The Global Economy: A True Catch 22

The force behind the Global Economy

The force behind the Global Economy

Every economist worth a dime knows that “Without growth you can’t pay your debt and with too much debt, you can’t grow.”

My jaw permanently dropped when I read the Wall Street Journal reporting several days ago that American’s wealth hit the highest level ever, last year, cleverly reflecting a surge in the value of stocks and homes that has boosted the most affluent US households, primarily or better yet exclusively created by the Feds pumping $20 trillion into US households since 2009, which of course makes this whole sordid record surreal.

Why? Because we all know that wealth cannot come from nothing. Wealth is a process of work, timing, luck, knowledge but mostly EFFORT. Greek philosopher Parmenides in the 5th century BC used the phrase “Out of nothing, nothing comes”, and even Thomas Aquinas, the 13th Century friar and philosopher as well as St. Augustine, the patron saint of brewers, later used this axiom to prove that the universe needed a “first mover,” to get things going.

So, where is all that ‘new’ wealth coming from. Some may say from the hand of the Almighty, as in Manna from Heaven of course… I prefer to leave the Almighty out of this however, seeing that his philosophy embraced the interpreted expression that: “If wealth rises, all should benefit.” Well, clearly that is not the case here.

We are led to believe that the Federal Reserve’s policy mission is designed to produce a general prosperity; the Fed claims to keep rates near zero so the entire economy benefits. But it isn’t true. Only some prosper.

For the less fortunate, all the stimulus makes money ‘worthless’. A retirement saver 30 years ago would easily get 8-10% on a CD (certificate of deposit). But that was 30 years ago, before world regions such as North America, Europe and Asia were “changed” into a global economy by the multi national corporations of this world. This movement has put global trade and financial interdependency on a course with the future never experienced before. Because large international corporations forced the Western World to open their doors to world trade, we now have a “Global Economy” and the West is no longer isolated from the poor workers of Asia, Africa and Latin America.  Mobile phones, motorized vehicles and refrigeration are available in every corner of the globe these days, providing the basic tools for rapid progress.

But this development has also led to an interdependence of all regions and countries. If Europe experiences hiccups and the US economy stalls, a domino effect will affect the exports of China and Japan and they, in turn, will start flounder. Now the big problem has become that the entire West (US and Europe) built its economy on borrowed money and with global debt numbers reaching $100 trillion, there are no realistic means today of repaying those loans, even if we would have a growth economy.

Hence, the West faces the hard task to either curtail its living standards for the greater good, leading to unemployment and recession, or accelerate development of growth markets in previously under developed nations to catch up with our standard of living. Option 1, curtailing standards of living will hurt Asia’s growth as Asia cannot survive alone. Playing catch up by the world’s poorest nation requires a tricky strategy, considering how wealth seems to embrace their own opulence. In any case what we are facing for the next 3 or 4 decades is a global equalization of living standards, where ultimately Westerners no longer have a reason to have a higher living standard than any other country. Cheap energy and technology supported a higher Western living standard but is now available across the Globe. A potential debasement of the Western living standards may cause a lot of mental and even physical pain in the West, if not anticipated correctly.

The Fate of the Baby Boomer Retiree

Thirty years ago a $200,000 nest egg ( for example a home) could generate up to $20,000 a year in interest payment without ever touching the principal. Retiring was an easy decision. Today’s potential retiree stays in the workforce as long as possible, clogging up the natural pipelines because, interest paid on a CD today is not even enough to keep up with the official inflation rate.

As it becomes increasingly clear that he Fed’s activist policies distort and corrupt the economy we learn that prices are bent. Next, taking their cues from bad prices, bad decisions are made and before you know it, everything is twisted in one direction or another. Low rates and rising prices tricked Americans into believing that the more house you had, the more money you would make.

Well to tell you the truth, the $20 trillion in new wealth is in the hands of America’s winners. It added little to US GDP… or to Americans’ incomes. It was merely another transfer of wealth. Owners of stocks and houses got richer. Wage earners and savers got poorer.
I would suggest to those who got richer to start taking the money off the table, but I know many of them are driven by greed, so the loss of their wealth is inevitably etched in their DNA.

Equally inevitable in repeating itself over and over again, is the human trap that lead to the 2008 great recession. Dave Ramsey probably described it best: “We buy things we don’t need, with money we don’t have, to impress people we don’t like.” I think the current reincarnation of that reality started with Malcolm Forbes who coined: ““He who dies with the most toys, wins,” a opulent lifestyle choice rapidly adopted and popularized in the 1980s by the yuppie generation.

Poisonous Wieners

After 25 years of increasingly believing that debt trees could grow infinitely, the first cracks appeared in the weakest part of the debt structure: US subprime mortgages. Around that time the Feds philosophy became firmly anchored in a belief that Money should cost nothing and Chicks were for free, at least if you were a Wall Street insider.

Greed created a global demand for mortgage-backed securities, a toxic sausage of Wall Street manufactured products that cleverly concealed, with the tacit backing of the ratings agencies, the junk hidden beneath the surface.

When it all collapsed in the demise of Bear Stearns, followed by Lehman, the feds rode in on a white horse with every quack cure they could think of. Bailouts, cash for clunkers, ZIRP, QE – one estimate put the total cost at more than $10 trillion, or about three times the cost of World War II.The crisis was caused by too much debt. And all the feds had to offer was… more debt. As Bloomberg reported last week global debt has grown to$100 trillion plus and since debt is an obligation laid upon the future, the future becomes more and more a harder thing to happen.

The Catch 22

The larger debt growth, the harder it becomes for the future to happen. There is a natural correlation between extreme levels of public debts and low economic growth and that is the catch 22. Without growth we cannot pay off our debts and creating money out of nothing to add more debts, will ultimately explode into deleveraging and debt deflation.

St.Augustine, yes the Saint, not the city to the south of us, said: “There is no advantage to being near the light, if your eyes are closed.”
Maybe we should heed that implied warning before it’s too late.

It Really IS a Small World

Searchamelia; it is a small world

As the world is getting smaller, questions beg for answers.

Living in an age of jet travel, the internet and mobile communication have their advantages. They make our world of 7 billion people seem a bit smaller since we’re just one plane ride or one “click of the mouse” away from connecting with anyone in the world.

But, along with the good comes the bad.
Worldwide interconnectedness not only connects us socially, it also connects us economically. What happens in China, for example, doesn’t necessarily stay in China. A collapse of their real estate market or a revolt against the government could have repercussions around the world.

A bit closer to home, the sovereign debt problems in Europe are helping keep a lid on stock prices in the U.S., according to MarketWatch. As the debt problem spreads from the peripheral euro-zone countries to the core in Germany – which had a failed bond auction last week — the U.S. is also caught in the cross fire.
What’s disappointing about being joined at the hip with Europe is that the U.S. economy is actually performing okay.

Consider these positive points:

  • • Our trade deficit declined for the third month in September, thanks to rising exports.
  • • Industrial production rose strongly in October.
  • • Residential building improvements are touching record highs.
  • • October car sales hit the highest level since February.
  • • Consumer sentiment in November rose to the highest level since June, according to data from the University of Michigan and Thomson Reuters.
  • • Personal income in October showed the largest increase since March.
  • • Black Friday sales rose sharply from a year ago.

Sources: Economist; MarketWatch

Of course we have to take into consideration that these improvements are coming off a low base and are so fragile that this modest recovery in the U.S. could get derailed if the euro-zone situation continues to deteriorate. Our small world is now focused on Europe and whether it can pull out of its debt debacle. Time to do so is running out for our friends across the pond.

DOES IT MAKE SENSE to invest outside of the United States? The concept of diversification suggests that you own a diverse group of investments that have uncorrelated return characteristics. One of these diverse groups of investments could include non-U.S. stocks. That might make sense because, as the following chart shows, the U.S. stock market captures only 29% of worldwide stock market value based on market capitalization.Global Market Caps

The above chart shows some interesting trends:

  • • The U.S. is still, by far, the single largest market in the world, but it has declined substantially in the past five years.
  • • China has catapulted to second place with dramatic growth in the past five years.
  • • Japan, UK, France, and Germany join the U.S. as developed countries that have lost ground over the past five years.
  • • Emerging countries such as Hong Kong (technically of course part of China), India, and Brazil have shown strong relative growth.
  • • Although not shown on the chart, back in the late 1980s, Japan’s stock market represented 45 percent of world equity market capitalization. Now, it’s less than 8 percent due to a 20-year bear market.

As the world turns from developed countries to emerging ones, we should all keep our eyes open and our pencils sharpened for the investment opportunities that might arise beyond our borders.

If You Build It, They Will Come. Well…Maybe.

Not only too much fixed investment, but also too status ambitious

Build it and they will come, seems to be an appropriate description of China’s economic growth model. Just one look at Shanghai’s waterfront or train station is enough to leave visitors believing China’s infrastructure can rival anything in the world.
Consider this 2011 photo of downtown Shanghai along the Huangpu River. Twenty-one years ago none of this was here. Now these buildings are among the world’s tallest skyscrapers.

Fixed Investment VS Consumption Spending

A significant amount of China’s growth over the past 20 years has come from what’s called “fixed investment” as opposed to consumption spending. Fixed investment includes tangible things like roads, bridges, trains, buildings, and machinery and accounted for 46% of China’s GDP in 2010, according to the Financial Times. The June 30 launch of the Beijing to Shanghai high-speed train is a good example of fixed investment. It cost $33 billion to build, reaches a top speed of about 200 mph, and connects the two major cities in less than five hours, according to The Vancouver Sun.

Fixed investment is good from the standpoint that it equips a country with the tools and resources needed to grow and be productive. However, too much fixed investment can lead to overcapacity and strained budgets.
Rather than continuing to rely on building and infrastructure for its growth, the Chinese government has developed a plan to re-balance its economy from investment and manufacturing towards consumer consumption and services, according to the Financial Times.

Ironically, this would put China more in line with the U.S., where consumer spending accounts for about 70% of demand in our economy, according to The Wall Street Journal. In China, the comparable private consumption number is 34%, according to the Financial Times.

One of the knocks on China is that the growth in fixed investment has risen faster than GDP and this could cause problems with too much capacity and too much debt to fund those investments. Should China falter in its effort to re-balance its economy, it could lead to domestic problems that ripple out to the rest of the world.

There’s an old saying that when the U.S. sneezes, the rest of the world catches a cold. Given China’s strong growth and massive size, we should be concerned about China sneezing, too. How they manage the re-balancing of their economy over the next few years bears close attention.  because if it does, a polite “Gesundheit” will not save us.

China’s Growth Powers the World – What Happens If They Falter? Part I

China's Great Wall, a remnant from another Imperial Era

As China’s phenomenal growth has vaulted it to a top position among the world’s economic powers, what are the consequences if their economic engine begins to falter?  Perhaps the more appropriate premise should be “when” rather than “if.”

For instance, a colleague told me a story that one evening back in June, after a long day of playing tourist in Shanghai, China, he flipped on the TV and was pleased to find CNN. After a few minutes, a story came on about Chinese artist and political dissident Ai Weiwei. That day, Weiwei was released by the government after nearly three months of detention for “alleged economic crimes.” Just as soon as the story about Weiwei came on the air, the TV screen went black. About 90 seconds later, CNN returned to the air in the middle of a new story.
Yes, TV censorship is alive and well in China!

“Toto, I’ve a Feeling We’re Not in Kansas Anymore”

China, of course, has been in the news for years as its economy has roared and moved the country to the second largest economic power behind the United States. Yet, for all its might, there are some glaring holes that might trip it up over the coming years – with media censorship being just one.

Given China’s importance in the world’s growth story, this is an opportune time to further ponder the Middle Kingdom and the potential for a stumble that could affect the markets. The United States has certainly managed to trip over its own economic shoe laces, so why should China be immune from a similar possibility? This is the first of three stories.

China Rises Again

China’s surge is really a case of déjà vu. For much of recorded history, China was the world’s largest economy. Even into the early 1800s, it accounted for 30 percent of the world’s GDP, according to The Economist. But, like many empires before it, China spectacularly flamed out over the next century. By the mid-1970s, the disastrous reign of Mao Zedong had come to an end and China was near rock bottom.

In 1978, new leader Deng Xiaoping laid out a vision of economic reform that has propelled China to unprecedented growth. Since then, China has massively reshaped the world order as its growth and demand for resources affects everything from auto production, to corn prices, to funding the U.S. budget deficit. Earlier this year, China overtook Japan as the world’s second largest economy behind the U.S.
With that very brief historical background, let’s review some facets of China’s phenomenal rise and what that may mean for you. We’ll first look at demographics.

Exploring the Demographics

Incredibly, China’s GDP has grown at an average annual rate of 9.3 percent since 1989, according to Trading Economics. However, changing demographics could cause this growth to slow in coming years.

You may be surprised to know that between 2000 and 2010, the U.S. population grew faster than China’s (9.7 percent in U.S. vs. 5.8 percent in China, according to the Financial Times). For the past 20 years, China’s economic boom has been partly fueled by urbanization – rural folks moving to the cities in search of higher paying jobs, plus a supposedly endless supply of cheap young workers. As it turns out, that supply may be coming to an end.

China has had a one-child policy since 1979 and it resulted in the “non-birth” of about 250 million babies, according to Time Magazine. As a result, China’s population is aging rapidly. Today, 12.5 percent of China’s population is over 60. By 2020, it will hit 20 percent and by 2030, it will hit 25 percent, according to The Economist.

Worse yet, the working age population will start to decline in about 2015, according to the United Nations. Fewer workers supporting a growing elderly population is not a recipe for economic growth.

Of course, China could reverse its one-child policy and rev up population growth, but that would likely cause other problems such as food shortages or environmental issues. As the demographic shift causes the labor market to tighten, wages have already started to rise, according to The Economist. That puts pressure on inflation and makes the country less competitive. While it’s easy to look at China’s growth over the past 30 years and extend it for another 30, changing demographics is one of several hurdles that could put the brakes on growth.

In our next installment we’ll look at the challenge of moving China’s economy from one led by exports and investments to one led by consumption. As a preview, we’ll talk about the perils of relying too much on infrastructure investments and how that could lead to excess capacity and bad debts.

Conflict and Contradictions in the Financial Markets

Capitalism as an Economic Structure is riddled with Contradictions

Lately, the financial markets are burdened by numerous contradictions and conflict, resulting in serious head-scratching and risk-aversion on the part of investors. The latest round of volatility is causing many to consider throwing in the towel completely.

Consider these head-scratchers:

• Mortgage rates are at a 50-year low, yet the housing market is still severely depressed.
• Ten-year Treasury yields hit a record low last week even though the government just experienced a downgrade in its credit rating and it is running trillion-dollar annual deficits.
• Gold prices hit a record high last week even though gold pays no interest and the core inflation rate is running below 2 percent.
• The value of the dollar fell to a record low against the Japanese yen last week even though Japan has been mired in a slump for 20 years and “Japanese government debt is more than double the Euro Area average and more than double the US,” according to Jim O’Neill at Goldman Sachs.
Sources: Bloomberg, MarketWatch

The situations described above suggest there are “distortions” affecting the markets that may not be explained by modern portfolio theory.

One distortion that has clearly impacted the markets is government policy and intervention. In just the past three years, we’ve seen the $700 billion Troubled Asset Relief Program (TARP), the $787 billion American Recovery and Reinvestment Act, the Federal Reserve’s zero interest rate policy, and the Fed’s QE1 and QE2 bond purchases. All these have generated numerous market side effects.
In addition, a major argument is unfolding between politicians who believe government intervention is necessary to prevent an even worse downturn and those who believe the free market should be left to fend for itself. Some politicians are even calling for the abolishment of the Federal Reserve.
A similar situation is playing out in Europe. For more than a year, European governments have scurried from one bailout strategy to the next in order to prevent a sovereign default.

All these distortions and philosophical debates are, not surprisingly, causing confusion in the financial markets. The result — a stagnant economy and falling stock prices.
The denouement of these interventions and political squabbles remains unknown. What we do know is, we can continue to plan wisely and do all we can to keep our individual goals and objectives on track.

As stock prices decline, does overall risk go up or down? The answer may surprise you.

Let’s start with a definition. For our purpose, we’ll define risk as the probability of losing money. With that shared definition, let’s look at the S&P 500 index. On October 9, 2007, it closed at an all-time record high of 1,565. On March 9, 2009, it closed at 676, which was a 12-year low, according to CNNMoney.
Now, was it riskier to own stocks when the S&P 500 was at its all-time high in 2007 or its 12-year low in 2009?

Intuition and hindsight tell us owning stocks at the all-time high was much riskier. Why? Because stock prices proceeded to fall by 57 percent over the next 17 months, while prices rose about 100 percent over the next two years from the 2009 low.

Money manager John Hussman framed it this way in a May 23 commentary, “As valuations become rich, risk increases, and as valuations become depressed, risk declines. At the same time, rich valuations imply weak long-term prospective returns, while depressed valuations imply strong long-term prospective returns.” In plain English, he’s essentially saying as stock prices go up, risk goes up, and as stock prices go down, risk goes down.

Warren Buffett was even more succinct. In an August 11 Fortune Magazine interview, he said, “The lower things go, the more I buy.”

It may go against human nature, but the lower prices go, the less risky they become and the more likely you are to experience strong long-term prospective returns, according to Hussman and Buffett.
For investors who are saving for retirement or simply trying to preserve their wealth, seeing lower stock prices is no fun. However, assuming you don’t need to sell today, what matters is what prices will be in the future when you do sell. And, with prices dropping now, it may be setting the market up for better returns down the road.

Making a Buck in the New World Order

International-Wealth-ManagerA new economic world order is forcing many investors to look at the rest of the world to make a buck. With a volatile and uncertain U.S. economy these days, investors are researching more options and (hopefully) better returns by seeking other investments from around the world.   Searching for growth outside U.S. borders may be a wise decision: Foreign markets make up roughly 60% of the world’s market capitalization (investment opportunities), and that figure is increasing.

However, international investing exposes investors to different risks that usually do not impact domestic markets.  These risks may include: political instability, higher tax rates, reduced liquidity, and currency risk. Before including international investments in your portfolio, it is a good idea to review and understand the unique characteristics of global markets.

Emerging Market or Developed Market?

When considering investments outside of the United States, countries are commonly grouped into one of two categories: emerging markets and developed markets. Developed markets include nations with more traditionally stable economies, such as Germany, England, France, and Japan. Emerging markets are typically those nations that are moving toward becoming more established, but still demonstrate higher-than-average volatility, such as the “BRIC” nations: Brazil, Russia, India, and China.

How to Invest in Foreign Securities

Investing in foreign securities, or at least providing some international exposure to your portfolio, is easier than you might think.  Perhaps the easiest way to include foreign exposure is simply to invest in very large U.S. companies, such as McDonald’s, Microsoft, and Coca-Cola. These companies have a worldwide presence and significant amount of their revenue comes from foreign companies.
If you wish to invest directly in stocks of foreign companies, you can do so by purchasing  American Depositary Receipts (ADRs) or by investing in mutual funds that invest in foreign companies. ADRs are negotiable certificates that represent the shares of a publicly traded foreign company. These instruments are issued in the United States, and the underlying shares are held in U.S. banks.

Keep in mind, access to specific information about foreign companies can be difficult to obtain, and understanding international markets (and their associated risks) is time consuming. Buying shares of broadly diversified international mutual funds or exchange-traded funds that may buy a mix of foreign and U.S. stocks is a fairly simple approach.

Currency Risk: A Special Consideration for International Investing

International investing can provide additional diversification as part of your overall risk management process, but it also poses unique risks and opportunities. A U.S. investor’s foreign-investment return is based on not only the stock price, but also on the local currency’s exchange value against the U.S. dollar. For example, falling currency values and plummeting stock prices in Asian nations in 1998 not only drove down stock prices for international investors in Asia, but also in the United States, because many American companies depend on Asia for customers.
For U.S. investors, currency gains or losses could also stem from a fluctuation in the dollar’s value against the currency of the foreign country in which they are investing. Keeping a long-term perspective and diversifying across a variety of international investments can help reduce these risks.

by Mark Dennis, CFP® A1A Wealth Management, Inc.