A client asked my thoughts on Sequestration and what I’m thinking/doing in both the short and long-term to prepare portfolios, so I figured I should throw my thoughts out there before tomorrow in case anyone else is wondering.
Sequestration
If it actually occurs, I’m actually a lot less concerned about the long-term investment implications now than I was at the start of the year. Since the cuts will take place over a ten-year period, the direct cuts will be somewhere around 0.50% of GDP. Now, it could certainly have a snowball effect that creates a greater drag on the economy, but this is very difficult to predict. In the long run, I’m less concerned now because of the Fed’s new approach of targeting employment as their gauge for monetary easing. If the sequestration results in job cuts, unemployment rises and the Fed continues on their path of easing. Basically, I think it would just delay the length of time it’s going to take to fully recover economically, meaning we continue on the same path we’ve been on which I feel I have portfolios appropriately positioned for. For anyone that read about Bernanke’s testimony this week in front of the House Financial Services Panel, I think it was clear that he’s not happy about this going into effect. He knows he can’t continue expanding the Fed’s balance sheet forever and does not want to see unemployment rise again because it will put him in a very tough pickle…
At this point, I’m actually a lot more concerned about the continuing deterioration in Europe and possible transition in China. We’re not hearing a lot about it in the media but we soon will…
Europe
Europe is a disaster and it baffles me to see the kind of “on-the-surface, headline analysis” that economists and the financial media come up with. Simply looking at the EU as a whole and saying things have been improving is crazy to me. When you dig into the numbers of each country, it’s evident that things are continuing to deteriorate in the southern nations of Greece, Italy, France, Spain, etc. Germany has been the only thing holding it all together and they can’t (and won’t) do this forever. Austerity measures forced the ECB to contract their balance sheet over the past few months. This is the reason we saw a rise in the Euro and a drop in government bond yields. However, I expect this to reverse at some point this year, most likely caused by a combination of plummeting production, rising unemployment and currency wars. When this happens, the Euro will start to fall again, bond yields will spike and we’ll be in the same position we were in last spring, only worse this time.
China
The economic progress in China over the last 20 to 30 years has been driven by government investment – about 50% of GDP which is much higher than most countries and not sustainable. They’ve essentially copied the growth model of many other nations throughout history, including the US, and so history says the next step is to transition to where consumption plays a much larger role in economic growth. When this transition actually occurs has been a concern of many China-focused economists over the past few years because it means their rate of growth will slow, but the tradeoff will be a far more stable economy that’s less reliant on government. The Chinese have been aware that they cannot continue their current model indefinitely because it would mean ever-increasing debt and major financial shocks. I actually think they had plans to transition earlier but the global collapse in 2008 probably prolonged things. But signs of this transition are now beginning to show. Things like:
- Slowing GDP from double-digit growth to the 7% – 8% range
- The massive stockpiles of raw materials (things like iron ore, copper, etc.) they’ve been building so they can eventually cut back on foreign purchases/imports
- Concern from the government of loans made through their “shadow banking system” that are fueling rapid appreciation of real estate prices – a negative effect of easy money. (FYI – Chinese statistics are almost always manipulated and it’s fair to assume they’re always worse than stated. If they say there is a small problem of leverage and bad loans, there’s probably a huge problem.)
This means we’ll need to change our portfolios accordingly. A transition from government investment to personal consumption will mean higher incomes, greater production and consumption, and a reduction of the national debt load. From an investment perspective, this translates to lower prices for hard assets like coal, iron ore, steel, copper, aluminum, etc., which will hurt the nations that have benefited so greatly to this point (e.g. Australia) and construction oriented companies. It will also mean that our focus should shift to all things associated with rising incomes: better food, better housing, clothes, cars, cell phones, etc. This is why the only hard asset I have in portfolios, other than precious metals, is lead, as I expect demand for autos and thus batteries to continue to increase.
It will be important to listen to what the new leadership has to say, as well as tracking GDP and the imports of raw materials, to judge whether or not we’re seeing the beginning of this transition.
Thanks for following!
Nick