Clarifying America's No-Win Economic Dilemma

|
Includes: BKF, CVX, DIA, EEM, QQQ, SPY
by: Stephen Leeb

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 (NYSE: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.