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The Worst Behind: Challenges and Opportunities Ahead

In less than one year -- between Oct. 29, 2007 to Oct. 27, 2008 -- global stock markets (represented by the MSCI Barra, All Country World Index in USD) declined 52.3%. Yes, by a half. Such an experience again proves that the collective expectations of the world of investors can be spectacularly wrong. Earlier in the decade, the S&P500 index also collapsed by a similar ratio. If there is any good news at this point it is that equity markets today are nearer reasonable values. As such, it has taken two brutal equity bear markets to squeeze out the stock bubble of the late 1990s. Of course, well diversified portfolios will have escaped the full brunt of these equity market downdrafts.

The months of September and October have been particularly difficult. If there was ever much doubt, the steep declines of the past 60 days have swept away all uncertainty. Many questions have now been answered decisively. Were financial systems vulnerable to meltdown? Was globalization so advanced that no nation could uncouple from the downdraft? Was a global recession in the offing? Could stock markets around the world yet crash further? The answers are now clear. Now that the worst has happened, what next?

Most likely, not what the consensus now thinks. For one, it doesn't necessarily follow that more great crashes still lie ahead. That has already happened. Lower stock market levels are still possible at some point in various countries... perhaps early next year. But in the main, the horses have already bolted the gate and a new global investment environment is already beginning to take shape. Huge initiatives and behavioral changes are now underway, both at the domestic and international levels.

Bear with us, we are now definitely leaning towards optimism for the long-term. That may sound cavalier given the obvious economic deterioration at present and yet ahead. In recent years, we were among the few who warned of unacceptably high risk levels and the unsustainability of underlying developments. That harvest has now been reaped (unfortunate, because it wasn't necessary) and the worst has happened.

But, crucially, this is now past tense.

But let's be realistic. Reactions to the past and current crises are still playing out. For now, most financial trends still continue to be shaped by fear, even though tentative signs of an unfreezing of banking systems are appearing. Such frights are warranted to an extent. But a new paradigm will be sure to unfold -- only the interim timing and the global pattern yet to be determined-- some of its features already apparent. But before economic speed is again recovered, some gear shifts first need to take place.

The first one has to do with consumer debt. Real demand is now down-shifting to the rate of household income growth. Imagine that -- demand growth that is not dependent on net new debt? That will seem like a radical idea to recent generations. But actually, this is the only sure-fire prescription for sustainable, stable long-term growth.

A second gear shift follows the first, and is best characterized as the global decoupling of China's export growth engine from America's debt-induced consumption bubble sump (both households and government). These shifts will be disruptive for the time being. But the quicker the better. Eventually, a rebalanced China and other hyperdriven net-export countries will be on steadier footing.

A third gear shift is already substantially complete (though not quite) and that is the recalibration of stock market values relative to underlying profits and income. Lastly, one fourth and final shift will soon be underway, we think, and that is a return to higher real interest rates. That will present both hurdles and opportunities, but more on this shortly.

Main Features of the Next Global Cycle

Let's next review the main features that we expect will unfold globally over the next 3 to 5 years. Also, please note the three different recovery scenarios and their respective probabilities that we outlined in the Global Spin of August 2008. We see no reason to alter them, still expecting that these will play out in sequential fashion. Briefly, we dubbed these scenarios: #1. Global Purgatory (Turning Japanese, I Really Think So); #2. New World Paradigm (Global Infrastructure Cycle); and #3. Global Boom (Inflationary Infrastructure Boom). Right now, we are still in economic purgatory. Turning to the main features of the new global economic/financial paradigm (some of these already foreshadowed by recent trends):

1. A New Global Wealth Order. Here, we mean, that the distribution of real wealth creation around the world will be tilted away from the high-income deficit countries. America and other deficit countries will face a stagflationary (now, more likely to be a stag-deflationary) environment, producing little real growth for 2 years or more. Here, deleveraging on the household balance sheet must first occur, which will be a good thing ... like taking cod liver oil by spoon. While global economic growth will be much slower than in recent years, most of this growth will be found in industrializing/globalizing countries such as India, Brazil and others.

2. Higher Real Interest Rates. Inflationary or wealth translation effects caused by government-backed bailouts of the banking system as well as new, stimulus spending must be considered. This will maim parts of the world economy for the time being, both with respect to retarding demand as well as fixed-income market performance. This will mean that the deficit countries will be choked by high real interest rates. While that will be good for the fortunes of retirees (and eventually, also again raise the attractions of fixed-income as an investment asset) it ensures that "over consumption" and large trade deficits will be ruthlessly squeezed further.

3. Global Infrastructure Spending Boom. This is an expenditure category everybody will love and endorse over the next few years. For developed countries, such as the US, this is a spending that carries a high stimulus punch. Deficit spending will be directed to new roads, electric transmission and transportation systems. MoodysEconomy.com recently estimated that for every $1 increase in infrastructure spending, overall GDP growth is boosted by $1.59. That would represent very effective stimulus spending for governments, especially so in the US where infrastructure generally is considered in poor disrepair. Developing nations, too, all still have high infrastructure needs. And, alternative energy development remains a high priority.

Frankly, the above features once they unfold -- assuming that the world makes it out of economic purgatory, and the necessary interim transmission shifts do not strip any gears -- couldn't represent a more favorable mix for stable, balanced growth and attractive investment portfolio returns.

All of the stock market sectors that stand to benefit from the above trends can now be bought at reasonable levels ... some even inexpensive. And, as for emerging markets, although one needs to be selective, these have also been marked down enormously ... as much as 60% and more. Good values can now be found here as well.

But First, Some Putting Challenges

However, before the new global paradigm can bloom to full flower, several challenges remain. Its a bit like playing a mini-golf hole that is obstructed by swinging timbers. There is a smooth, green surface on the other side, but you first have to make it past the careening logs. Any one of them can throw a portfolio out of bounds. Right now, there remain a few of these swinging logs to contend with. Here we point out three of the bigger hazards that active portfolios will need to navigate through:

1. A Wall of New Government Bond Issues. The first side-swipe to avoid is the effect of massive deficit spending upon the bond market. While some high-yield sectors (at least, what now appear to be valued at highyield levels) can offer opportunity, the rest of the USgovernment- backed bond sector could be a trap. A massive wall of treasury bond issues is barreling down the pike. Even the US Treasury's acting undersecretary, Anthony Ryan, admits as much, saying "This year's financing needs will be unprecedented." Barring a collapse in imports and oil consumption, the US current account is sure to soar. (The BCA recently estimated this deficit may soar as high as 13% of GDP!)

As such, we expect that the US dollar will be reappraised and sold off. As soon as liquidity fears subside, money will go back up the risk curve, leaving "safe haven" bond sectors in the dust. But when? Could this be when China offers to lend its huge cache of foreign government bonds to Western foreign central banks? Or, when the upcoming G20 meetings scheduled for Washington and Paris draft up new Bretton Woods II? We don't know what the catalyst will be, if not having occurred already. Actually, government bond markets are already behaving poorly.

Over the next year, it is highly probable that stocks will outperform bonds. As such, portfolios should already begin to reflect this shift.

2. Repatriated Foreign Portfolio Capital. For several years, US-based investors have benefited from a declining US-dollar by investing abroad. To illustrate, while the MSCI EAFE Index (which covers developed equity markets outside of North America) rose 29% in local currency terms between October 2005 and its top 2 years later (October 2007) the US dollar based return rang in at 52% over this same time frame.

Needless to say, this attracted portfolio capital to move abroad, setting up a virtuous circle. State Street Global Markets recently estimated that as much as $5 trillion in US portfolio capital had found a home overseas. We have always thought that when this money runs back home, the US dollar would rally. Indeed, recently repatriation of foreign portfolio capital has in fact been in a stampede.

In the crush of this rush, the US dollar has spiked exacerbating losses and sending international markets stumbling even faster than US domestic markets. Losses to US-based investors have been magnified. As such, not only is the US facing one of the toughest of recessions of all developed nations due to macroeconomic reasons alone, magnified portfolio losses for households and pension funds now add an additional dimension of stress.

Even respectable Canada -- one of the very few OECD nations to achieve a government budget (to this point, at least) and trade surplus -- has bitten the hand of its southern neighbor. The here-to-fore darling market of overseas and US investors -- both its currencies and stock markets having risen to unsustainably ridiculous levels through these manic adulations -- has now stung them as badly as a banana frontier market. To add insult to injury, not only did resource markets collapse, so did the Canadian dollar. In less than 120 days, US-based investors would have suffered a maximal loss of 53% from the CAD market high (June 18th).

When can the portfolio repatriations be expected to stop? We cannot be sure. However, this development stands to play a role in this next golf putting hazard.

3. A US Dollar Whipsaw. One of the great conundrums of recent times is the strength of the US dollar ... or so it is popularly thought. How could the US, the "ground zero" of global financial collapse, sport a strong currency? At this surface, this does seem absurd, especially given the large financing requirement of the US current account deficit. However, it is only a shortterm phenomenon in our view, one that is explainable.

We have already pointed out the influence of repatriated portfolio capital. Yet, the catalyst to this trend was likely something very different. To recall, the US dollar had already fallen to an undervalued level earlier this year (under 1.60 to the euro). At this level, the euro was overvalued by more than two standard deviations, according to our currency valuation methodology. The dollar was therefore vulnerable to a rally ... at least for an interim.

Then, the financial busts began, these at first stemming from the sub-prime mortgage excesses. Bear Stearns was the first over the brink. The cracks quickly spread and then the "global ring fencing" began in earnest. Shaky financial institutions (and others), sensing troubles, quickly shifted their choice financial assets back to the US (the country of their head office) and importantly, favorable bankruptcy and creditor laws.

In our view, that started the USD trend to tip, this cascade later to be joined by frightened portfolio capital. But this is not a trend that can be sustained indefinitely. We expect the US dollar to again weaken ... possibly back to the 1.50 level versus the euro. Given the expectation of $1 trillion-sized budget deficits, there will be a surfeit of US dollars looking for foreign buyers in the next year.

Portfolio Setbacks: Post Game Analysis

Many investors will be asking whether it was at all possible to entirely escape the financial carnage of the last year. Yes, this was possible ... but only for a very, very few. There may be investors that are nimble and prescient enough to reliably move all their assets from one life boat to another before they sink. But, these be gods. That all investors can move to safer ground, then to precisely time the purchase of new undervalued assets, is a myth. It is not possible. Consider that the total value of cash and government bonds as a percentage of global wealth is less than 25%. True liquidity -- cash deposits and quality money market investments -- represent an even smaller sliver of total wealth.

Remarkably little capital is shifted during crisis periods in any case, as liquidity tends to dry up. And by nature, it is the most popular investments (since these tend to become large market capitalizations) that cause the greatest underperformance mistakes. As such, a tactical and balanced investment approach is best suited to long-term growth. Not all losses will be avoided, but neither will upsides be missed and the mistakes of emotional investing compounded.

So far this year, it was not reasonably possible for longonly, balanced portfolio managers -- at least not throughout the September/October period -- to bring in positive returns. In our case, up until the end of August this year, most portfolios had still been flat to positive year-to-date. We may have been too self-congratulatory at the time, considering how badly others investors may have been fairing.

Then the bottom -- literally, like the trap door on the gallows -- fell out. By the end of October, it was realized that the capitalization of the entire world equity market had halved in value from the prior peak. However, this was not the worst of it. Shockingly, bond markets did not perform as usually can be expected during stock market collapses and panic phases.

It certainly cannot be said that a new bond bull market has begun. In fact, large parts of the bond market -- anything not government-guaranteed by a relatively trusted sovereign country -- were also crushed. During the previous equity-market rout of 2001 to 2002, North American investors could at least move into the bond market ... even better, at the time, euro-denominated bonds.

Conclusion: Opportunities in Midst of Adversity

For US-based investors, the dynamics we have described go a long way to explain why hedge and mutual fund redemptions have been torrential in recent months. The enormous decline in global equity values is one more contributing factor to the perfect storm that has hit US households. Not only have home values declined at the fastest pace on record, investment portfolios and retirement capital has been sliced, as well. In the meantime, the great hope for the US economy also been forestalled -- export growth. Not only is it now expected that global demand will decrease, the US dollar soared against the euro by over 20% thus undermining pricing competitiveness.

Looking ahead, the US economy faces an unavoidably difficult, grinding adjustment phase, perhaps lasting 2 to 3 years ... if not resisted in some way. It is only in this sense that the future looks unclear. Either, household savings rates, external capital deficits and balance sheets -- from national, to household and corporate -- begin to mend, or the nation embarks on a wild program of manipulated, hollow solutions, resulting in even greater and longer crises. Which outcome will occur? The jury is out. We hope for the former outcome. But frankly, this is not yet certain. It may be too late for a society that may have become either too coddled or debt-strapped.

We are reminded of the responses of citizens in some of the Asian countries during the Asian crises of 1997 to 1998. People knuckled under, accepted responsibility, and even collected gold and jewelry to pay off national debts (yes, this happened in South Korea). They did not expect

governments to bail them out of their mortgage payments and past profligacies. As it was, there was little of either. Indeed, recent financial collapses have been tragic, as really none of this was ever necessary had more sensible policies and capital market policing prevailed. No doubt, short-term market trends are, and will, remain unpredictable. However, here we are referring to long-running trends and policies that were evident for years, all of which had one thing in common -- unsustainability. The obvious lessons that have been learned once again are that unsustainable trends must eventually stop and that long-term problems eventually become today's problems.

Yet, remarkably, our longer-term outlook, in terms of major strategic and regional themes has not changed much. It does not depend entirely upon what happens in the US as is the new global growth paradigm will likely not be UScentric in any case. It is a global story. And, if anything, our longer-term outlook for global growth is becoming cautiously more optimistic given the radical adjustments that are now occurring ... assuming that all the interim shifts we have outlined actually unfold.

What has changed -- these being the reasons we have change our minds? For one, the speed of engagement. In other words, the rapidity of the transition phase. Stock markets have fallen more quickly and collateral financial damage has been much wider. The fear that this has produced has galvanized incredible behavioral changes as well as interventions. In fact, relative to history, these changes border on the unprecedented.

Recent economic statistics show that attitudinal shifts have been cathartic virtually everywhere, mostly certainly in North America. For example, US auto sales in October virtually stopped -- down 31% from year-ago levels -- the worst in 29 years. The ISM Index (Institute of Supply and Management) recently declined to the lowest level since 1983. Order backlogs for trucks have virtually disappeared. Many other statistics suggest that the focus has turned to balance sheets. Behavior has indeed changed ... overnight. Households are saving again!

In the meanwhile, investors continue to stampede out of mutual funds and hedge funds in droves at the highest pace on record. Despite that US households showed net-negative financial investment over the past few years -- hardly portraying an investment mania as in the 1990s dotcom bubble -- these outflows have nevertheless still proven to be violent. Unfortunately, these outflows are now happening at an inopportune time and likely are heading into cash and other investment assets that will likely underperform.

All in all, there are hopeful signs that the road to recovery has begun. And, negative investment sentiment is now vulnerable to improving expectations. Without a doubt, it is time to reinvest cash and position portfolios for a long-term global rebound.


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