September is the month for one of our semi-annual economic updates. Both of our scenarios begin with the major problem facing the world economy today: the large current account deficit in the United States, and its counterpart current account surpluses in other countries (principally in Asia and more recently in OPEC). the world economy has become very dependent for its demand growth on the United States and China. However, domestic demand growth in the United States has been based on a combination of consumer and government borrowing (along with relatively loose monetary policy) that is, in the long run, unsustainable. Quite simply, neither U.S. consumers, nor government, and certainly not both together can forever spend beyond their means by borrowing from the rest of the world. Unfortunately, domestic demand growth in China looks even less stable. Behind the 7.8% private sector balance lie enormous internal imbalances.
The essence of the problem confronting the world economy -- and investors -- is this: we all know the current system must come to an end. What we don't know is how or when this will happen (although the sharp rise in oil prices seems to be hastening that day's arrival). In the back of everyone's mind is an optimistic scenario one might call "the grand bargain." In it, the governments of the world come together, and agree to the following: (a) a reduction in the U.S. public and private deficits; (b) a fall in the U.S. exchange rate; (c) an increase in exchange rates and domestic demand in the Eurozone, Japan, and NICs; and (d) hope that this keeps the wheels from coming off in China. We don't put too much stock in the "grand bargain" scenario, for the simple reason that too many things have to go right for it to work -- and the joint probability of all those things happening appears to be quite low. This is especially true given the political pain that many of these measures would entail. If it happens at all, we think it will take a severe crisis to get leaders to seriously consider it, and by then events may have gotten too far out of control for a grand bargain to work. That leaves us with our two principal scenarios.
In our "conventional wisdom" scenario, the global economy continues to "muddle through" for a while longer without a major crisis. Logically, this requires continued demand growth in the United States and China, which fundamentally depends on the continued willingness of foreign investors (especially Asian central banks) to keep accumulating dollar denominated assets to finance the United States current account deficit.
Our most dangerous scenario is characterized by a sudden rush out of dollar investments. There is no telling for sure what could cause this to happen. It might be a sharp drop in U.S. consumer spending, triggered by the rise in oil prices or a slowdown in the increase in housing crises (for an example of the latter, one need look no further than what is happening in Australia or the Netherlands today). Or it might be caused by foreign (and some domestic) investors' declining confidence in the ability of U.S. political leaders to resolve that country's fiscal problems (particularly those related to the exploding costs of Social Security and Medicare).
We think the most interesting question is how the "end game" of that crisis would play out. Suppose you are a U.S. political leader, and you are faced with this choice. One way to get out of the deep recession (and quite possibly deflation) I'm facing is to crank up the money supply and inflation. This will hurt bondholders (at least those who own nominal return bonds), but will help all those voters who bought their houses with fixed rate mortgages. The other alternative is to maintain monetary discipline (and the wealth of bondholders), even if it means the economy must endure a prolonged recession (which will cause a lot of voters to lose their homes when they lose their jobs and can't make payments on their mortgages). If push comes to shove, our view has been that the vast majority of political leaders will choose the inflationary route out of the crisis.
We review the options that are available to investors wishing to hedge their downside exposure to potentially overvalued asset classes, and to the impact of our most dangerous scenario. We conclude that put options and cash both have limitations, given our uncertainty about how much longer the current imbalances will continue before they are reversed. Stop loss orders have a lower cost, but present challenges in setting the stop loss price at a level that will not be triggered too early by normal day to day price changes. Finally, we note that while rebalancing to below target weights in overvalued asset classes (and above target weights in asset classes that will do well under our downside scenario) makes sense, it probably makes sense to defer this until we publish our revised model portfolios later this year.
Among other subjects, our product and strategy notes compare oil exchange traded funds to existing commodity index products. We continue to prefer the latter. We also review the trade-off between capped and uncapped indexes in smaller country markets. We find that the choice depends on the extent to which an investor's portfolio is diversified internationally.
| Equity Market Valuation Update | Economic Update: Semi-Annual September 2005 | This Month's Issue: Key Points | Global Asset Class Returns | Product and Strategy Notes: Oil ETF vs. Commodity Indexes, Reader Comments: Everbank Minimums, USDX, VSTOXX vs. VIX, IPOX-30; and Canada (Active vs. Passive) | This Month's Letter to the Editor: Convertible Bonds, Defined Pension/Social Security and Siegel's Paradox |