11-10-2009

How to Invest For 2020

The following is the text of a speech given at the Wealth Beacon Lecture Series Nov 9, 2009:

“I’m going to take a few minutes to give you a forecast of what is going to happen in the world economy over the next ten years.  And this reminds me of a question and answer that are prominently etched in my psyche.

The Question is:  Why Did God Create Economists?

The Answer is:  To make Meteorologists look good!

So given that those that are forewarned are for-armed, let me stick my neck out by telling you that:

At this moment two of the largest fundamental changes in our investing lifetime are occurring together.

1.    First, the most populous countries in the world have dramatically stepped up their participation in the world economy over the last 30 years.  They now have hundreds of millions of people working and earning money.  These people have had incredibly high savings rates for over a decade and are now ready to consume more.

 2.   Second, a 30 period of disinflation that was brought on by policies and actions in the United States is coming to an end.  Business cycles will be characterized by increasing levels of inflation. 

These two dramatic occurrences are inter-related, and will cause an investment environment over the next decade that is strikingly different than the one we have just lived through. 

            The most dramatic differences will be:

            Long Maturity bonds will not be good investments.  Interest rates can be expected to slowly rise from business cycle to business cycle for many years.

            Stock markets can be expected to rise, but not all parts of our stock market will perform in lockstep.  Companies doing business abroad will grow more quickly and companies that benefit from a rising inflation outlook will do better than those that are hurt by rising inflation.

            Real assets will rise in value as world aggregate demand rises more quickly than world aggregate supply,  a major change from the last few  decades’  economic fundamentals.  This doesn’t mean that real estate in the U.S. will rise in value in an equal proportion to other real asset classes.

Let’s do a quick dive into these changes:

Emerged World Growth

China has 1.3 billion people- that is equal to 4 ½ United States’ populations.  Since 1978, they have brought over 400 million people from rural existence to work in their cities.  Their middle class is exploding and they will bring an additional workforce equal to the size of the total U.S. workforce into their productive economy within the next five years.  China will soon be the second-biggest economy in the world.  Chinese workers have been saving 40% of their income per year.  They have not had a social safety net.  The government is quickly focusing on creating a social safety net and increasing health care availability, cleaning up their air by forging ahead with Green technology, and refocusing their production to accommodate internal demand rather than exports.  Their government has also effectively economically colonized several countries’ production in Africa and made deals with both Asian and South American countries that will ensure the flow of natural resources to China over the next few decades.

India has a population of 1.2 billion people, but will soon be more populous than China.  Forty percent of these people are under the age of 18.  India has been a participant in the world economy longer than China but at this time only 61% of the country is literate and only 10% goes to college.  Even with these statistics, all of us are aware of what the educated portion of the population has been able to achieve in creating outsourcing of services that previously had been delivered by the more established world economies.  The country’s GDP is growing 8-9% per year and as they ramp up the educational process their position on the world stage will continue to increase.  They already are graduating 2.5x as many engineers per year as we do in the United States.

Brazil has 200 million people, only 2/3 the population of the United States.  However, the country is very large and amazingly rich in natural resources.  They have had double digit growth in their economy every year since 2002.  They are the world’s largest exporter of ethanol.  They are world’s largest exporter of soybeans, and 80% of the world’s orange juice comes from brazil.  Petrobras, their national energy company, is the largest company in South America.  Vale is the second largest mining company in the world.  Their rapid growth is being accentuated by rapid growth around the world.

Other countries are also experiencing exceedingly rapid growth including South Korea, Chile and South Africa.  Russia and Nigeria are also growing very rapidly but they both have very serious corruption problems that, when addressed, will allow for them to emerge. 

But let’s get one thing straight, China, India and Brazil are not emerging markets; they have emerged!!

The United States, European Union and Japan’s growth will be largely influenced over the rest of our lifetimes by their ability to serve these markets. 

ANYONE WHO DOES NOT TAKE ADVANTAGE OF WHAT IS GOING ON AROUND THE WORLD IN THEIR INVESTMENT STRATEGY WILL NOT DO AS WELL THOSE PEOPLE WHO DO.

Inflation fundamentals

Disinflation ending is being caused by two large changes.  The first is totally integrated with the last discussion.

•  Emerged countries are quickly shifting from net suppliers of stuff to the world to net demanders of stuff from the world.

• The cost of avoiding another great depression around the world will be paid for by significant issuance of government securities.  This issuance will crowd out private borrowing at low interest rates and lead to significantly higher interest rates over time. 

Emerged economies have emerged because they have accommodated growth in their workforce.  To do this they have had to develop their cities: their transportation, energy, and communication infrastructures.  They have had to rapidly deploy capital in the creation of buildings, neighborhoods, and commercial zones.  When a worker comes to the city from rural or nomadic status in one of these fast-growth economies, there is a pecking order of what he does with the income he earns.  She or He usually uses some of the money earned for subsistence and sends some of the money back to her/his recently abandoned nuclear family.  After working for a year or two, this worker begins to consume beyond subsistence.  They add protein to their diet, they buy a cell-phone, they buy a pair of comfortable sneakers, they upgrade their apartment and so on.  As these workforces progress, they begin to want to consume more and more.  

The build-out of cities and the increasing consumption of workers leads to an emerged economy becoming a net demander of stuff, rather than a net supplier of stuff.  China is right on this fulcrum point at this time. 

During the 1980’s and 1990’s, the extreme savings rate of workers in emerging markets and the extreme export focus of these same economies worked to keep world disinflation in place.  The swing that is taking place in these countries toward mounting consumption will move demand up in the world, while the supply of exports available to the world from these countries will flatten out.  This creates net inflation pressure.

The other part of the inflation story comes from a world, which having benefitted from low inflation and interest rates for decades, moved toward enormous increase in borrowing and taking of risk.  This led to the financial explosion that brought on the big recession we experienced in 2008 and 2009.  World governments took concerted action to avoid the great depression of the 1930’s.  These governments effectively decided that the public sector would take over some of the spending and risk that the private sector had exhibited to prevent things from getting worse. 

The bill for these actions is yet to be paid.  We all know that unprecedented fiscal deficits are occurring in the developed world economies.  These deficits will be paid for through the issuance of government bonds worldwide.  The issuance of these bonds will crowd out private borrowing at the same rates paid by governments.  This crowding out will lead to higher interest rates being paid by companies and consumers.  This isn’t happening yet, but it will over the next few years.  This is inflationary by definition.  Printing money faster than the rate of growth of the goods and services that are demanded will lead to higher prices.  

These are two big stories that will unfold at the same time.  What can investors do to protect themselves from the risks and take advantage of the opportunities?

At Beacon Trust, we’ve been guiding our clients with three investment principles to move their portfolios from the old world environment into the new world environment:

1.    Keep Bond maturities short to take advantage of the higher interest rates in the near future. 

2.    Buy stocks of U.S. companies that will benefit from the new environment as the world economy recovers 

3.    Open your mind to investing in international companies that view the world as one market and that benefit from the rapid growth occurring in the emerged world. 

Thanks for your attention, and NOW I will turn the podium back over to Marc who will introduce our keynote speaker The Honorable Governor Christine Todd Whitman.” 

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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