Thursday, August 12, 2010

The Grind

I guess the double dip question still stands. US, UK and China growth are all heading down. For the US market you add in growing volatility and cross correlation and an increasing probability of deflation and it's pretty tough to be an investor in equities. The only happy way out of the western debt crisis was growth.

But without a consumer that can spend, growth will be difficult - whether it's the US consumer who is to broke or the German and China consumer who is too smart to spend. Fiscal spending can help but only to a point - it is debt financed spending that quickly produces diminishing returns. I guess we will have to wait for the US consumer to pay down debt, retrench and change behavior and expectations built up over a generation. We will certainly need to see housing stabilize, finally.

Without growth, we can devalue our debt through inflation. This is the job of the central bank and short of handing out money at the western union stores, they are doing pretty much all that they can. But there is no guarantee that a central bank can create inflation no matter how hard it tries. If banks don't lend, borrowers don't borrow, and consumers don't spend, then the money doesn't move and inflation turns into deflation. Add in lots of excess Chinese production capacity and an undervalued RMB. Japan has struggled with this for 20 years. It is not clear how the US will avoid this without some additional extraordinary and unconventional fiscal and monetary stimulus.

This outcome suggests the dollar will continue it's long term decline, particularly against the export currencies like China's RMB, but also against the safe haven currencies like the Swiss Franc, the Kronor and maybe the commodity currencies. Gold still looks good given the lack of clarity provided by the European bank stress test, the ongoing lack of GDP growth and the sovereign balance sheet issues still lurking in the PIIGS.

Ireland has more bad bank loans to nationalize, pushing their economy perilously close to a debt tap: GDP is down 20% from the peak, debt close to 100% of GDP and growing. Spain has yet to realize the full impact of bad mortgage loans resulting from declining house prices - down 10% from the peak given the overbuild seems a bit lite. When the house price decline becomes clear, it will further crush the Spanish consumers and  banks and therefore the Spanish government balance sheet. It will also likely feedback into the British market given the level of UK exposure to the Spanish housing market.

The China question is equally unclear. We can all talk about the downside to social stability if growth drops for too long, but blowing the country's balance sheet on worthless investments might be equally bad. The government is trying to slow the economy down and it is becoming clear there are natural limits to growth - things like pollution. But it may be the stimulus to growth that is the bigger problem: if the West slows significantly, then China could be hit by both a decline in the export markets and a decline in Chinese consumers. It is not clear China has the mechanisms and policy in place to meet this type of challenge.

This line of thought is interesting: stagnant growth in China would mean (aside from social instability) a decline in commodity volumes, hammering the Australian, Canadian, OPEC, Russian and Brazilian economies. The only antidote to this is for the China infrastructure machine to kick into even higher gear and I guess it's a question of how much money the state can spend through this channel. At $2.5T they have the foreign reserves to do it, but if they need to spend $400B a year on growth and their trade turns negative, those reserves could disappear fast.

So the chip rebound looks like a failure - inventory restocking and heavy reliance on cars and consumer electronics, all bets off there. Gold is still a long with increased uncertainty in western growth and the need for US inflation (it is our only way out). The US rate declines look set to continue. The long GBP trade is off and the short EWP trade is on. The UK will run into problems getting their austerity program through while keeping the coalition intact, not to mention the changes to the electoral system. Spain has more declines in housing prices ahead.

I like RIG long in the low 50's. It's as uncorrelated to the S&P as you can get and less correlated to oil than normal. It's dirt cheap, has limited liability to the GoM exposure and will be paying a dividend again. And it has the best in class fleet of off shore drillers. Oil would have to get hammered for RIG to go below $45. And that's it for conviction. If you have a retirement portfolio, you should be in a fixed income ladder, some equity with big dividends to top up income (and maybe some highly rated apartment REITs as well) and a long term S&P put to protect that equity capital exposure.


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