Over the past few days, the ongoing credit-crunch in the US has grabbed all the media attention and the capital markets have responded with sharp declines. At present, there is an ongoing debate as to whether the sub-prime debacle will sink the US into the next "Great Depression". Not surprisingly, the bears are out of their dens again, forecasting the very end of capitalism! So, what should we make of the current situation and more importantly, how should we invest during these volatile times?
There is no doubt in my mind that the US economy is past its prime. Gone are the days when the international markets used to shudder in fear at the very thought of American investors withdrawing their capital from overseas. Remember, not so long ago, financial crises used to spawn in some far-flung "emerging" nations in Asia, Latin America and Eastern Europe. And the US establishment used to stand firm as the lender of last resort. This time around, however, it is ironic that the world's most influential nation is weighing down on the global economy and causing a mini-panic in the markets. A few years ago, the US was a creditor nation, but today it is the largest debtor nation the world has ever seen. Previously, Americans used to fund other less fortunate nations, however these developing nations are now funding the American way of life by financing those horrendous deficits! Based on these facts, it is clear to me that over the coming years, the over-leveraged American society will have to undergo some sort of adjustment. Moreover, I suspect that this adjustment will not be easy. In other words, I expect the standard of living in the US to gradually decline in the years ahead.
Now, I am aware that there are a number of well-respected economists and analysts out there who are forecasting the end of the world due to the ongoing problems in the credit-markets. I tend to agree with their assessment that the US economy is in a bad shape but I do not expect a deflationary collapse in global asset-prices due to the sub-prime mess for the following reasons:
Firstly, it is worth noting that the size of the US economy is roughly US$13.5 trillion, global exports are over US$13 trillion, global non-gold foreign exchange reserves are above US$5 trillion and under the worst-case scenario, sub-prime mortgage losses could amount to US$300-400 billion. No doubt, these losses would be a total disaster for the effected households, but they are not big enough to cause a major recession at least in nominal terms.
Secondly, I believe that with its ability to print an unlimited quantity of Dollars, the Federal Reserve will come to the "rescue" at the cost of the American currency. After all, we are in the third year of the US Presidential cycle (historically, the best year for stocks) and you can bet your bottom Dollar that the American establishment will do everything in its power to avoid a major bear-market or recession prior to the elections next year.
Now, I can almost hear some of you say that this era of endless prosperity cannot go on forever and that a deflationary bust is inevitable. For sure, this fantasy "fix" through even more inflation and a further debasement of the US Dollar cannot continue ad infinitum. However, as long as the public remains oblivious to the inflation menace and keeps buying into the low-inflation propaganda, our current "monopoly-money" system could easily continue for several more years.
I happen to believe that the US Dollar will be sacrificed in order to avoid a painful contraction in the economy and asset-prices. The necessary adjustment in the US economy will be stealth and is likely to occur through a weakening currency rather than an outright crash in asset-prices. Already, since 2002, American savings have depreciated by 50% against the major European currencies and even more so against the major commodity-producing economies (Canada, Australia and New Zealand). In the period ahead, I expect the US Dollar to diminish in value against the Asian and Latin American currencies, which are still grossly undervalued against the greenback.
The final reason why I do not expect a deflationary collapse is due to the fact that despite the ongoing credit-problems in the US, the emerging economies of Asia, Eastern Europe and Latin America continue to expand rapidly. This should act as a cushion against any major financial set-back in the US.
So, given the current economic outlook, how should investors position themselves? First and foremost, I suggest that investors continue to avoid exposure to US financial assets as the risks far outweigh the potential for return. Moreover, if my assessment is correct, after some additional near-term weakness in the markets, I expect the up-trends in natural resources and emerging-markets to continue. As a money-manager with the capability to invest in global assets, I have allocated our clients' capital to these sectors.
Despite the rally over the past 5 years, stocks in the emerging-markets are reasonably priced in terms of valuations (with the exception of China) and commodities remain extremely cheap when adjusted for inflation. After the big run-up over the past several months, these markets had become somewhat over-stretched and are now in the process of consolidating their recent gains. Such periodic pull-backs are normal within long-term bull-markets and should be used as a buying opportunity. Accordingly, I would urge investors to shake-off their sub-prime blues and take advantage of the ongoing panic by buying solid resource-producing companies positioned to benefit immensely from the ongoing growth in the emerging-nations. Remember, in the business of investing, it usually pays to buy the panic!