7 Scenarios to Mitigate Risk, Position for Opportunity

by: Christopher Begg, CFA

When we stop and listen to the cacophony of the marketplace the noise appears most deafening around uncertain macro and geopolitical outcomes. The consensus appears to be exaggerating the magnitude and swiftness of potential outcomes. It’s during these times that it makes sense to elevate one’s perspective.

We believe there is a historical sea change underway whereby there are paths of considerable risk and conversely paths of great opportunity. Let me explain the “what” and the “why” – the “wu” and the “wei.”

In Chinese philosophy “yin” and “yang” are complementary opposites that interact within a greater whole as part of a dynamic system. Yin yang is used to describe how polar or seemingly contrary forces are interconnected and interdependent, and how they give rise to each other.

When defining yin and yang it is common to describe in terms of sunlight moving over a mountain. Yin literally means “shady place” and yang means “sunny place.” As the sun moves across the sky, yin and yang gradually trade places with each other, revealing what was obscured and obscuring what was revealed.

One could argue that the world has been out of balance for some time. Only 25% of the world’s population lives in the developed world, yet this group has been consuming 75% of output (GDP). This multigenerational yang phase led by the US, Europe, and Japan culminated in a leveraged induced bubble which imploded in 2008.

The contrary force was the emerging countries, led by China, India, and Brazil which provided the inexpensive human capital and natural resources to serve the developed world’s appetite. China, India and Brazil make up approximately 40% of the world’s population.

Today we are witness to a seismic shift as the actors in these roles change places. Within our global dynamic system, a rising yang is represented by emerging countries and the waning yin has transitioned to the developed world. Westerners often confuse yin and yang with good and bad. That is inaccurate and this change should also not be interpreted as positive or negative for either party.

It is a natural progression and there will be investment implications to consider as rebalancing occurs. We will need a rational and thoughtful process to anticipate risks and the opportunities that will materialize. It seems logical that we may need to invert our own developed world perspectives to ask the right questions and synthesize constructive answers.

The developed world appears not to have processed this paradigm shift and the emerging countries are not just aware; the process of change is culturally indoctrinated, particularly in China. The I Ching is one of the oldest of the Chinese classic texts and its philosophy is not only intrinsic to the Chinese culture, it is also seen by the Chinese as being the “universe in miniature.” The principal message centers on the dynamic balance of opposites, the evolution of events as a process, and acceptance of the inevitability of change.

While investors have priced in imminent dramatic change, our differentiated view is with regard to the timing and structure of the prospective transformation. We anticipate a deliberate and prolonged rebalancing with China leading the emerging country yang cycle. Investors should anticipate the Chinese to follow a Taoist “wu wei” approach. This is defined as action that does not involve struggle or excessive effort - the paradox of action without action.

The consumer will be the driver of change and rebalancing. With the Middle East uprisings, one can observe just how interconnected the world is and more importantly the human desire to live a better life. We should not underestimate the power of the interconnectedness of technology and its effect on the aspiring emerging market consumer. Many of the imbalances that exist today in trade, currency reserves, and resource distribution will slowly solve themselves. [1] The newly minted yang consumer is and will be the linchpin.

At East Coast we are keenly focused on what businesses earn the right to sell goods and services as demand patterns evolve globally. We believe our biggest opportunity will come from the consumer force that will change over the years and decades to come. Simply put, we want to own global businesses that have a localized advantage.

Below is a list of outcomes where we see reason to mitigate risk and position for opportunity:

  1. Developed countries continue to exercise “force majeure [2]” and print money to debase the value of their debts. Unemployment continues to be a focal point of the developed world. Quantitative easing appears to be the medicine to quell further job losses. A US election cycle will incent the Federal Reserve and our Administration to err on the side of more stimulus.
  2. Emerging countries play their hand deliberately and allow for their consumer populations to grow and rebalance mismatches versus sudden shocks that could drive social unrest.
  3. Inflation will be heightened globally and accumulated wealth is at risk of losing purchasing power. Limit fixed-dollar investments.
  4. We believe global equities will perform better than expected as investors seek an alternative reserve currency as paper currencies and bonds lose value.
  5. High quality businesses that can raise prices and whose products have localized advantages with a growing emerging market consumer will thrive. We conclude that high quality businesses also represent the most attractive valuations from today’s prices.
  6. Interest rates continue to move higher to calibrate for real purchasing power erosion. Rates have already moved 100 basis points and upward pressure will continue.
  7. We expect weakness in the developed world currencies (USD, Euro, and Yen) versus emerging country currencies which serves to increase attractiveness of developed world exports and helps bridge imbalances.

[1] Chen Deming, China’s Minister of Commerce, recently expressed his optimism on Chinese consumer demand in the high-end segment with the following comments: “In a few years, we will replace Japan as the No. 1 (luxury good importer); this is not surprising as China has a population of 1.3 billion people, which is 10 times that of Japan.” According to McKinsey, sales of luxury items in China may more than double within five years to 180 billion Yuan ($27 billion) in 2015. CLSA forecasts that demand for luxury goods and travel from China will account for 44% of global sales by 2020, up from 15% currently.

[2] Referenced in our Q42010 Letter – “A Unified Theory of Investing.”