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My outlook for 2010
I wish I can be a little bit more enthusiastic when I exchange “Happy New Year” wishes with family and friends. I just cannot do it because deep inside, I think there will be more pain to come in 2010 for investors. When I look at the events that have taken place in the past year, my gut feel is that we have only fixed our problems with band aid solutions and potentially set ourselves up for bigger problems in the future. Massive government intervention in almost every country globally has managed to stimulate a “recovery” and I will be the first to admit that I had underestimated the short term effectiveness of government stimulus and missed out on the stock market rally in 2009. Growth is normally measured by looking at the Gross Domestic Product (GDP) and most countries have managed to turn in more positive GDP numbers in the last few quarters. However, GDP is more of a measure of spending. Ideally increased spending is due to increased earnings (healthy growth) but it can also be due to increased debt. Most of the recent GDP growth is from government spending which is often funded by increased government debt which does not seem very healthy to me. The challenges in 2010 and beyond would be how governments can find the money to repay these debts and how corporations can wean themselves from government aid and still remain competitive. I have already talked about the problem with sovereign debt in earlier posts and there are also plenty of articles about it in the financial news ever since the Dubai World announcement shook global markets on Thanksgiving Day in 2009. I will focus on latter point instead.
The following example clearly demonstrates industry’s dependence on government aid / intervention. On 30 December 2009, the US government announced that it will impose new duties on imports of steel pipes from China. US steelmakers have accused China of “dumping” cheap steel products in the US. Chinese steel manufacturers have been able to sell the products cheaply because they received subsidies from their government. This is the largest trade dispute to date between the US and China and there has been many others over tires, poultry and movies in recent months. Similar trade disputes have also been happening between China and the European Union and Canada over the “dumping” of steel products. All this makes me wonder how healthy the “miraculous” GDP growth is in China. There is already an overcapacity problem in China and the government continues to encourage fixed asset investment so the people can continue to have employment. But is producing at a loss a sustainable model when there is not enough real end user demand for the products? Below is a graph showing the rate of government sponsored investment taken from a report published by the Productivity Commission entitled “China’s Policy Responses to the Global Financial Crisis“. The report highlights the risks in the measures taken by the Chinese Government on China’s long-run growth. This report is worth reading as China has been credited with leading the recovery and Australia’s fortune is closely tied to China’s.
With China (and many other export driven countries) ready to flood the globe with cheap goods, it will be difficult for the rest of the world to increase prices which is why I am of the view that we will experience price deflation rather than inflation (see my earlier series of posts on Inflation vs Deflation). In 2010, the US state of Colorado will reduce its minimum wage, the first decrease ever since minimum wage was adopted in 1938.
During the Christmas break I read an interesting report from Gavekal, a research company based in Hongkong. They also highlighted the overcapacity problem in China but what I found most interesting were their ideas for asset allocation for different investment scenarios. According to Gavekal, there are four investment scenarios: 1) Inflationary bust 2) Inflationary boom 3) Deflationary bust and 4) Deflationary boom. The inflationary boom scenario has been most prevalent in the post WWII years. In this scenario, emerging markets and commodities would do well. For the first time in a long time, the investment scenario could be shifting to a deflationary one. Looking back through history, deflationary busts tend to happen when governments commit one or several of the following cardinal sins:
- An increase in taxation
- An increase in regulation
- Protectionism
- A war
- Following too tight a monetary policy
There are already signs of increased protectionism which would lead to more tension between countries. I would also expect governments to increase taxation to raise funds to pay their debts. In a deflationary scenario, cash and high quality government bonds would be the best investments. Interesting food for thought as we prepare our investment strategies for 2010.
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[...] outlook for FY 2011 is not very different from what I wrote in My Outlook for 2010 at the start of this year. The same macro problems are still there e.g. the sovereign debt [...]