Annual Outlook — January 2008
I hope that you had an enjoyable and relaxing holiday season in the company of family and friends. As we start a New Year I would like to extent my best wishes for the year ahead, and thought that I would summarize for you the areas where I believe an investor should have some investment consideration for the coming year. These are my opinions and conclusions as reached through my observations of the global economy.
This New Year marks an important anniversary for my professional career since I started in the business in 1988. Throughout the years I have had the benefit of having met and studied many business people and investment professionals. These have influenced and shaped my investment philosophy. As such, one of the best pieces of advice I received early on came from one of my first mentors in the business, who said that this business is about figuring out the spread between the perceived reality and the actual reality, when everybody gets it, the irrationality of greed or fear takes over and it’s time to take profits. Figuring out this spread has become the primary focus in my search for an understanding of the global forces that are shaping our investment environment. I believe that this analytical process allows an investor to stay ahead of the curve in finding investment opportunities.
For this coming year I see four themes that will have positive influences for the value of our portfolios; dealing with the sub-prime mess, increasing food inflation, the changing global energy environment, and the economic growth of the emerging markets. Interestingly, all these factors are related, and as investors it is important to understand the effect of these themes so that we can take advantage of the opportunities.
By now, most pundits on MSNBC have woken up to the fact that there is a problem with the global banking system due to the US’s banking irresponsibility. Though the markets have been and will continue to be volatile, this mess will not cause a major crash in the system due to the ability of Global Central banks to print money. The volatility will continue because we need time to allow these mortgages to roll over, and therefore the uncertainty of this mess will not be fully figured out for a couple of quarters. What is certain is that the Central Banks will bail out the banking system by printing as much currency as will be needed to pay for this mess; in 2007 $600 Billion were injected into the banking sector by global Central Banks. It is this liquidity in the system that will support the markets for now. What is important for the investor today is the inflationary effect of these cash infusions. The issue of the long-term implications of this level of debt creation is a concern for a future date. As a result, I do expect a tough first quarter as earning numbers start to show the economic slowdown of the US, however all this liquidity will make its way into the system and support the markets.
In this inflationary environment Gold should continue to appreciate. I think that it is necessary to re-visit the cause of inflation as defined by the Oxford Dictionary; inflation is caused by an increase in available currency and credit beyond the proportion of available goods and services. In other words, things are not increasing in price, but the money you are buying them with is depreciating. Inflation will be and has been the net result of all this money creation by Central Banks and in this environment gold will appreciate, as it is the only financial constant that cannot be duplicated. It’s also no wonder that since the year 2000 the best performing asset classes have been those that cannot be duplicated. Furthermore, analysts that have correctly called this market throughout this period are those that have correctly identified the effects of this money creation. From a historical and philosophical perspective gold has always been the answer to a more fundamental question; why do we have to use money whose value is determined by bureaucrats? This current level of money creation has always led to a return to a gold standard. This might explain why in every century, going back prior to Christianity, the global financial system has had a gold standard.
The sub-prime mess will be the “noise” for the media in 2008 and the main catalyst of volatility. Of greater interest as an investor, is the changing global energy and food. Like gold, most commodities have appreciated in this inflationary environment; however what is not yet apparent to most is the changing supply demand imbalance of these valuable resources, in view of the current level of global economic growth. It is for this reason that I do not think that the slowdown of the US economy will lead to global deflation. Wall Street expects, and hopes, that as the US economy slows down the global economy will also follow and cause a pull back in most commodities as demand for them abates. My observations lead me to believe that this will not be the case for two reasons. Firstly, inventory levels for commodities are fairly low and the global economy is still growing at a healthy pace. As a result, the rest of the world’s economies could greatly benefit by a slowdown in demand for the things needed for economic growth. Secondly, as pointed out previously, money creation by all Central Banks is growing at very healthy pace, and this inflationary effect will greatly influence the value of commodities. Within all the commodities, oil and food are of special interest as they have immediate effects in the global economy.
Oil and food are related because we are in the process of switching our food production for the purposes of keeping our vehicles on the road. The logic of this strategy can only be understood through eyes of a junkie that does not understand that he has to do something about his addiction. Currently the US has a target of harvesting twice the amount of corn; this policy has had the negative impact that growers of other crops, necessary for human consumption, are switching to corn and creating shortages and increasing the price of all foods. In the fall, Mexico had many demonstrations by people protesting the increases in the price of corn, and in early December Russia stopped all export of wheat in order to stop the increase of food inflation. Historically, food inflation has always been the catalyst for hyperinflation because no matter what, we have to eat, and it does not seem to me that this current path will change anytime soon. The current status quo will prevail through 2008 as the world's biggest energy consumer is in election mode and no politician is willing to rock the boat.
Wall Street’s consensus for oil prices for 2008 is in the range of US$ 55 per barrel. This is the same crowd that had a target of US$ 45 for 2007, US$ 40 for 2006, and US$ 30 for 2005; their targets have been wrong for the last couple of years. Wall Street’s current optimism stems from a strong belief that the global economy will slowdown in 2008 and that the Saudi Princes will produce more oil. Jeff Rubin, CIBC’s Chief Economist, believes that oil will trade for US$ 100 in 2008. With targets for oil all over the place I think that it is more important to assess what we do know.
According to the International Energy Agency (IEA):
- Current global oil production is 1.2 Million barrels lower than we produced in May of 2005,
- Current global oil demand growth is expected to grow at 3% yet has been growing at 5%,
- The world three biggest oil fields are declining at an average rate of 8% a year,
- OPEC has consistently promised more oil but has yet to deliver,
- It is currently impossible for Asia to have the same standard of living as we have with current levels of global oil reserves. In a nut-shell we have to start finding enough new oil reservoirs to meet increasing oil demand and the ongoing depletion of current oil reserves, and currently we are just not finding it. In view of these facts a rational investor should therefore forget about Wall Street’s oil target and assume much higher oil prices for 2008. Please note that I did not even discuss the geopolitical picture of oil or the fact that most of the world’s oil reserves are currently controlled by National Oil Companies, whose interest are best met by lower levels of oil production.
The consensus for 2008 is for an abatement of global growth due to the economic slowdown in the US. I do think that the US and maybe some of the other mature economies will have slower economic growth. However a slowdown in the economies of the rest of the world will only come about as result of serious energy shortages. Currently, with oil at US$ 96, we have had no demand destruction thus signaling that we need much higher oil prices before people change their spending patterns. This is a clear sign that the global economy will continue to grow for the time being. Furthermore, I think that the real story for these economies will come from their currencies, which have just started to appreciate against the US$. It is important to understand the fine balance between these economies’ account surpluses and their need for commodities required for economic growth. Since all commodities trade in US$, many of these economies keep much of their currency reserves in US$ and much of their foreign exchange pegged to the US$. In 2007 we started to see that most of the currencies of Asia, Latin America, and even the Middle East have started to climb against the US$, thus making the things they need to buy much cheaper. I think this trend reflects two facts; first the growing importance of the Emerging Markets, and secondly the fact that in view of the scarcity of global resources these economies are going to exert much more economic power. For an investor it is important to recognize that these economies are developing and supporting a new batch of consumers that will continue to grow and demand greater quality of life, and as such require some consideration and participation.
It is my conclusion that as investors we should expect much volatility for the year ahead, and will benefit from some consideration in the following areas; gold, oil, food and the Emerging Markets. The degree of investments in each should be in relation to our personal risk tolerance and investment objectives. Lastly, I would like to point out that these conclusions are only analyzing the areas where I think we will benefit the most, and do not negate the fact that there are many other opportunities that will be attained through a properly diversified portfolio. We must remember that a properly diversified portfolio is the best way to underpin the accumulation of wealth over time, and that it is this diversification that will also reduce the level of volatility.
Jaime E. Carrasco, BA, CFP
Investment Advisor
T: 416-864-3623
C: 416-271-6630
E: jcarrasco@blackmont.com
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