How to Invest Now in Economy 2.0 (the New World Order)

Posted on April 26th, 2009 by admin in How to Invest

This post shows how to select assets depending on your beliefs about the macro state of the US economy. Before discussing how to choose assets for further analysis for your portfolio, you first need to recognize reality, which I hope to show here.

Your hardest decision will concern your estimate of when the US economy will transition from deflation to inflation. While we have a cycle of reduction of GDP, layoffs and price reductions, we cannot claim technically times are now deflationary, but they are close. We have argued in previous posts that the USA and rest of the world will experience deflation for some years and then inflation: .

Just this week, this rather gloomy forecast was strongly argued in the Economist magazine (23 APR 09, p.13). The editor says, for openers, don’t be fooled by recent rapid rise in the stock market:

It is easy to read too much into the gain in share prices. Stock markets usually rally before economies improve, because investors spy the promise of fatter profits before the statisticians document a turnaround. But plenty of rallies fizzle into nothing. Between 1929 and 1932, the Dow Jones Industrial Average soared by more than 20% four times, only to fall back below its previous lows. Today’s crisis has seen five separate rallies in which share prices rose more than 10% only to subside again.

He continues to argue for a prolonged deflationary or deep recessionary economic state. He continues:

Add all this up and the case for optimism fades quickly. The worst is over only in the narrowest sense that the pace of global decline has peaked. Thanks to massive-and unsustainable-fiscal and monetary transfusions, output will eventually stabilise. But in many ways, darker days lie ahead. Despite the scale of the slump, no conventional recovery is in sight. Growth, when it comes, will be too feeble to stop unemployment rising and idle capacity swelling. And for years most of the world’s economies will depend on their governments.

Consider what that means. Much of the rich world will see jobless rates that reach double-digits, and then stay there. Deflation-a devastating disease in debt-laden economies-could set in as record economic slack pushes down prices and wages, particularly since headline inflation has already plunged thanks to sinking fuel costs. Public debt will soar because of weak growth, prolonged stimulus spending and the growing costs of cleaning up the financial mess. The OECD’s member countries began the crisis with debt stocks, on average, at 75% of GDP; by 2010 they will reach 100%. One analysis suggests persistent weakness could push the biggest economies’ debt ratios to 140% by 2014. Continuing joblessness, years of weak investment and higher public-debt burdens, in turn, will dent economies’ underlying potential. Although there is no sign that the world economy will return to its trend rate of growth any time soon, it is already clear that this speed limit will be lower than before the crisis hit.

Welcome to an era of diminished expectations and continuing dangers; a world where policymakers must steer between the imminent threat of deflation while countering investors’ (reasonable) fears that swelling public debts and massive monetary easing could eventually lead to high inflation; an uncharted world where government borrowing reaches a scale not seen since the second world war, when capital controls ensured that savings stayed at home.

If you accept this reasoning from the data, the next task is to choose assets from which you’d like to construct a portfolio. We provide ongoing analysis of a collection of such assets, e.g.,

but this post will jump back a step and look at some generic asset classes and see how they are best used. It’s actually pretty easy at the top level.

Look at this table of asset types:

Assets for Economic Macro States

Assets for Economic Macro States

The left column titled Asset Class shows five main categories of assets, or financial instruments. These don’t represent every possible type of asset, just a selection most investors are familiar with. They aren’t esoteric as many securities are, like “collateralized mortgage obligations.” The next column gives examples of the asset types. The next two columns show broadly what each asset type should be used for depending on your belief in deflation or inflation.

First, consider equities. While stocks usually do poorly during inflation, deflation also seems to drive them down. We have little experience of deflation since the Great Depression, and they certainly dove in during the ensuing giant bear market. However, that is a generalized assessment. In all economies, smart technology investments are possible, and tech is the source of innovation that in all conditions propel econimic growth. Thus, all stock investments are firm and industry specific at all times. Special knowledge really works for tech stocks!

Fixed Income of all forms is easy to assess. When money is scarce relative to goods during deflation, cash increases in value. Thus, if you receive cash flows or even hold cash in your mattress, you gain. Of course, during inflation, the reverse is true. You gain by repaying debts in cheaper money as inflation bites, so fixed rate mortgages or other debts get cheaper from inflation.

Options and Alternative Investments can be crafted to match the direction of economic forces  either way. For example, if you believe a major chunk of large company business will be adversely affected by deflation, you can capitalize on a falling S&P500 Index by buying out of the money puts, or buying S&P500 inverse ETFs (these give the negative of the daily S&P500 return).

Finally, consider real assets. Commodities perform well under inflation, and with severe drops in demand, likely will have low prices with deflation. Oil is a particular example of that assessment. Gold is a bit perverse, in that it trends upward with very high volatility, but does well with inflation and well with deflation. Gold has a specail place in fearful investors’ hearts.

Real estate is quite tricky for both environments. Residential homes would be best, purely from a financial viewpoint, to rent during deflation. That would enable the renter to let his landlord have the headaches of maintenance and loan payments as the general price level drops. Of course, living in your mortgaged home is best under inflation if your payments are fixed rate.

This brief analysis can help clarify your thinking about what to do in this New World Order of economic reality. Of course, the details really matter about each possible asset you choose.

The most important of those pesky details which you must consider is the timing of the transition from deflation to inflation. It matters, for example, in selecting the duration of any fixed income securities you buy. Should you keep your cash in negligible return money markets, ready to buy high rate bonds under inflation, or buy high rate bonds of three year duration now, and sell them when inflation becomes obvious in (an assumed) three years?

If you are not willing to perform such analyses, I suggest, quite self-servingly, you hire a good investment advisor!

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