Investing in a global economy where growth remains fragile

It is easy to succumb to .glum views, but good firms will get through the turbulence, as they always do

Things are looking up: maybe not, as the US market is overvalued

Things are looking up: maybe not, as the US market is overvalued

Tue, Oct 15, 2013, 01:00

The Republicans had no option but to approve the raising of the US debt ceiling, and they’ll have no option the next time either. The stand-off between the Republicans and Democrats on the issue was a smokescreen and had more to do with deep dissatisfaction by Republicans with Obamacare, the costly healthcare insurance programme introduced by President Barack Obama.

Everyone knows that the US is running a sizeable budget deficit which, along with quantitative easing, is designed to offset the contraction in consumer spending and bank deleveraging following the global credit crisis shock in 2008. The US budget deficit means that the rise in US debt has been totally predictable.

What we do know about the global economy is that growth has positively surprised in 2013. Japan has returned to growth after a 23-year slump, Europe has surprised on the upside and China’s slowdown appears not to have derailed its economy.

Growth is still below average and is fragile. Indeed, many argue that the growth is not real. Take away quantitative easing in Japan, the US, the UK and the euro zone and GDP would likely decline again making the debt load even more dangerous for many major economies.

Quantitative easing
Looking at the US in isolation, the Federal Reserve may continue to struggle to ease back on quantitative easing. Growth simply is not strong enough. The Fed now has a mind-boggling $3.7 trillion of assets (and growing) on its balance sheet bought with printed money. This has hugely assisted the US banking system to deleverage.

It can try and sell these assets back to the market over time, but that will surely mean at higher bond yields (lower bond prices) which would hurt when debt levels are so high – and rising.

In a best-case scenario, the US and global economy is strong enough down the line to allow the Fed to let the bonds on its balance sheet mature (in effect, taking the money back out of circulation). That is clearly what the Fed is hoping. The situation in the UK and Europe is somewhat similar, while Japan is in an even more precarious position; the yen will surely resume its decline sooner or later.

Given the debt load that is saddled on the major economies, central banks and governments simply cannot allow deflation as it would lead to insolvency for entire economies and banking systems.

The clear and future danger must, therefore, be inflation. In the developed world, because of the lack of consumer demand (as they deleverage) and lack of investment by corporates (due to waning consumer demand), there is little sign of inflation – yet.

Growth however is picking up and with the greatest amount of liquidity available to the banking system ever witnessed (ie the extra $3.7 trillion lent to them by the Federal Reserve), it is a brave person who would bet against eventual inflation. The real pessimists expect hyperinflation!

Yes, central banks could, conceivably, navigate economies safely back to trend growth and manage to take away all the excess liquidity from the banking system in time, But a serious ramp up in inflation has to be a realistic outcome down the line.

Gold, as the only currency that cannot be printed, remains a source of protection against this eventuality. We are in uncharted territory and gold offers protection against the continuous printing of money to pay off previous debts.

Gold bull market
In my view, it is highly unlikely that this gold bull market is over. It is resting, as I see it. Recent calls from the likes of Goldman Sachs and Morgan Stanley that the gold price is going lower are nothing more than random speculative calls designed to encourage trading. They, like everyone else, simply do not know.

It is a strange world central banks are creating, although I acknowledge that they may have had no choice, post-2008 anyhow. Those with assets are benefiting from the uplift in asset values fuelled by an abundance of cheap money issued by central banks out of thin air.

Central banks are silently shipping free profits to the banks. In the US, for example, banks can borrow from the Federal Reserve at the overnight rate of 0.25 per cent and then buy longer-dated bonds with higher yields and pocket the difference.

In Europe, banks are borrowing from the European Central Bank (ECB) at 0.5 per cent and buying their own governments’ longer-dated bonds, and the ECB has guaranteed that long-dated bond yields will not be allowed to rise (ie the ECB is underpinning long-dated bond prices). This is assisting the euro zone banking system to recapitalise (a silent tax, if you like).

The corollary, of course, is that the ordinary saver in society pays for it via lost income on his/her bank deposits. It represents a significant and ongoing transfer from risk-averse savers to the banks. In addition to this lost income, the downturn has depressed incomes for those out of work as well as for those in work.

With and without assets
The net result is that the divide between those with assets and those without assets in society is growing, not narrowing. That is not a healthy trend in democracy and who knows where it leads!

At the recent Coca Cola agm, the iconic chairman of Berkshire Hathaway, Warren Buffett, said the world “does not belong to the pessimists”. His point was that we have been here before and have overcome even more difficult times and that the US entrepreneurial spirit is alive and well. Standards of living in the US, Buffett points out, are six times what they were in 1930 when he was born.

It is easy to succumb to the bearish views, but good companies will get through the turbulence, as they always do. Markets overall seem reasonably valued to me, although the US market is clearly overvalued relative to history.

Given the fragility of the global economy, a recession, and an accompanying bear market, is a constant possibility. We must be cautious and respectful of the dangers but, as Buffett’s words remind us, it is always wrong to succumb to fear.

Long-term assets
And this can only be good in the long-term or real assets (businesses, property, commodities and precious metals) that cannot be printed in the same way as paper currencies. It is the threat of a permanent loss of capital that we must fear.

Shares in quality businesses and property assets have a claim on the earnings power of these assets, and are not as vulnerable (as bank deposits) to money printing in the long-term.

This is especially true for businesses with a geographically diversified earnings stream and that have decent pricing power. Yes, rising interest rates in response to inflation can depress the value of even quality assets in the short-term, but that hardly represents the threat of a permanent loss of capital over the longer-term.

This environment plays against those saving through bank deposits as inflation slowly erodes their value. We can’t know the future but we can plan for the eventualities. As I see it, inflation is the most likely real risk, and sitting on cash deposits due to fear offers little protection against potentially persistent inflation.

Attractive equities
Despite the significant rally in markets since March 2009, personally I still choose equities. A quick example serves to show why; Coca Cola’s share price has been lagging the market this past six months but I noticed recently that its dividend yield for 2014 has risen to 3.3 per cent, due to a lower share price and an ongoing rising dividend.

Coca Cola’s growth rate may be slower now than in the distant past but a 3.3 per cent starting yield plus even 4-5 per cent annual growth in that yield offers investors the prospect of an annual return of 7-8 per cent from one of the world’s strongest and non-cyclical companies.

This beats the pants off bank deposits (near zero returns) and longer-dated government bonds (a German 10-year bond yields only 1.9 per cent and offers no growth).

Rory Gillen runs the online investment newsletter, and is author of 3 Steps to Investment Success

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