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QUESTIONS FOR 2011, PART 2

Fidelity just released part 2 of their “questions for 2011” so I have decided to take a crack at these questions as well (see my “questions for 2011” part 1 here):

Do you think the U.S. and China are headed for a confrontation in terms of currency or trade policy?

I think this confrontation is already occurring although it is occurring in relative silence.  The Chinese, via their currency peg, are blatantly manipulating their currency lower.  The same can be said of the USA, however.  When a country intervenes to influence the direction of interest rates it intentionally (or perhaps even unintentionally) is having an impact on its currency.  For China this manipulation is an in-your-face and blatant purchasing of US dollars in order to maintain a favorable exchange rate and generate a stable and reliable source of economic growth.  For the USA this currency manipulation comes in a more subtle form of interest rate manipulation.

Interestingly, because China maintains this peg they are essentially adopting US monetary policy which is highly inappropriate considering the vast differences between the two economies.  This has caused severe imbalances with the Chinese economy and I believe the Chinese are now learning the result of this peg through the surging rate of inflation.  This imbalance is unlikely to last, however, I think it is unlikely that the United States will do anything to intentionally disrupt this imbalance via tariffs or other such misguided policies.  The Chinese currency peg is causing domestic problems within their borders.  In time, this imbalance will resolve itself through market forces.


Will emerging markets (EM) remain the driver of global growth, even though China and other countries are counteracting the Fed’s monetary policy?

We can only hope.  The United States is muddling through a period of economic malaise as debt de-leveraging continues to weigh on the country.  Europe is in a similar condition although their growth is more fragmented due to the single currency system.  Germany remains quite strong, however, the rest of Europe continues to struggle with low growth and high debt levels.  Because Asia suffered their own debt crisis in the late 90’s they have entered this environment far better off than other regions.  I believe Asia will continue to be the driver of growth in the coming year although there is increasing risk that China fails to contain their inflation woes and is unable to engineer a soft landing.  If this occurs all bets could be off in 2011.  China, in my opinion, is likely the single most important economic indicator heading into 2011.

How much longer do you think the secular bull market in commodities can go on?

There are several powerful trends driving the commodity bull market and none is stronger than the population boom and urbanization of the emerging world.  As the following chart (courtesy of Goldman Sachs) shows the population boom in emerging markets is just beginning as emerging market populations are expected to double by 2050:

The other powerful trend that is likely to continue driving the secular bull in commodities is the financialization of the commodity world.  Investors, speculators and average joes are increasingly looking for ways to invest in hard assets as governments engineer bailouts, recoveries and concerns over fiat paper grows.  The financial markets are helping to meet this demand with an ever increasing product line related to commodity markets and ways to invest in commodities.  Although notoriously volatile, the commodity bull market is likely to continue as these two powerful trends continue to drive demand.

Are gold and silver the new Treasuries? Are they becoming the safe haven of choice?

I have long maintained that gold would serve as a safehaven from perceived government recklessness and the perceived weakness of fiat money.  Specifically, bailouts and QE2’s perception as being inflationary as well as the EMU’s currency crisis are generating enormous fears over the stability of governments and their currencies.  This has all resulted in doubts over fiat currencies.  Although I believe the fears are misguided (QE is not inflationary and the EMU is a single currency system much like the gold standard was) we have to recognize that these trends are very real.  Perception is reality in this case.  In addition, there are attractive fundamental reasons to own previous metals. In particular, China’s voracious appetite for the yellow metal. These are powerful trends and I still maintain that gold is on a collision course with an irrational bubble.

But this does not mean gold is replacing anything as a currency.  I still believe the idea of gold ever becoming a reserve currency again will become extinct in the coming centuries.  The modern monetary system is very young and highly misunderstood.  The move away from a gold standard was an evolutionary step in the process of improving human prosperity.  Ironically, what we are seeing in Europe today, is what a single currency system like the gold standard once did to the entire world.  Although there are powerful near-term trends driving investors to believe in the price of gold and silver I do believe we are moving closer to a period when gold is no longer perceived as a reserve currency.

Ironically, in this environment where real inflation is not driving gold prices (but rather both are serving as near-term safehavens) the very best trade might just be a combination of US Treasuries AND gold.

Will markets remain as highly correlated as they have been since the fall of 2008?

We remain in a period of enormous uncertainty as global imbalances remain and governments around the world continue to engineer economic growth.  This has resulted in an investment world that is “risk on” or “risk off”.  With continuing uncertainty in the USA, sovereign debt woes in Europe and a potential inflation scare in China I would expect this trend to continue.

Will we get an inflation surprise in 2011?

This depends on where you live.  If you live in China there is a chance that inflation will spiral out of control.  There are already signs that inflation is uncomfortably high.  Their 2009 stimulus package was greatly misguided and they are now seeing the impacts.  In early 2009 I said:

“This is likely to cause an inflation problems as China’s credit markets remain intact and an unnecessary stimulus bill injects funds into an economy that already has excess liquidity.”

Bingo!  There are no signs of this letting up any time soon and I believe the Chinese government is behind the curve in corralling this problem.

In the USA I still maintain that inflation fears are overhyped.  The US economy remains weak and as the US consumer continues to de-leverage and banking system remains fragile we will continue to see very tepid loan growth.  In addition, there are some signs that housing is now double dipping.  This should put further downward pressure on prices.  QE2 is helping to generate some commodity price inflation, but I believe producers will have a difficult time passing these price increases on primarily due to weak labor markets, stagnant wages and and a high output gap.  I still believe the risk in the US economy is a continued period of disinflation with a higher risk of deflation than hyperinflation.

Is the bond binge ending and do you think the vast flows will chase equities or commodities?

I think bond markets in the USA will continue to reflect low levels of inflation and general economic malaise.  If a stronger recovery takes hold we could see higher interest rates, however, I think it is unlikely that we see dramatically higher rates.  The Fed would be very uncomfortable with a surge in long-term rates so we’re likely to see further intervention to keep rates low in the USA.

In Europe where there truly are bond vigilantes I believe we will continue to see bond investors press on the periphery nations and force the ECB’s hand.  They have tasted the bailouts in Greece and Ireland and I presume bond investors will push rates higher in Spain and Portugal until they receive similar treatment.

Will 2011 be risk-on or risk-off?

It depends.  If you had  bought the S&P 500 in January and held it until today you would have a total return of 10%.  But this doesn’t tell the story about the rollercoaster ride you had to endure in the meantime.  In just the last 11 months alone we’ve seen three double digit rallies and three near double digit sell-offs – one of which was a mini market crash.  Why does this environment remain so incredibly volatile?  Because the recovery is uneven due to continuing global imbalances.  This is the primary reason why I believe the secular bear market is not over.  In essence, the global imbalances that caused this crisis in the first place all remain intact.  Therefore, I still think you have to be nimble and flexible when approaching this investment environment.



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