try to seek reasons for it to be a great performer. Those reasons are of the speculative variety, much the same as oil. Whether they become true or not is difficult to predict, therefore I do not grant them much weight in my forecasting.

This is even more true for Silver. It’s dual utility as an industrial metal makes it not only a safe haven for instability, but a barometer for economic vigour. It’s volatility demonstrates this paradox very well.

In a period of slowing economic growth, it is characteristic for all asset classes, including PMs, to decline in value relative to cash. It must be noted that the gold sector is not one dominated by the US, like most other asset categories. Therefore, in forecasting the direction of gold during such a slowdown, the psychology of American investors is not nearly as relevant on a world scale. How will an Indian investor handle depreciating assets in India when their GDP growth is revised downwards from 8% to say 3%? Will they buy Rupees? Or will they buy gold? What of the Saudis, the Russians or the 1.3 billion Chinese? Will the Chinese hourly manufacturing worker convert his Yuan savings to gold? Unlike most Westerners, the lower and lower middle classes in the developing world have positive savings. Understanding what they will do with these savings is key in determining the direction in the price of gold over the long term.

Another thing to consider is “how are most Westerners exposed to gold?” Other than the very few gold bugs who keep coins and bars stashed in safety deposit boxes or buried in their backyards most people are exposed to gold and silver by way of mutual funds. Many of these funds have exposure to all sorts of natural resources and mining companies. The decline in copper prices last week showed us this in a very matter-of-fact way. Gold and silver were dragged down with the industrial metal as people liquidated their exposure to metals in general. Were people purposely selling gold because it was a bad investment? No. It suffered guilt by association. With this in mind, I would not be surprised to see gold trading in the $480-500 range and silver around $9.00-9.50 at some point in 2007. But I also leave open the possibility for a quick bounce upward off the lows as people clamber for safety as financial institutions and hedge funds begin registering losses on a large scale.

Industrial Metals and Lumber
If oil is tied to economic growth then a similar argument can be made for the industrial metals such as copper, zinc, nickel and others but also for lumber. These are key materials in construction and infrastructure projects and are therefore intertwined with the health of those sectors. We have already seen the prices of these metals and for lumber drop substantially in response to the housing slowdown experienced thus far. How much further will they drop when it is fully apparent that very little building will be necessary for a number of years? We must keep perspective of the fact that just as little as 2 years ago the notion that copper prices could surpass $2/lb was preposterous. 18 months later we had copper prices at $4. We’re now sitting at around $2.50, a half dollar above those preposterous levels.

I could legitimately see copper reaching a low of $1.50 in 2007 with the other metals depreciating by similar percentages. I am a believer that we are in a cyclical (supply shortage driven) bull market for commodities, so this kind of a retraction will prove to be a fantastic buying opportunity for those with capital left to spend.

Agricultural Commodities
Because of the cyclical nature of our commodities bull market, there will be times when metals and energy perform well and there will be times when agriculture products perform well. This is one of those times. Unlike industrial metals, demand for agricultural commodities like wheat, soybeans, corn and sugar are constant. People need to eat. They can eat less (some places this is more true than others!), but people will buy food over getting their patio redone. This much we can all agree on. Additionally, we have a growing world population - at a rate of 1.14%. That may not sound like much, but it adds 74 million people to the world every year - roughly the population of Germany. And they’re all hungry.

To add to that, we have a little phenomenon called global warming. And she is causing all sorts of trouble with the weather. Droughts, unseasonable temperatures, flooding, typhoons are just some of the curves being thrown at farmers over the last few years. Meteorologists are expecting 2007 to be the warmest ever year on record. This may be great for your tan, but not so good for John A. Farmer who relies on rain in the 3rd week of March to produce a decent yield for the year. Whether you believe Global Warming is caused by humans is frankly not something I concern myself with (for the record I also don‘t concern myself with those that think the Royals will make the playoffs this year). The fact remains that temperatures are rising and they are playing havoc with our crops. The prices of agricultural commodities could easily double in 2007.

As a debt instrument, bonds of low grade or junk grade should not be considered in an environment with heightened systemic risk such as today’s. Furthermore, any company or institution that purchases these bonds and uses them as collateral for other speculation should be avoided like the plague. Because I believe that interest rates in the US, Europe and most western countries will be at most left alone and quite possibly raised, I don’t believe long term treasuries are a particularly good investment. If you are looking for a fixed income source I would suggest foreign bonds over domestic (from a US perspective that is). The best way to invest in these that I know of is through mutual funds. They generally carry a high management fee, but offer sufficient protection against currency volatility and quite often provide a better yield than US bonds. Specific recommendations would be the Investors Group Global Bond Fund and the Templeton Equitable Life Global Bond Fund.

Foreign Currencies
Over the long run, the value of all currencies will inevitably decline against assets with intrinsic value. The logic is simple: currency can be multiplied infinitely; hard assets cannot. If you were to go live on a deserted island for 20 years, I would not advise to put your money in a savings account until you got back. You would surely be poorer on a relative basis than when you left. Having said that, all currencies are not created equal. Some will perform better than assets and other currencies, while some will perform much poorer.

I have already outlined my opinion on the US dollar. To summarize, I feel it will become more valuable domestically and less valuable internationally. The amount of dollars it takes to buy a Ford truck will be less than it is now, and the amount it takes to buy a bottle of ice wine from Sweden will be more.

The Euro will continue to gain value against the US dollar. But slower economic growth in Europe will also be a negative on the value of the currency relative to hard assets. European economies could suffer from competitiveness issues with a depreciating dollar, making aerospace, pharmaceutical and high-tech industries more attractive for business in North America. There is an outside chance that the Euro could fall out of favour with some populist leaders in Europe, however this is again mere speculation. One should only be aware of the risk.

As I mentioned earlier, a slowdown in Asian economies could prove to be buoyant for the Japanese economy and by extension the Yen. However, any nation sitting on a Debt ratio of 194% of GDP has a currency that I want no part of. Any value in the Yen is short term and only if other Asian economies crash.

The UK does not seem to be phased by it’s strong currency. That could change if the housing crash affects England as much as it will the rest of the west. I am neutral on the pound sterling.

I like the position of the Canadian economy over the long term, however they face great challenges in diversifying their export markets, much the same as China. If the government can manage to stimulate the economy by utilizing it’s vast natural resources effectively and exporting energy efficiency technologies worldwide, Canada could become an economic powerhouse into the second quarter of this century. Until progress is made on that front, the Canadian Dollar will inevitably be tied closely to the USD and the price of oil. For 2007 I am very negative on the CND.

Currencies I like include the Scandinavian Kroners, the Australian and New Zealand Dollars, Swiss Franc, the Ruble, and the Singaporean and Hong Kong Dollars. Resource based economies with a low debt to GDP ratio make for stable currencies and will eventually outperform currencies whose governments need to increase the money supply to service debt and import raw materials.

Most other assets like automobiles and consumer durables should become even cheaper in 2007. The common theme will be “wait because it will be cheaper next month.” Manufacturers have been producing based on unrealistic expectations of future growth in sales. They will continue to do so until it is painfully apparent that sales will be slowing dramatically. This means oversupply and oversupply means bargains for those with money to spend. I know nothing about the art market so cannot comment on it’s potential as a store of value.

In Summary
- Over speculation and oversupply in the housing market throughout the western economies will lead to a continuing decline in home values.
- This dramatic reduction in equity will put a damper on the engine of the US economy - consumer spending and send the economy in general towards recession by Q3 of 2007.
- Slower growth in western economies will lead to lower prices of nearly all assets.
- Slower or negative growth in the US could have a disastrous effect on the banking system which is highly leveraged to future growth.
- In such a situation, the price of precious metals could rise exponentially.
- Agricultural commodities will carry the torch of the commodities cycle on the back of being immune to lowering demand and due to abnormal weather.
- Oil will trade lower on prospects for lower growth, but remain volatile due to socio-political events.
- Export driven economies dependant on US consumer spending and housing will need to find internal sources for growth before continuing their economic expansions.
- Domestic demand for cash in the US will outpace foreign demand, devaluing the dollar against other currencies
- Interest rates in the US will not be lowered to inject liquidity because such a move will not be effective enough to risk dollar hegemony.
- Bargains will be had in all asset classes as people liquidate their holdings to pay off debt

How the inevitable could have been prevented
Many western economies are on the cusp of a sea-change in their demographics. The Baby boomers of North America are retiring now and the effects will be felt gradually throughout our economies. No longer do western economies have the human capital advantage over their third world counterparts - at least not to the same extent of the boomer generations. Had they used the technological advantage achieved through the 1990s to adequately fund future development via education, R&D and efficiency improving infrastructure a cost advantage may have been maintained. Had they used this capital to adequately fund social security and medical programs for their growing needs (they saw the census data after all), our younger generations may have had the opportunity to compensate for their lack of strength in numbers. The excess capital was instead used to fuel wars, tax cuts, and wasteful asset bubbles. Future generations will have to pay the price. The proportion of GDP needed to fund pension and medical programs will relentlessly increase for the next 20 years. This is less capital being available for positive return investments.

Evidence for this change can be witnessed already, albeit subtly, in some unusual areas. Unemployment levels have been incredibly low. Abnormally low. So low that rates of this level would normally be bringing large wage increases and alarm bells for hyperinflation would be going off. Governments are not surprisingly taking credit for these low unemployment rates as a result of their superb planning and they are being interpreted as a very good sign of a healthy and robust economy. Sadly, this could not be further from the truth. The first wave of baby boomers has now reached the finish line and they are being replaced by a younger generation who are not so numerous. Unfortunately, at the bottom end of these employment numbers are those that are normally seen by society as unemployable - for whatever reasons that may be. They are now members of our workforce. As fantastic it is for them to be able to support themselves and their families with a decent paying job (or not), productivity will inevitably start to bear the brunt of this.

It is never too late to begin saving for the future. The average American and western governments all over will eventually come to realize this. This realization will come through a long period of hardship and a back to basics approach to growing our economies. I.e. investing in education, sponsoring innovation and through hard work. Today’s excesses in society will at one point in the not too distant future be looked at with disdain, and people will change their spending habits to reflect a new set of social values. The longer we continue to spend wastefully and borrow from the future, the necessary correction will become sharper and more severe. The sooner this excess is eliminated, the better off we will all be.

“Economics is not a subject that greatly reflects one’s wishes.” - Nikita Krushchev

Let me wish you a prosperous New Year and Happy Investing!

Matt Stiles


Matt Stiles said...

Feel free to leave any feedback on my post here. If you have questions, I will do my best to answer them. I welcome constructive critisism!

Anonymous said...

I enjoyed reading your summary and concur with much of what you've put down here. You do a nice job of putting your point forward in an easy to understand manner and without taking an emotional or biased stance toward particlar asset-classes, regions, etc without backuping up your points.

Well done.

Your points on volatility are well taken. The level of liquidity in the global system is at all time highs, the are large unsustainable imbalances, world-wide asset bubbles and political moves going on all over the place.

It's difficult to say what the speculators, who manifest themselves in the small bond spreads and inflated asset prices, will do at any point. That makes it a difficult market to invest in.

I agree that this will all unwind at some point, but how it will do so and in what manner it will unwind seems to be a question that everyone has a different answer for.

As to when it will unwind, I recall Keynes quote, "Markets can remain irrational longer than you can remain solvent."

A major global financial event on the horizon with no idea of when it will come or what it will look like, is an unnerving thought.

Matt Stiles said...

Thanks anon!

I keep that Keynes quote at the back of my mind. Having pocket aces doesn't do much when you're short stack.

Oroborous said...

Regarding peak oil: We're near a peak in Middle Eastern oil, but that's not the same as a peak in global oil production.

We'll just shift from the cheap & easily-refined M.E. stuff to the more expensive & harder-to-refine stuff that is found all over No. America.

Matt Stiles said...

Regarding peak oil: We're near a peak in Middle Eastern oil, but that's not the same as a peak in global oil production.

We'll just shift from the cheap & easily-refined M.E. stuff to the more expensive & harder-to-refine stuff that is found all over No. America.

Yes, this is true. However, the increasing cost of production and the cost of setting up infrastructure for it's extraction should still be enough to send the price of oil into triple digits when combined with production decreases from OPEC. And as the easy oil is extracted first, production will become progressively more expensive. This eventuality is many years away, so it's not relevant on my timeline.

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