Clarifying America's No-Win Economic Dilemma 31 comments
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In last week's update, we outlined the no-win situation that the U.S. economy finds itself in today. We were pleased that so many people sent us comments and questions. Considering how much work we put into these missives, it's great to know people are reading them. And while we can't reply to every message individually, we can attempt to address the most common issues and questions people had.
Our basic argument is that the U.S. is becoming a smaller part of the global economy, while the combined emerging markets and resource-rich markets are starting to matter more.
This shift in power and influence carries some dire implications for Americans. For, if the world's economy continues growing, commodity prices will rise to ever higher levels. For obvious reasons, the resource-rich nations will benefit from this trend. Brazil, Canada, Australia (and to some extent Russia and China) will grow rich by supplying commodities to everyone else. Emerging nations too will prosper. Their strong growth will be the driving force behind commodity prices.
At the same time, that growth will outpace inflation, enabling them to comfortably pay more for commodities.
Unfortunately, the U.S. is neither emerging nor possesses excess resources. Moreover, the U.S. consumer has been dealt a serious blow in this recession. In the past decade, consumers spent more money than they earned, creating more GDP growth than their GDP contribution.
But those days are over, forcing the U.S. to experience much slower growth. Consequently, for Americans, rising commodity prices will not be a sign of expansion but rather a tax that inhibits spending.
Some of our readers suggested that we err in separating commodity prices from U.S. growth. But there are two problems with the idea that one automatically means the other...
NO LONGER THE ECONOMIC SUPERPOWER
As we point out in this month, over short-term periods commodity prices correlate strongly with world growth, including U.S. growth. Higher production usually raises demand for raw materials. Thus we see that this year stock prices have risen along with commodities. Similarly, brief downturns in commodity prices can occur alongside brief downturns in stocks.
However, over longer periods, the correlation reverses. In fact, looking at data as far back as the 1970s, we can see a negative relationship between commodities and growth. Sharply higher commodity prices can limit growth and rapid growth can bring commodity prices down. We won't go into the math here, but the statistics clearly support this view. (If you want the figures, let us know.)
The other mistake people make is to regard the U.S. as the top player on the world stage. That's because, until quite recently, it was. For decades, the U.S. economy accounted for over 50% of the global economy.
People's understanding of the world changes much slower than the world itself. So it's no wonder most people still believe that if the U.S. sneezes the world catches a cold (and, vice versa, if the U.S. strikes gold the whole world gets rich).
The world has been changing, however, in ways that few Americans comprehend. China and India combined now account for more of the world’s GDP than does the U.S. (in real terms). Moreover, their growth rates are many times ours, which means that by the time you read this the difference between Chindia and us will be even greater. Throw in Brazil, Russia, and the rest of Asia and you'll discover the U.S. is no longer the economic superpower it once was.
Today, growth in the U.S. can falter without derailing commodity prices (at least not for long). What's more, the longer the developing world keeps its growth rate above ours, the bigger its influence on the world economy will become, and the smaller ours will be.
Just as no one worries if a recession in Switzerland will cause the price of cocoa beans to plummet, eventually a recession in the U.S. will have much less of an effect on oil prices.
How do we deal with this brave new world?...
OUR BARBELL APPROACH TO HEDGING RISK
In the new reality that is taking shape, the world would suffer much more if a group of related emerging economies – China, India et al - suffered an economic disaster than if the U.S. did. A recession led by a fall in China would really cause global commodity prices to plummet, taking the world into a full-blown Depression. We can't preclude that possibility, but we hope it doesn't happen.
Meanwhile, we must have an investment strategy to deal with the possibility of either a serious deflationary event or severe stagflation – in which the U.S. faces higher prices, minimal growth, and a weaker dollar. The best strategy we've come up with is in the top portion of our Growth Portfolio.
Our strategy is to overweight a group of investments that represent a kind of barbell. On one end of the barbell, we have our inflation hedges, in particular gold and gold stocks. Gold generally does well in deflationary times, but its best performance occurs in the face of inflation.
On the other end of the barbell, we hold a position in zero coupon bonds. Yes, these may seem unexciting, but we urge you to own some because they are essential insurance against deflation. They are highly leveraged to any economic downturn. Even if we are correct in thinking that inflation is the most likely long-term problem, we expect other brief deflationary scares will occur – perhaps even worse than we saw in 2008. And you need to protect yourself.
Also in this section of the portfolio are defensive/offensive plays. For example, FPL qualifies as an alternative energy stock, since it is the nation's largest wind producer. Yet, at the same time, it's a defensive stock because it earns much of its income as a utility. Chevron (CVX) too (like other integrated oil companies) is a play on oil prices, but is also a defensive stock. The last time it cut its dividend was before I was born (and believe me, that's a long time ago).
So we have designed the biggest chunk of our portfolio to give you balanced protection against the greatest risks going forward, as well as to generate good returns.
Again, our baseline projection is dramatically rising commodity prices over the long term, which will be a shock for the U.S. This will cause inflation that will depress corporate earnings. Investors will recognize this trend, probably sooner than later, and this will lead to a severe setback in the U.S. market.
On the other hand, we also recognize that there is the alternative scenario of deflation – hence our leveraged hedge in zeros. What we emphatically doubt, however, is that the U.S. will find its way back to non-inflationary growth.
Stick with our barbell strategy, along with the rest of our portfolio, and you should be able to weather any storm and thrive in most.
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But in the face of any real recovery and economic upswing, it is not a strategy to keep. Also, as the author pointed out, the US is becoming increasingly irrelevant. Of course if the dollar ceases to be the sole reserve currency that will only accelerate. Rather than hedging by buying commodities and bonds, it may be more prudent to rather invest in ADRs in European companies.
Dr. Leeb:
This is a well-thought out article, and I agree with your core assumptions.
Most importantly, I agree with your core premises about global demand and inflation, and believe that commodities should be included in any inflation basket. seekingalpha.com/artic... I especially liked your reference to Switzerland, which has become irrelevant for global commodity demand. An exaggeration, to be sure, but it drives the point home in a painfully concrete way. You've hit a sensitive patriotic nerve, and I bristle at the candor: Has America petered away its global competitive edge for a Hummer and a McMansion? The truth hurts.
I must respectfully disagree, however, that commodities automatically limit growth. Past statistical correlations are just that--correlations. If economic growth is driven by innovation and productivity, a society can afford to pay more for commodities as the population expands. China and India are good examples of this: As incomes grow, people can afford more oil, steel, cement, beef, etc. Commodity prices can rise in real terms because of global growth, and this should not cause inflation unless monetary policy is loose.
Of course today's U.S. monetary policy is extremely loose, as America pulls out all stops to reflate its debt-laden economy. This risks not only inflation, but long-term erosion in the U.S. dollar.
Therefore, Moon Kil Woong, rightly points out that your commodity hedge should include non-dollar assets. That's why I include non-dollar bonds and a currency short in my inflation basket. seekingalpha.com/artic... I also am looking at shorting the long bond, once Fed support for dissipates. (Quant easing is supporting treasury auctions, as Zero Hedge has repeatedly pointed out. seekingalpha.com/artic...) As Jim Grant says, long-term U.S. bonds are "return- free risk."
I must also question your assumptions about "real GDP" in China and India. You noted that China and India combined now have a larger real GDP than the U.S. According to the CIA Factbook, U.S. GDP in 2008 was $14.3 trillion, while China was $7.8 and India was $3.3 www.cia.gov/library/pu...
Wikipedia's numbers were virtually identical, though it lists India's GDP as just $1.2 billion. en.wikipedia.org/wiki/...)
This puts U.S. GDP 29% higher than China and India. For these countries to be larger, you must be adjusting their GDP upwards by 30%+ to make their "real" GDP larger than the U.S.
And before we write off the U.S. as irrelevant to global commodity demand, we must remember that the economy is depressed, and reflation WILL take hold at some point. Cheap money and massive deficits will boost our $14 trillion economy, and a small change in this number has a big impact on global markets.
Finally, I will note that your portfolio strategy should include some defensive stocks that will flourish in any economic environment. Health care fits the bill, and bullish earnings revisions make them timely. seekingalpha.com/artic...
An excellent, sobering article.
Keep it coming!
Rob
The bosses know a big thing that most of the people cannot or dare not grasp: The elites can and will increase even as America decreases. The ruling elites of America identify far more closely with the equally corrupt and self aggrandizing elites of China and Russia than they do with the American middle class, which has become an object of contempt and a lowing, mooing herd to be milked , slaughtered and skinned.
Ameican elites are among the most skilled in monetizing both American decline and the opportunites for personal reward from globalization.The debasing and selling out of America has been and continues to be a vastly profitable enterprise for the the few hundred thousand men and women (and their families and cronies) who rule the US .
America still has 4 formidable strategic advantages:
1. Our combined endowment of agricultural, water, mineral and energy resources and related technologies is the greatest in the world. If the US wanted, it could be the largest exporter of both energy and food in the world but the elites decree that American resources cannot be used for the benefit of the American and force the Nation to import at substantial cost in income, wealth and jobs that which we should be exporting.
2. American global leadership in a suite of technologies ranging from life sciences, to aeronautics and space, to bioinformatics to robotics is still considerable but each year it diminishes not only because the world seeks to catch up but more importantly because of the systematic degrading of our educational system at every level since the 1960s. Again this degrading is a willed choice of the elites.
3. The American Middle class, demoralized and compressing rapidly, still is the greatest repository of entrpreneurial and professional ideas and execution ability in the world. If allowed , it can once again propel economic growth and job creation and expand the productive economy. Again, by a series of willed and increasingly malign choices, the elites have embarked on a war of supression against the Middle Class and have deliberately chosen to feed the parasitic economy while starving the productive economy. The object of class warfare is to to trap and herd the Middle Class in a cruel and relentless pincer between the upper class and the growing lower class.
With the consent of the political bosses and the applause of the media bosses, Wall St has become the largest organized crime syndicate the world has ever seen, dwarfing by far the Russian mafia or the Latin American drug cartels
4. America's military has unmatched capacity to project force globally, rapidly and effectively and its officer class is true to the Constitution . Yet the elites seek every to vilify the men and women who have served and serve.Veterans are abused in public for daring to express their opinions. Never in US history has the gap between the values of the political, media and financial elites and those of the officer class been greater. The elites shred the very Constitution that the military has sworn to defend.
There are many bad reasons why America should not continue to be a free, safe, and prosperous middle class society and a global hyperpower. The elites have discovered all of them. There is not, however, a single good reason given the 4 strategic advantages of this Nation.
The comment said, " The de-coupling argument was disproven last year. If the U.S. economy lapses into recession, it will take down demand for exports from emerging markets, which are also highly vulnerable to credit market conditions. " I don't know that the argument has been disproven, but is Dr. Leeb saying that the rest of the world doesn't need America's consumption?
1. IMO you should be clearer in your mind on timeframes. Have a long term view. Long term you favor emerging markets, commodities and inflation (I agree) so invest on that basis. Short term you don't know (neither do I) so implement hedgeing strategies. But don't get too concerned with the short term to miss the big picture. Where are your emerging market stocks that capture the huge long term growth in the middle class? These were the winners in our stock market history.
2. You say "Sharply higher commodity prices can limit growth and rapid growth can bring commodity prices down". Yes, sharply higher commodities can limit growth. This mainly happens through supply shocks. This is what you see when you look at your data back to the 70s. But rapid growth can not bring commodity prices down. Growth can bring gold down and it can be independent from softs, but not commodities generally. The only way growth can bring down industrial commodities or energy, is if it encourages additional investment. But "rapid growth" does not give you enough time to build mines or develop oil fields.
This shift in power and influence carries some dire implications for Americans.<<
The relative shrinking of American economic dominance is inevitable and probably began at the stock market peak in 2000. At that time the cold war was over, gold was $300 per ounce, oil was $25 per barrel, the Yen was pushing 140 and the Euro was struggling to hold parity with the US Dollar.
What we could do to help ourselves is maximize our use of the available energy we are rich in (coal, natural gas), while developing alternatives. Nuclear energy is a no-brainer but its not even in the discussion.
We are rich in agricultural resources as well, so rising food demand won't hurt everyone (Jim Rogers has been saying for years to buy farmland in Iowa, lol).
But if we continue on an unsustainable path of borrowing to pay for a larger and larger Federal Government and its expenditures our currency will continue to decline and interest rates will rise. It's so inevitable its sad. Imagine getting 10% interest in a money market fund, and paying 15% for a mortgage. It's inevitable given past and current fiscal policy.
Just when the teeter-tauter flips is anyone's guess, but once this deflationary-credit bust is over, the US Dollar will quickly resume its downward trajectory began in 2000, and interest rates will rise relatively rapidly.
I will be offsetting this will foreign currencies, commodities, and foreign stocks. The 2003-2007 bull run was prelude to decades of market action if the US becomes a stagnant indebted welfare state.
The replies are outstanding and I found myself agreeing - in part - with every response.
However, Dr.O states "...We are rich in agricultural resources as well, so rising food demand won't hurt everyone (Jim Rogers has been saying for years to buy farmland in Iowa, lol). ..."
No, rising food demand won't hurt "everyone" like the ruling elite that this article so aptly points out (though doesn't mention the largest & most influential - the Celebrity Class - clueless, entitled, setting policy and winning over the hearts and minds of the lower and middle classes. anyway, I digress) and the ruling elite is getting ready to gut the ability of the small family farms and natural products industry. All in the name of safety, but in reality another gift to the ruling elite of the farm/ food/ chemical/ foreign community. We have to remember that Ted Turner, yes THAT Ted Turner, is the largest "farmer" in America, and HIS free government cash proves it. We also have to remember that nearly 70% of our food comes from Asia, Mott's Apple Juice and nearly all WalMart brand food comes from China. Increased costs, fees, regulations, excessive government interference and paperwork for ANY size American company, while the huge Chinese processors are ignored.
Once again, the small businesses (selling REAL food, not genetically modified and dubious) are being sacrificed on the altar of big business and foreign competition.
We in manufacturing tried to warn you all a decade ago. We tried to tell you that once manufacturing was gutted, they would come after you. Did you listen? Nope.
And you aren't listening now either; else you would be on the phone telling your elected official not to pass the food safety act. Or, do what you did with free trade, nothing, and allow another strata of your own customers, and this once great nation, to be decimated.
Some of the developments taking place in India and China can be attributed to our outsourcing employment to those countries, contributing in part to the emergence of their respective middle classes.
Knowing the US consumer is down and out, from a policy perspective we should be doing everything possible to exploit these global developments by developing an export policy which would support current value-added exporters (Boeing, BASF, ADM, CAT, GE, 3M) and others positioned to best mine the new wealth being created in emerging markets. An excellent starting point would be to streamline export controls imposed by the State Department and other agencies to protect technologies and components critical to national security.
Because of bureaucratic overlap and poorly written guidelines, many companies find it difficult to obtain export licenses and rightly argue that the US is crippling its own export industry.
I don't know why anyone would want any domestic oil company. The power elite in D.C. are salivating at the thought of HUGE windfall profits taxes on the domestic oil companies, once we get oil back above 100 bucks per barrel.
I prefer PBR for this reason.
On Aug 18 08:50 AM Tony Petroski wrote:
> Let me get this straight. Buy gold because it protects against both
> inflation and deflation. Round that out with Chevron because China
> and India are rising?
Gold is a universal currency. Even in deflation it's value holds constant or goes up. Gold prices went up 65% from 1929 to 1938 during deflation.
During inflation, as the purchasing power of a dollar drops incessantly, the value of gold does not because it is not a fiat currency but a tangible asset valued by all cultures and useful in personal and industrial applications. The best crown you can get for a bad tooth is still gold.
If dollar value drops, the cost of things we produce drops for the rest of the world. What we produce the most of that the world also values the most is food. We kept millions of Russians alive through the past 50 years via exports, and have saved millions of lives with our improved rice and other cereal grains in Asia and South and Central America.
When there are socio-political crises at home or abroad, commodities are what have value.
Why would someone invest in equities at this point? Yes, I might miss a vaporous nitrous oxide fueled ride up to DOW 15,000 if the stars align, but it will come back to the reality of fewer jobs, less spending, higher taxes, and much lower corporate earnings sooner or later. I don't want my ability to have heat and food dependent upon a corrupt government in collusion with Banks and Coporations maximizing their portfolios at my expense on a quarterly basis, thank you very much.
On Aug 18 08:50 AM Tony Petroski wrote:
> Let me get this straight. Buy gold because it protects against both
> inflation and deflation. Round that out with Chevron because China
> and India are rising?
So now the Fed needs to enlist a gaggle of professional speculators just to keep all the balls in the air. What a joke. This isn't a rebound; it's just more hype. Here's Warren Buffett summing it up on CNBC:
"I get figures on 70-odd businesses, a lot of them daily. Everything that I see about the economy is that we've had no bounce. The financial system was really where the crisis was last September and October, and that's been surmounted and that's enormously important. But in terms of the economy coming back, it takes a while.... I said the economy would be in a shambles this year and probably well beyond. I'm afraid that's true." "The economy is in a shambles". That's from the horse's mouth. Inventories are down 11 percent year-over-year, durable goods are down 10.4 percent y-o-y, industrial capacity is at record lows, manufacturing is still contracting, housing is in the tank, shipping and rail freight are scraping the bottom, retail is in a long-term funk, and--according to Krugman--the slight dip in unemployment was a statistical anomaly.
No recovery ison this horizon.
In my day we preferred PBR as well as in Pabst Blue Ribbon.