City Trading Post

Not a great deal of particular significance has happened since we last looked at the world economic stage in January. There have been no sudden changes of direction, market reversals, alien invasions (or American invasions, no new ones anyway), ecological disasters, or massive population wide mood swings – there’s just been plenty more of the same gloom and doom, plenty more confirmation of what we already suspected was happening, which is that the global economy is slowing down (and being propped up by the likes of China and other chunky emerging markets), the US and the US$ are in decline (hands up who still thinks the current US$ weakness is just temporary… you crazy people), the UK property market has stalled, lenders are not lending, inflation is looming in the face of economic stagnation, and gold is soaring (but still less than half way to its previous inflation adjusted peak from the early 1980s).

Click here to view the gold price chart

Click here to view the oil price chart

Yes, the world economy is definitely slowing down, in spite of the fact that the two charts above are heading north. Neither the US recession nor the UK housing slump are surprising – they are just inevitable way points along the greater economic cycle. In many ways the cyclical nature of the global economy is a good thing, as it operates as a natural selection mechanism on business. In the growth phase of the cycle, new companies spring up to offer new services and products, injecting new ideas and fresh blood into society; but when the music stops, only the strong or flexible or clever or unleveraged survive. A recession, in this sense, is like a cull, which removes the old, injured and flawed from the herd, and clears the way for the strong and beautiful to thrive.

But what never ceases to amaze us here is the relative shortness of the economic cycle. Logic suggests that it would be at least a human generation long, perhaps even a human working life time long – as surely the same mistakes will only be made once by the same group of people. Apparently not – we seem to be back where we were just a few years ago.  Perhaps this length of time should be known as a ‘gold fish bowl year’ – the length of time that it takes for human society to forget that you can’t spend more than you earn. The Americans and the British, who are second and first most indebted nations on the planet in per capita terms (yes, we did get that the right way around; sadly the British are more in debt than the Americans) should have Charles Dickens’s Micawber principle drilled into them at school: "Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

However, this cycle has gone too far even by recent standards, thanks to a compounding combination of excess borrowing by consumers, excess leverage by investors and businesses, and reckless risk taking by banks who should know better but instead think, ‘what the hell, the government will bail us out!’. It’s easy to point the finger of blame at the US subprime mortgage debacle, but the reality is that this was just the weakest link. The way things were going, something had to give – someone had to be the first to trip over the coffee table and vomit on the carpet at the decade long easy credit party. So, now that we’re in this mess, two questions spring to mind –

What happens next
And what should we do?

What happens next: First, realize that the globalised economy is an extremely complex system, similar to the weather in that you can explain it to a degree, but not accurately predict it. For that reason, everything that follows comes with the caveat ‘we think’ or ‘in our opinion’. Any economist or financial analyst who tells you what’s going to happen next will almost certainly be wrong; his forecast is only one possibility in a range of possibilities that may follow from the current set of circumstances and conditions. An enlightened guess, at best.  Not even the full range of possibilities may be known; there is always the possibility of an ‘unknown unknown’.

Second, realize that your UK centric view is just that: UK centric. There are large parts of the world that are, economically, doing just great! That’s part of the problem, because some of those countries have been lending to the west on a vast scale thereby inflating the credit bubble in the first place. But they’re also part of the solution, because possibly for the first time ever – unless there really is an absolute meltdown and a return to cave dwelling in the US – the rest of the world should not be so badly affected by this US recession as it would have been in the past. The Chinese and Saudis helped pump up the bubble with air, and now the Sovereign Wealth Funds are helping to replace the air with badly needed capital to shore up battered balance sheets.

In spite of what’s going on at home in the UK, we are confident that the US will take action to avoid a serious meltdown. They have both monetary and fiscal policy tools at their disposal, and they’re not afraid to use them. Expect further Fed rate cuts and increasing government spending. Our view is that they will prioritize balanced trade and employment over currency strength and status. Perversely, it may be the large US bond accumulators such as China and Saudi who end up putting a brake on the US recovery by not allowing the currency devaluation to proceed as quickly as required by refusing to dump (we meant ‘strategically reallocate’) their US$ stock.

Click here to view the historical interest rate chart

We are also confident that there are huge piles of cash available for investment – it’s just that those huge piles of cash are in Middle and Far Eastern Sovereign Wealth Funds, which takes a bit of getting used to. As US assets get cheaper and cheaper, this cash will be deployed, and the US economy will climb out of its dive. What a tangled web.

And finally, we’re still seeing strong economic activity in the big emerging markets and most of South East Asia – they’re a lot less dependent on the US than they were a few years ago. Growth in this part of the world combined with inflation and devaluation in the US is likely to drive further growth in commodity prices. Yes, oil is expensive in relative nominal terms, but for the first time in human history the world is now consuming oil at a rate of over 1,000 barrels per second, and China’s dependency on foreign imported oil has now reached 50% of its total requirement, which itself is growing by the equivalent of the entire UK energy requirement each year. Inflation in China is officially running at around 7%, although food prices increased approximately 18% during 2007. The US$ is weakening. And the Gulf states are making noises about breaking their pegs to the US$ (translation: stop propping it up). Of course the price of oil is going to keep going up!

  Click here to view the past, present and estimated GDP figures

The same forces are at work on the price of gold: restricted supply, increasing demand, priced in a weakening currency. Of course it’s going to keep going up! In fact, since our January newsletter, which opened with the words, ‘Buy Gold’, the price of gold has risen from around US$800 per ounce to well over US$900.

So, what to do? Answer: Nothing. Hang on in there, keep your head down, and watch out for black swans. If your investment time horizon is really short then you shouldn’t be in anything other than cash anyway. If it is, and you’re not, then go to cash now, because while we think that now may be a good time to be buying, we can’t be certain that this time next year won’t be an even better time to be buying. Volatility can be a killer in the short term. All we know for sure is that the storm will pass – we’re just not sure when.

Actually that highlights one of our golden tenets of investment: Forget market timing, it’s a mug’s game. Go for steady, regular contributions over many years, and concentrate on asset allocation and portfolio construction rather than market timing and stock picking. Focus on the long term.
 

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