Ok, you must have heard the phrase the "New Normal." Coined by Pimco's uber-smart chief Muhamed El-Arian in 2009, the term essentially refers to the fact that the US economy will persistently have sluggish growth & high unemployment, and wealth will continue to migrate from industrialized economies to more emerging countries.
My question is, what does this mean for how to allocate assets over the next 5 years. Because right now, the dollar seems stable, the US economy appears to be humming along, and emerging market stocks last year lost out to the S&P 500. That is a first in a long time, and even this month EEM (a good emerging market ETF) is barely up 0.3%, vs the S&P is up 2.0%. So should we buy US stocks and avoid EM markets now? What will the US economy really look like compared to EM markets in the next few years?
Generally speaking, I think its worth backing up and looking at WHY we are in the "New Normal." And also asking the question, is the New Normal OVER for the US?
To put it bluntly, no, its not over. It's been delayed, the proverbial can has been kicked down the road again, so to speak. We have a leverage problem that will take years to solve. The analogy I will make is that economies are no different than a household. Think of the US economy as your house, Japan as another house etc. That is, your household generates a certain amount of income. Then, you spend that income. Hopefully you spend a little less than you make. That's how you get rich. By saving. Your accumulated savings builds up, and eventually (hopefully) you start making money off your money. The American dream. Retire with lots of capital to have fun with.
Now, imagine the US economy is your household. The US economy generates a certain amount of income. That is, the US generates business income in the form of profits, and consumers generate income in the form of wages (and profits too, say from stocks or businesses or loans). (Governments generally get a piece of everyone else's income). Then our economy (household) spends money. That spending number is GDP. Think about that. Nobody really looks at income in our country, we only look at GDP. Sure we call GDP income, but it's not. Economists and politicians strive to grow GDP, not strive to grow NET WORTH or income, which means they just want everyone to spend money, even if anyone and everyone has to borrow that money to spend it.
If you remember your economics, GDP is:
Consumer Spending, plus
Govt Spending, plus
Corporate Spending, less
Net imports.
SPENDING money isn't the same as generating wealth, and really why the US may be one of the poorest countries in the world. Essentially, the problem we have in this country, among others, is that politically its very painful to see GDP decline. People lose there jobs, demand falls, worker's wages decline. Not good. Especially around election time.
So for the past 30 years, Consumers and our Government have been steadily borrowing more money so that they can spend more and grow GDP. Spending has nothing to do with generating wealth however. I find it ASTONISHING when I read things like this: "The economy is suffering because people aren't spending as much as they used to." Or, "the government is encouraging banks to lend more." HOLY CRAP, that is most riduculous thing I have ever seen. Saving money is NOT BAD for our economy, it is the only way to truly generate wealth. This is true of consumers, businesses, governments, and entire economies.
Since we have ignored savings for decades, our infrastructure is declining and educational system are also seeing far too little investment. We aren't competitive in the world in manufacturing, and its not a surprise that we have lost 3mm manufacturing jobs since the year 2000, and China has gained 6mm manufacturing jobs.
So the quandry we have now is that our debt growth has actually fueled GDP growth for about as long as we can remember. Somewhere around the early 1980s we decided that peace time government deficits were ok. The problem is that politicians have entirely ignored that our country's income has been lagging spending grossly. And, just like your house, at some point you cannot borrow any more money, the well runs dry and you have to repay your debts. That is where we are today. GDP will not only revert back to income levels, but likely has to revert to below income levels to begin de-leveraging.
Now, Keynes would have you believe that when the economy hits a rough patch, government spending can make up for slowing business and consumer spending. That is partly true...you lose your job you can make up for lost wages by borrowing a little money. However, what our economic leaders of this country (lead by Bernanke and Tim Geithner and the entire Republican party) believe is that Keynesian economics always works. They take Keynesian economics to the extreme, that you can always turn on the government spending spigot and keep our economy growing forever. Ridiculous, I encourage anyone serious about this subject to do a little work on the Austrian School of Economics, which is what our economic leaders will eventually learn, the hard way.
So, to put some numbers and historical perspective on that, Total US Debt (corporate plus consumer plus government debt), is now at 350% of GDP. In 1980, that number was 150% of GDP. In 1929, that number was 300% of GDP. Take a look at this chart courtesy of Morgan Stanley to see why we will face a New Normal for at least a decade.
http://paul.kedrosky.com/archives/2009/03/us_total_credit.html
(on chart GSE debt is basically mortgage debt backed by the US govt, more govt debt).
That brings up one other side point. The Great Depression wasn't caused by bad monetary policy, as Bernanke would have you believe. It was caused by the after-effects of a decade of de-leveraging. I don't understand how its not abundantly clear that everyone and their brother margined stocks in the late 20's, then got stuck paying back the bill for a decade. The same is going on now, but its mortgage debt turned governement debt that we'll be repaying for a long time. (there is also the problem that we have been shifting mortgage debt to our govt's balance sheet, via bailouts and subsidies on home purchases and guarantees of mortgage debt, much of which will default).
So, why is GDP looking like its going to grow 2.5 to 3% this year? Well, while consumers were net borrowers for years up until the bust of 2008/2009, savings rates have stabilized now, at around the 5% level. However, government borrowing continues to rise to offset consumer saving to keep the debt train going. Tax rates are actually falling in 2011 in the face of more govt spending. I was amazed that our newly appointed Republican House, elected because of American's disgust with large deficits, immediately CUT taxes and basically got on board with even larger deficits. Somewhat a slap in the face in my opinion.
All of this makes me worry what will happen to the US economy come 2012 or 2013, when we are forced to make government spending cuts. GDP will get hurt, government workers will be cut. For a preview, see today what is happening at the state and local level. The muni market is again selling off, dramatically this week. Workers are losing jobs, taxes are going up (Illinois just raised state taxes by 50% or something crazy). Ugly.
So, as we are already seeing, US unemployment isn't really improving. Sure GDP is growing a little, but that isn't necessarily a good thing. It's just huge government spending. We aren't saving anything, we are getting poorer as a country. If you think this is fine, we'll talk in 10 years and compare China's wealth and clout in the world vs ours. China has 15% government Debt to GDP, however Consumers save 50% of GDP, and they have net trade surpluses of another 4% of GDP. Their economy is saving MASSIVELY. Who do you think will be richer in 10 or 20 years? Who owns much of our debt that we have to repay? Foreigners, to the tune of 50%.
As for Japan, much has been made of their declining population, coupled with huge government deficits and pension obligations as their population ages. However, their consumer savings rate is 15% of GDP, and their governments hold large quantities of cash/money market funds, especially at the local level. So while gross government debt is the biggest in the world at over 200% Debt to GDP, their total societal or economic debt is probably around 100-150% I estimate, far less than the US at 350%. And China has net wealth (not debt) of at least 30-50% of GDP.
So what does that tell me about allocating personal savings? Clearly owning non-dollar assets is key. The dollar can only fall in the face of a weak economy, government deficits and debt monetization. Second, it's imperative to find non-dollar assets that will benefit from global growth. Right now the problem with EM stocks is that PE ratios are pretty high, 15-25x, a fair amount higher than the historical valuations in the 10-14x range. That said, growth is higher, but then again, political risk and currency risk are also higher. Brazil was up 83% in 2009 but then only 7% last year. I don't really know enough to want to get long these equities now, they are more expensive, there has been a lot of popular media attention on owning EM stocks. Its tough to add here. Perhaps when they pull back.
That said, I think Jeremy Grantham, one of the smarted investors in the world, makes the most sense. He likes big cap US equities with international exposure. Furthermore, many blue chip companies are trading at near all time valuation lows. (the S&P is flat in the last 10 years, but not because earnings are flat). Now, while the US economy will bumble and stumble for a long time, I think that stocks with low valuations and high international sales offers a good way to get exposure to EM and foreign markets, without paying high multiples. Here are a few I like, and already discussed in prior emails:
IBM, CSCO, HPQ, JNJ, KFT, AAPL (yes 57% of Apple's sales last year were international).
I know these name seem boring, but when you can buy them at 7-10% FCF yields, and benefit from a falling dollar, which is clearly inevitable, then there is much to like. I also think Newmont Mining, NEM is interesting here, its gotten beaten up with the dollar rallying. I see that Gold prices are up 50% in the last 2 years, and this stock is flat. It trades at 12x earnings, a 7.5% FCF yield, and is a good hedge to the dollar falling. While I think gold is a bubble to some extent, the bubble is not over. Consider Argentina in 2001 after the peso devaluation. Gold skyrocketed from $265 to $1120 an ounce, in ONE year. (Aug 1, 2001 to Aug 1, 2002 to be exact).
Oil stocks are another necessity to your portfolio. While oil is priced in dollars, and seems crazy at 90 a barrel, its still well below the 2007 highs of $140 a barrel. There is only a fixed amout of oil in the world, with new reserves clearly declining every decade since the 1970s. If you don't believe in peak oil, send me an email and i'll send you a chart of new oil discoveries by decade for the last 100 years. We peaked 40 years ago. Either way, dollar declines benefit oil prices in addition to simple demand growth for the commodity.
Oil plays to consider are COP, PBR, and XOM. My next task to figure out which one.
Finally, own some non-dollar hedged EM bond funds and currencies. I am today adding a small amount FXA per one of my smart hedge fund buddies. Its an Australian dollar ETF, and actually yields 3.2% given higher rates in Australia. Australia is a $1 Trillion economy, GDP grew 3.3% last year, unemployment is 5.4%, Debt to GDP is 17%, very low. The negatives are a 6-7% current account (trade) deficit, and high real estate prices. The Australian dollar tends to be somewhat correlated to the US stock market, so if it falls as I expect a pullback soon, add more then. But LT its one of the best currencies in the world.
As for EM bonds, I like PLBDX. Also consider TPINX. I have almost 20% of my PA in PLBDX, and it was up 12% last year. Its down 3.2% in the last 3 months, mainly on a bounce in the US Dollar, but I think PLBDX will rally as the dollar starts to decline again.
I also will mention WGRNX, another international stock value fund. Up 20% last year, its down a little in January, again as the dollar has rallied. Its my biggest position and is 68% long non-USD companies.
Net net that gets me well over 60% of my exposure is to foreign currencies, gold or non-dollar denominated assets. Note that that includes the international components of my big cap US stocks and mutual funds. But on the whole its a level of exposure that I think is a necessity.
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