Tag Archives: globalization

The Credit Crunch and the Market

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The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.


The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

Out of Favor, Into the Portfolio

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The Dow Jones Industrial Average is hitting new all-time highs while crude oil is making new lows for the year. Moving in opposite directions is normal for these markets, but recent movements may come as somewhat of a surprise against a backdrop in which core inflation has risen to levels not seen in a decade and the yield curve is inverted.

China and India seem to be in a race to secure energy reserves in anticipation that within three years, Asia’s oil consumption will surpass North America’s. Global economic production is expanding by about 4%, about double the average rate of the last 50 years. Growth rates are highest in the countries with the largest populations, and consumption is being subsidized by growing global debt markets.

Stock valuations anticipate strong growth while commodity prices anticipate adequate supplies. This is an intellectual error.

Only fools and economists believe in infinitely compounding growth

For major world markets to continue recent growth rates, many major supply-related hurdles would have to be overcome. Current capacity for energy supplies are insufficient to support more than a few years of continued growth at this rate; additional capacity will have to be created. However, whether or not one believes in the “peak oil” theory or not, it is indisputable that known oil reserves are shrinking while discoveries are taking longer and yielding less.

While the pendulum of stocks and commodities has swung toward stocks, the fundamentals seem set up to push the pendulum back the other way.

Stocks and Commodities; Owning Both

Commodities often move in the opposite direction from stocks over periods of three months or longer. Over longer periods, this negative correlation becomes quite strong; as much as -42% for five-year periods. The result is that these two asset classes have provided strong diversification benefits when combined in a portfolio. Their risks offset each other to a high degree, resulting in more consistent wealth accumulation.

The fundamental basis for this behavior is easy to understand: stocks do well when the resources they need are cheap. Similarly, profits are diminished as the prices of natural resources go up. In addition, as commodity prices rise central banks tend to raise lending rates and slow down corporate growth rates. For this reason, commodity prices tend to be a better hedge against unanticipated inflation than
stocks, and much better than bonds.

Combinations of these two asset classes can be represented along an efficient frontier. This chart makes clear that risk was dramatically reduced by the
introduction of commodity futures while having a very small impact on returns.

Risk-averse investors who are sensitive to maintaining their purchasing power should consider commodity futures as a component of their portfolios.

Ignored Risks

The risk to the value of the U.S. dollar should not be overlooked. Many countries own substantial foreign reserves in U.S. dollar denominated debt. If these countries decided to diversify into a broader basket of currencies or assets, the outflow of capital would put pressure on the value of the U.S dollar. Commodities provide a hedge against volatility in the value of the dollar by maintaining purchasing power.

Global Growth implies Unprecedented Demand

World population is rising at a rate of about 1.3% per annum, or about 10,000 new people every hour. At the same time, productivity in the U.S. is rising at about 2.6% annually. The U.S. has very high productivity relative to other countries, and it is growing. At the same time, the vast majority of the world population lives in countries where productivity is much lower – but catching up.

The process of productivity convergence has been dramatically accelerated by the opening of trade, reforms toward capitalism, and the growth of the internet to share information. The long-term trajectory is for developing countries to grow toward U.S. productivity levels. This simple dynamic has some profound implications: we’re not ready.

If Chinese productivity rises to even half of U.S. levels, that economy’s GDP will expand from less than one fifth that of the U.S. to more than double that of the U.S.

Consider 2 scenarios:

1) An unrealistically pessimistic scenario:


a. World population suddenly stops growing.

b. The U.S. never innovates, and simply maintains existing productivity levels.

c. Other countries catch up to U.S. productivity levels in 50 years.


a. China would average 6.6% growth for 50 years, raising its production by more than 24 times to more than four times the size of the U.S.

b. India would average 8.5% growth for 50 years, raising its production by almost 60 times to more than three times the size of the U.S.

c. Global production would rise by more than 5 times.

2) Constant population and productivity growth:


a. World population continues to grow at 1.3%.

b. U.S. productivity continues to grow at 2.6%.

c. Other countries catch up to U.S. productivity levels in 50 years.


a. China would average 10.8% growth for 50 years, raising its production by more than 169 times, to more than 30 times the current output of the U.S.

b. India would average 12.8% growth for 50 years, raising its production by more than 410 times, to more than 25 times the current output of the U.S.

c. Global production would rise by more than 41 times.

These long-standing and slow-moving global economic trends will almost certainly be interrupted by commodity shortages during this period. Even the most optimistic forecasts for natural resource capacity do not anticipate supporting even the conservative scenario for growth.

Something has got to give.

We expect that as population and productivity trends push demand higher, commodity prices will rise to keep demand lower. Equilibrium prices are likely to be driven increasingly by production capacity as shortages develop. Over time, this will likely slow global growth rates and provide advantages to companies and countries that are net suppliers.

Global Risks, Global Opportunities, Investment Commentary, Q3 2006

The following article is also available with charts, graphics, and additional information here.

The global population participating in world markets has risen from about 500 million to about 5 billion since the end of the cold war. This 10-fold increase in the number of workers and consumers is the dominant force in the world economy, underlying many major trends such as:

  • The boom in outsourcing and world trade
  • The falling “real” cost of low-skilled labor
  • Deflationary pressure
  • The de-industrialization of the United States
  • Overwhelming demand for natural resources

The political response from developed nations has been to embrace free trade, promote global growth, and fight deflation by increasing the money supply.

As the world adjusts to the new labor force and production capacity, we expect these trends will evolve naturally. Outsourcing will continue and broaden as technology continues to make distance and language less of an impediment. The real (inflation adjusted) wages of low-skilled labor will continue to lag. Deflationary pressure from expanding trade and improving productivity will be offset by an expanding capital base. The de-industrialization of the United States will slow as energy and commodity prices rise because U.S. industry is more energy-efficient than most competitors. The overwhelming demand for natural resources will continue to drive up prices, as demand continues to grow faster than supply.

There are still major unanswered questions that will guide global growth. For example:

  • How quickly will emerging markets raise their consumption toward levels that are common in the developed world?
  • Will the deflationary pressures of trade and productivity be offset by rising asset prices and an expanding monetary base, such that inflation can remain low and stable?
  • As limited natural resources are bid up by new global demand, will market forces be able to restrain governments from nationalizing resources?
  • Will developed nations be able to retain labor standards and a social safety net while competing freely with nations that do not?

Investors might consider the following strategies against this backdrop of trends and risks.

Overweight U.S. Stocks

We believe U.S. equities are generally cheap, with prices already anticipating a broad economic slowdown coupled with higher interest rates. While earnings have been growing very well, prices have lagged, leading to an earnings yield premium that looks more like the average of the 70s than any period in the 80s or 90s.

If the economic slowdown is less than expected, prices may rise substantially from these levels. If the slowdown is greater than expected, clearly there is risk to the downside, but the equity markets appear more attractive, on balance, than fixed income securities.

Within the U.S. equity markets, macroeconomic trends point us toward nimble multinationals and commodity producers. It might be wise to avoid owning companies that depend on the U.S. middle-class consumer. U.S. consumer spending has some structural disadvantages because of rising mortgage rates and an interruption of the rising real estate market, so is unlikely to continue growing in line with recent history. The deceleration in consumer spending may be gradual or dramatic, but it is very likely.

Underweight U.S. Bonds

The U.S. bond market may not be attractive at this time compared with equities. After a prolonged bull market in long-term bonds, the risk/reward balance, compared with stocks, appears unfavorable.

Foreign governments are buying U.S. bonds to stabilize the value of their currencies. Insurance companies and pension funds are buying bonds to offset predictable liabilities. These sources of demand are driving up bond prices independently from other investments, making bonds less attractive.

Demand from foreign governments may diminish because they may decide that holding a global portfolio of bonds is better than concentrating in U.S. bonds. Demand from insurance and pension funds may diminish because managers are migrating toward efficient asset allocation, as opposed to strictly offsetting their liabilities.

Any one of these changes could cause a drop in the price of U.S. bonds. For example, if Japan privatizes its postal saving system as planned, it would mean that more than ¥224 trillion ($2.1 trillion) in savings and ¥126 trillion ($1.2 trillion) in life insurance would no longer be invested by the Japanese government. Japanese citizens may be less eager to buy US bonds than the Japanese government has been. Indeed, they may redirect some of those assets into Japanese equities.

Investors who must hold bonds should restrict ownership to only the highest quality, short-term bonds. Even investors seeking tax-advantaged municipal bonds are cautioned that avoiding the inflation tax, which stealthily confiscates principal, is more important than avoiding taxes on mere income.

Lock in Your Mortgage

For the same reasons that long-term bonds are in a bubble, long-term mortgages are artificially cheap. The boom in adjustable rate mortgages was the result of a very accommodating Federal Reserve, and that time is past. Now that the yield curve is flat, locking in long-term financing within 1.25% of the overnight lending rate is a rare opportunity.

Diversify U.S. Dollar Exposure

Conservative investors should hold some investments that are linked to assets or are diversified among a variety of currencies.

The stability of the U.S. dollar is tenuous. The large trade deficit and large foreign ownership of U.S. debt and investments are a tribute to the strength of the US economy; however, they also represent a risk to the U.S. dollar. Interest payments to service these debts already exceed the budgets for the U.S. Department of Homeland Security, Department of Education, Department of Justice, Department of Transportation, the entire Legislative Branch, and NASA, combined. Then, at some point, foreign debts will have to be repaid. A more immediate risk is that foreign investors will sell their U.S. investments if they believe they can achieve better returns elsewhere.

A similar dynamic came to crisis in dozens of countries in Asia and Latin America in the last 20 years. The increased risk of U.S. dollar weakness justifies diversification. Even a gradual long-term resolution to this imbalance would richly reward asset-based and foreign currency investments.

Heavily Overweight Commodities

The risk to the value of the U.S. dollar is enough to justify an overweight position in commodities. The additional trends in global demand growth also suggest an overweight position. Also, many individual and institutional investors have long ignored this asset class, so increased interest from the investor community may provide additional upside potential.

For fundamental reasons, commodity prices may trend higher for a long time. Previously, there had been a sustained stagnation in real commodity spot prices from 1972 through the turn of the millennium. This stagnation was partly due to the collapse of the Soviet economy, and led to a slowdown in investment in new commodity production capacity. Global demand growth was widely overlooked as producers concentrated on meeting U.S. consumption patterns. This oversight was largely because emerging market commodity consumption had historically represented such a small fraction of the total market demand.

The 4.5 billion new members of the global economy are, on average, increasing consumption at a rate far exceeding that in the U.S. Per-capita demand for commodities in emerging markets is only about 10% that in the U.S., so total commodity demand could grow at an accelerated rate until they catch up. If emerging market demand rises to 20% of the per-capita consumption in the U.S., even while the U.S. does not grow at all, total commodity demand would increase by 47%. There is simply not enough production capacity to meet that demand.
How long will it take global per-capita commodity demand to rise to half that of the U.S.? If that happens, global commodity demand will have almost tripled (even assuming the U.S. does not grow at all). Commodity producers (and investors), take notice.

Overweight Select Foreign Stocks

In many cases foreign stock valuations are low, yields are high, and prospects for growth are favorable. In addition, they are less dependent on U.S. consumer spending, and can be a good way to diversify currency exposure.

Neutral Position in Foreign Bonds

Foreign bonds offer the benefit of currency diversification, and may benefit from global central banks moving away from strictly using U.S. Treasuries. Long-term bonds issued in major currencies such as the Euro, Yen, and British Pound may benefit from flattening yield curves. However with rising global interest rates and inflation, shorter maturities may be preferable for bonds in other currencies.

Impose Tariff Triggers to Raise Global Labor Standards

Problem: The US has lost some of its competitive advantage with companies in other countries. A major part of this problem is the differences in economic policy and labor standards that prevail in various countries.

Solution: Set specific global Tariff Triggers. For example: 5% on countries that peg their currency, 10% on countries that allow child labor, 10% on countries that outlaw organized labor, etc. These numbers are just examples. The triggers should be set to offset some of the unfair competitive disadvantage.

Benefits: US workers will be competing more fairly with international competitors.

Some foreign countries will improve their labor standards in order to avoid tariffs on their exports. In those cases, US workers will benefit because the foreign competition will have have to operate under similar rules as US companies.

Some foreign countries will not change their labor standards or economic policies, so they will trigger the tariff. This will also protect US workers from those unfair practices (to some degree) because import tariffs drive up the prices of those specific competing imports.

View and comment at SinceSlicedBread

Trade keeps inflation lower

My latest quarterly investment commentary discusses how trade is effectively importing low inflation.

“Prices are only stable for imports.”

“The US imports a low inflation rate.”

Download: 2005 Q4 Investment Commentary

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