It’s been my long-held and often expressed view that the world’s developed economies would suffer a bout of deflation on the way out of the group’s long-term growth cycle that culminated in the credit crisis. If you’ve been on the Emerging Markets Speculator bandwagon since 2007, you’ve been on the deflation bandwagon, too, long before it got crowded in recent weeks.
You are, therefore, not surprised by recent developments in the US Treasury market and the Federal Reserve’s participation in it. The Fed announced this week that it would begin rolling over maturing mortgage-backed securities into longer-term Treasuries. This move prevents tightening of interest rates.
It also confirms a forecast I first made in The Silk Road Investor in early 2009, that the Fed won’t raise its benchmark rate until the middle of 2011. The tenor of the Fed’s statement this week indicates, actually, that the central bank may stand pat until 2012.
Core inflation in the US next year will remain below 2 percent, validating the portfolio hedging strategy I’ve long recommended: investing in US Treasuries.
This scenario has soured the market mood, while the permabears have found yet another new excuse to bombard their audiences with the “end of the world” stories that are so fashionable today.
The US economy has a lot of problems to deal with, many of which are not new but have been exacerbated by the recent crisis and the socioeconomic changes–including more government interference in the economy–that have come about in its wake. Setting aside these longer-term perils, the fact remains that the Fed’s move is also a way to prepare for an aggressive asset-purchase program if one is required.
What the Fed sees (apart from the deflation issue) and everyone knows is that growth is decelerating, with domestic demand leading the way. The consensus view is that the 4.1 percent growth in domestic final demand we saw in the second quarter is vanishing. The question now is whether the economy will be able to sustain at least some growth.
My view is domestic demand will fall to around half the second-quarter rate, which, although not spectacular pace, will prove to be sustainable. It’ll also turn out to be an upside surprise for the market. In today’s economic environment–particularly with regard to developed economies–any growth in domestic demand (as long as it’s sustainable) is positive.
The Fed also must account for the political process. The US Congress must act before the end of the year or advantaged rates for dividends and capital gains will expire. If Congress fails to pass legislation addressing the so-called Bush tax cuts, it’s likely the Fed will be forced to step in to reassure markets in the wake of another external blow that it will do whatever possible to achieve sustainable growth.
Central bankers are in a very difficult position these days. The waters they must navigate are difficult, and they have to do it in ways that are politically acceptable, i.e., there can be no deflationary outcome, no inflationary outcome, no depression–in other words, no pain. It is far from certain that their efforts will succeed. But they do have the ability and the power to make effective policy.
As for the market and the economy, my view hasn’t changed since I wrote the following in Silk at the end of June:
Since the beginning of 2010 investors have been extremely pessimistic on the sustainability of the recovery. As long-term readers know, my view has been a little more upbeat, and I considered several selloffs during the first six months as opportunities to add to positions.
That being said, sitting on the sidelines for the rest of the summer doesn’t seem a bad idea. Markets remain uncertain, and as the summer progresses volume will continue to suffer, rendering market moves volatile and unsustainable.
My view remains that the global economic recovery is sustainable, though it’s likely to be weaker than previous rebounds. Limited income growth in the G7 economies is the main worry for investors. The slowdown in inventory restocking that’s been a major force in the recovery is cause for additional concern and explains investors’ recent pessimism.
What all this pessimism has done is bring valuations down to desirable levels, especially in Asia and other emerging markets. Asia excluding Japan is now trading at around 2 times the overall price-to-book ratio, very close to the market’s 30-year average. If markets remain weak for another couple months, valuations will come down significantly more, making Asia the place to be for the final stretch to the end of the year.
The bottom line is this: Look for a market low during the next one and a half months. Look to add some beta to your portfolio as we gear up for the fourth quarter. Asia will prove to be the most profitable region, as it’s the only important economic block where asset inflation is still in order and will remain so for some time.
Focus on real estate, technology, industrial, and financial names. Consider also global materials, particularly during times of weakness.
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