China In 2012: Growth Driver Of The World Economy?

On Jan. 23, the Chinese New Year began; it is the year of the Dragon. Every year is symbolized by a new animal, following a 12-year cycle. A symbol for good fortune and change, the dragon also stands for progression and perseverance. Given the fact that China has become such an important driver of global growth, it would certainly be good to get a little help from the dragon this year. Will China be able to hold up and help to stabilize the struggling economy in the Western world?

The economic challenges in the Western world remain unsolved; therefore, economic growth will be moderate at best. For the United States, this might mean that gross domestic product growth will remain weak; countries in Europe might even see negative growth in coming quarters. In China, the situation is different. So far, economic growth has been able to keep up surprisingly well and is currently standing around 8 percent. This represents a slowdown from the previous years when growth was in the area of 9 percent to 10 percent. The slower growth rate was primarily caused by two factors. First, the general slowdown and economic crisis in the West, since almost 40 percent of China’s exports go to Europe and the United States. Secondly, the Chinese government has been trying to slow down economic growth in order to control inflation, which is one of the biggest problems.

In recent months, there has been growing optimism that China has successfully managed to control inflation; consumer price inflation fell from 6.5 percent around mid-2011 to 4.2 percent in November, a trend which is clearly encouraging. Chinese policy makers managed to control inflation by taking various measures, which included monetary, fiscal and regulatory adjustments.

Financial markets have been worried about the slowdown in China, realizing how important the country has become for the global economy. In a time when the United States and Europe are struggling like they are today, a hard landing of the Chinese economy would have the potential to turn the crisis in the West into a global recession possibly even a depression so a lot is at stake here. However, there are a number of reasons to be cautiously optimistic that China continues to be a growth driver for the world economy. Especially important is the fact that we are going to see a policy shift in China this year, which should support economic growth.

China has the financial means to give a lot of stimulus to its economy, a much different scenario from the West where deficits and debt burdens are huge and interest rates are at historical lows already. In China, inflation seems to be under control and policy makers will have more room to lower interest rates again, despite the fact that there has been a lot of talk about a real estate bubble in China. While high real estate prices in some of the major cities continue to be a problem, prices have started to come down in a majority of places, a clear indication that the housing market is cooling off a little bit. China is also under pressure to grow the economy and continue to create jobs. Policy makers are very well aware that job growth and improving living standards are the most important factors for social stability in the country.

It seems very likely that we are going to see a policy shift in China this year which should result in accelerating economic growth. This has far-reaching consequences for the Western economies in general and for global financial markets in particular. The psychological impact of this policy change is yet underestimated. China is not the only driver of the global economy, but probably the most important at the moment and much better positioned than some of the other emerging market nations, such as India. India has a lot less room to stimulate its economy, primarily due to fiscal problems and high inflation, despite 13 rate hikes since early 2010.

Market Comparisons
(Chinese Stocks are off to a good start this year)

Fixing the debt problems in Europe and the United States will not only include measures to cut spending. The austerity measures implemented in many Western countries might even make the situation worse, but Western countries also need to restructure their economies and become more competitive; only this will improve the situation long-term. It is clear that this would be easier to achieve if global growth remains robust and does not add further pressure on those countries.

With the policy change in China, there seems to be a good chance that global growth will hold up fairly well and give Western countries a little bit more breathing room. However, Europe and the United States need to make use of this opportunity and bring the house in order. I have my doubts about this, especially in a big election year like we have in 2012, it’s all about making new promises for change and a better tomorrow. Changing things to the better most often includes unpopular adjustments, sometimes even painful adjustments; it’s unlikely that we are going to see too many of these adjustments in a big election year.

With the encouraging progress in Europe (stability fund, fiscal pact, falling risk spreads), the policy change in China and upcoming elections in many major countries, the year 2012 has the potential to surprise to the upside. This is true for economic growth and financial market returns. After a very difficult and volatile 2011, things are starting to improve from rather low levels. Stock markets already anticipate a more positive development going forward. Most major equity markets have started to recover, emerging markets have even seen double digit performance so far this year and it looks as if this could continue in coming months.

In the long run, things can only improve if structural adjustments are being made in the West, and the world will watch this progress very closely. There is hope that the coming years bring positive developments but only if Europe and the United States are able to make convincing steps to address the debt problems and restructure their economies. Emerging markets can have a stabilizing effect on Western economies by providing growth opportunities in many areas. While most emerging markets have been seen as cheap places for production in the past, they are now getting more and more important as new and growing markets where Western companies can sell their goods and services. This growing importance becomes very obvious when one studies the financial reports of major Western corporations, companies that are able to pursue growth opportunities in emerging markets.

It’s good to get a little help from the dragon, but long-term success can be achieved only by structural adjustments in many areas. China continues to be a major driver for the world economy, but the Western world needs to get their act together in order to keep and improve living standards for its people.

European Debt Situation Improving?

In 2011, financial markets were dominated by news surrounding the debt problems in the Western world, and markets saw record levels of volatility. The issues in Europe as well as in the United States are equally alarming, and the coming months will show us whether policymakers are able to stabilize the situation.

The structure of the problem might be very similar; however, Europeans and Americans deal with it differently. While Europe seems to be engaging in a more active discussion about how to deal with its situation, the United States has not made a lot of progress in getting its house in order.

The risk Europe faces is that it might cut spending so much that the austerity measures cause the economy to contract significantly. The measures taken might have far-reaching consequences, and the contracting economy might eventually cause actual government income to decrease. Lower spending and lower income would result in a stagnant, high deficit.

On the other hand, the United States is trying to be less aggressive. While cutting spending is important, officials are trying to do so in a bit more moderate fashion than Europe.

It has yet to be seen which strategy will work better, but it seems to be obvious that inflation eventually becomes part of the solution. Ultimately, inflation could play the greatest role in solving the problem, if the size of the existing debt were devalued by an increase in inflation. In that sense, a devaluation of money would cause inflation. Savers and creditors would be hurt the most, while people with debt would see their situations improve. This summarizes the main structure of the problem as we have outlined in previous reports.

It should be obvious to everyone that the global economy and financial markets will continue to be heavily influenced by the way the Western world deals with its debt problems. Therefore, I would like today to look at the recent developments, especially in Europe, in order to judge the situation and whether an improvement can be expected soon.

Given the recent downgrade of the Eurozone countries by the rating agency Standard & Poor’s, one might think that the situation has worsened since the start of the year. However, I think there is reason to believe that the situation might improve in coming months. A number of European countries have tested the market since the start of the year by selling short- and long-term bonds to investors. These bond auctions have been quite successful, not only with regard to the actual demand for these bonds but also in terms of the yield investors demanded.

Yield spreads for Italian and Spanish debt have fallen significantly from the levels seen in the last quarter of 2011. For example, Italy is paying a yield of 4.83 percent for bonds maturing in 2014. That’s almost 1 percent lower than what it had to pay in December. For bonds maturing in 2018, the yield was 5.75 percent also down significantly from 2011 levels. Also, Spain had a number of successful bond auctions.

Another sign that the “fear premium” for European sovereign paper is falling is shown by the results of the German bond auction last week. The country paid a yield of 0.9 percent for five-year bonds, setting a new record low. Demand for European government paper has also improved, with demand exceeding supply by a wide margin. Germany’s auction, for example, attracted almost twice the amount in bids than what it had to offer.

While some people think that the recent slide in yields was caused by some kind of “behind the scenes” central bank intervention, this argument fails to explain the broad-based slide in government yields. In my view, this development reflects a general move to a more “normal” market environment again.

Last year, fear and panic resulted in a hysterical market environment, sending yields of European governments bonds to record levels. Just two or three years ago, we had the exact opposite extreme when Italian and Spanish yields were almost as low as German yields, therefore reflecting little to no risk premium. Looking at the economic fundamentals, it should be clear that this was also a general mispricing of credit risk. A reversion to the mean had to happen at some point.

We have now witnessed an overreaction to the upside; and, once again, we expect yield spreads to move back to fair value. Fair value in this case means that Italy and Spain have to pay higher yields to attract buyers like they had to do historically.

While the start to the New Year has certainly been encouraging, it remains to be seen whether the situation will improve further. Italy and Spain face a number of tests in coming weeks, as they are going to renew a lot of debt for longer maturities. A continued trend toward a further normalization of yields would be very encouraging, but this is possible only if the European Union finds a solution for Greece’s financial woes.

Despite the relatively small size of the country, it is important in the overall context. There is real risk that Greece will default on its debt obligation should it not be able to negotiate a debt restructuring with its creditors (banks, hedge funds, etc.). While these lenders seem to be willing to accept a cut of up to 50 percent of their positions, they do not seem to agree on the rate/yield at which the debt is being rolled over. Should Greece find an agreement with its lenders on how to restructure the existing debt, then I think it is possible that the European debt situation can be managed. Of course, it is not going to be enough just to cut spending; troubled countries need to work out plans how to make their economies more competitive and, therefore, stimulate growth in the long run.

The debt problems in the Western world are far from being solved. Actually, the Western world might not be able to solve these problems entirely, at least not in the next decade. For now, the key is to make one step after another and make policy changes and structural reforms that make sense. The pressure from financial markets is finally forcing change, and governments are measured by their ability to balance their budgets. This will be a key issue as a large number of major governments face election tests this year.

United States Of Europe

Today’s sovereign debt problems in Europe and the United States create the single biggest risk for Western economies. In order to deal with the economic challenges, the European Union is becoming an increasingly integrated and centralized structure.

I have never been a big fan of the EU and its currency, the euro. When the European Union signed the Maastricht Treaty in 1992, a core group of European countries agreed to adopt the euro as their main currency, with the object of eventually replacing individual currencies, such as the deutschemark, the French franc and the Italian lira. Seven years later, the euro was officially introduced in non-physical form. Finally, in January 2002, the euro was introduced in physical coins and notes.

At that time, I thought it impossible to bring so many different countries together and have all of them adopt a common currency. In my view, these countries were too different from each other to be merged into a single currency bloc, given huge economic and cultural differences, as well as different languages. Because I am Swiss, I am always skeptical of large and centralized political systems like the EU and even the United States. However, I have to admit that the European Union and the integration of many countries over the past 20 years worked much more smoothly than I thought it would.

I was also surprised by the convergence of European bond premiums. In the old days, it was normal that Italy had a higher risk premium than German government bonds. But over the years, that yield spread narrowed so much that credit markets viewed the credit risk of Italian bonds as being equal to the risk of German government bonds — even though Germany appeared to be in a much better position.

The European debt crisis brought this credit risk convergence to an end, and spreads started to widen again. I consider this a very healthy development, since the market has been repricing the risk of these bonds. The result is that Italy pays more for its debt, because the market perceives it to be riskier than Germany. What should the yield spread be between these two countries? This question is hard to answer, but I believe it is clear that the difference should be quite significant.

Earlier this week, Italy was issuing bonds with a 12-year lifetime at a yield of 7.30 percent, and Belgium issued 10-year bonds at a yield of 5.65 percent. Even though these yield levels look extremely high, the rates are down slightly from their peaks several days ago. For quite some time, it was not even clear whether Italy and Belgium could successfully place bonds in international markets.

In comparison, Germany can borrow from financial markets at a rate of below 3 percent for 10 years and is paying just 3.02 percent on 20-year bonds. Italy is paying more than twice the yield on its bonds than Germany. In addition, Italy’s funding costs are significantly higher. In fact, Italy’s funding costs are at levels not sustainable in the long run. The same is true for other EU member states such as Spain, Portugal and Greece.

The challenge the EU faces is that for most of its member states, the overall funding costs are now significantly above levels that can be considered sustainable. In the short run, these countries can be supported by the European central bank, the European Stability Fund or even the IMF, but this will not solve the real underlying problems in the long run. In my view, it is a not a question of “if” but “when” the EU will start issuing Eurobonds, similar to Treasury bonds in the United States. The money raised from those bonds would be used to finance individual member states through a central funding institution that acts like a Eurobank. The Eurobank would directly negotiate funding terms and conditions with individual member states that need money.

There is currently a lot of debate about this, but I don’t think the European Union has another option that would bring down borrowing costs. This also means that economically strong countries like Germany would probably pay slightly higher rates, but would still have the opportunity to issue its own bonds — if it could do so at lower yields. From a political and economic point of view, I don’t like this development, but the question today is: What other options does Europe have? In my opinion, there are none.

Again, I don’t like a setup like the EU, a centralized system in which an individual member state loses more and more of its voice. But Europeans have taken this project so far that I think the point of return is far behind them. It is absolutely critical for the EU to bring down funding costs, raise confidence among financial investors and stop the attacks on individual member states. All of these practices put the future of the EU at risk.

I think the EU is an odd concept and setup, and I doubt it will work very much longer. But now, there is no way back. That is why I think Eurobonds will be issued soon in order to calm financial markets.

Eventually, U.S. Treasury bonds and Eurobonds are going to be almost the same. Also, the underlying debt problems of the U.S. and the EU are going to be similar in size, and I am almost sure that both will print money to deal with the debt burden. The likely consequence will be that both are going to have structurally weak currencies, and investors should make sure not to hold too much exposure to these two currencies.

I don’t know which of the two currencies will be stronger in the long run (or should I say “less weak?”). Against the U.S. dollar speaks the fact that its global influence is in decline, after being the world’s dominant currency for more than 60 years. On the other hand, the euro is still a relatively young currency; and the fact that so many economically and culturally diverse countries form the EU does not make it seem the better alternative. However, I am surprised how different the United States and Europe are in their approach and willingness to deal with the current debt crisis.

The current focus of international investors is clearly on the European situation. There is a great deal of urgency to address the debt problems. As a result, a number of governments have been toppled in order to force reforms. The EU now needs to decide whether it wants to become a true political union with a centralized government, in which the influence of individual member nations is reduced further.

The current situation is similar to the United States’ situation between 1777 and 1787 when the 13 former British colonies formed a union (“Articles of Confederation and Perpetual Union”). The various problems with this decentralized setup led to the adoption of the U.S. Constitution, which made all member States part of a single republic with a strong central government. However, even if Europe were to decide to form a closer union, doing so would not guarantee success.

The United States’ situation today looks more stable only at first glance; the truth is that the situation is not much different from the one in Europe. What worries me with the United States’ situation is that not even the Congressional supercommittee has been able to devise a plan to reduce debt, and everything seems to be stuck in a political deadlock. How much longer will international financial markets tolerate this situation? I doubt it will be for very long.

U.S. Debt Situation Worse Than Italy

The European debt crisis has been in the spotlight for a couple of months already.

In recent weeks, the situation has gotten worse and is causing enormous volatility in global financial markets. After Ireland and Greece, two very small countries within the Eurozone, larger countries like Italy and Spain are now also struggling.

Italy has recently issued new government bonds with a five-year lifetime. The price for those new bonds is 6.29 percent. This is the yield that investors demand to get compensated for the investment risk they are taking. Back in October, Italy could still borrow at a rate of 5.3 percent. This represents an increase of almost 20 percent.

The departure of Prime Minister Silvio Berlusconi will not change much for now. It will take years to correct the mistakes of his administration, and structural reforms are desperately needed in many areas. New Prime Minister Mario Monti will have a very challenging job of turning the Italian situation around. Difficult? Very difficult. Impossible? No, but quick action is needed since financial markets are getting very impatient.

The situation in Italy is similar to the one in Greece, but probably not quite as bad. However, the fact that Italy is so much bigger makes the situation a real threat.

Italy has a debt burden of about 1,900 billion (euros) and it looks like they will need about 300 billion more next year. The help from the European Central Bank and the new European Financial Stability Facility (EFSF) will not be enough to save Italy. The country needs to take swift action in order to avoid insolvency.

The Italian parliament has recently accepted a new savings plan, but it will also require further spending cuts and privatization of state-owned enterprises to keep going. The situation looks scary, but it is possible it can be controlled for now and improved in the long run.

Italy is, for the European Union, too big to fail, and therefore a very different situation compared to Greece. Also, most of Italy’s debt is held by domestic investors and a comparably low portion of debt is held by foreign investors. In that sense, Italy’s debt situation is bad but manageable.

The situation with the United State’s sovereign debt is different. Although the U.S. situation has not captured much attention lately due to the European debt crisis, it has not improved at all. And what’s worse, no measures have yet been taken to address the situation. So while there are a lot of discussions in Europe about how to solve the debt problem, nothing has been done in the U.S. It is only a matter of time until world financial markets focus on the U.S. situation again.

How can it be that despite all these problems in Europe, the U.S. Dollar has not been able to gain ground versus the euro? It is still trading at around 1.37 (see chart below), and despite the headlines about the Greek and Italian debt problems, the European currency has not crashed. Actually, it has been able to appreciate against various major currencies of late. Are we missing a point here, or can we blame speculators for this obvious mispricing of currency values?

First of all, I don’t think that the market is mispricing the value of the euro. I also don’t think that the yen is as highly overvalued as many market participants believe.

The euro clearly takes some strength from the fact that countries like Germany and France are still doing relatively well. Germany is, right now, the star economy in Europe, hugely successful in exports despite some structural problems. But looking at debt ratios in most European countries should send an alarming signal and, in combination with the severe structural problems in many countries, one would expect the euro to be much more vulnerable.

Let’s take simplistic look at the sovereign debt problem for a moment.

Sovereign debt is public debt or borrowings that a country has. Simply put, the governments in the past have spent more money than they took in. Governments make their money from taxes, and use tax money to provide public goods and services. A government needs to manage its money in a way that taxes can be kept at moderate levels. However, if a country spends more money than it has available, it has to borrow money in capital markets to finance the shortfall.

This is exactly what the U.S. and many European countries have been doing for many years. For as long as a country’s total wealth is sufficient to cover these borrowings, the country should remain solvent. It might be difficult to raise taxes quickly, but what is important is that any shortfall in the finances of government is sufficiently covered by savings in the private sector.

Also, a government might have a lot of assets that it can liquidate over time to free up cash. This is typically called privatization. Countries like Greece and Italy, for example, still have a lot of government-owned assets that, over time, need to be sold as the countries restructure their economies.

European countries, as well as Japan (or Asian countries in general), are places where people tend to save a lot of money. This is in sharp contrast to the U.S., where the savings rate has been in a long-term downtrend for most of the last 60 years and has only recently started to move back up. This is a clear indication that people in the U.S. are deleveraging by paying down loans and mortgages in the face of uncertain times.

However, the overall wealth of American households is significantly lower than one or even two decades ago. This is mainly driven by stagnant incomes and a crash in housing prices. What makes the situation even worse is the fact that the government is running record levels of debt, which means that the overall wealth of America (private and public wealth) is significantly reduced to the levels seen back in the 1980s.

According to official statistics, Americans’ average household net worth fell by 23 percent between 2007 and 2009 and has not really recovered since. This hasn’t been the case in Europe and Japan, where the public debt levels look even more alarming (as a percentage of gross domestic product).

Compared to the overall wealth of those nations, their debt levels look much more moderate. For example more than 50 percent of Italy’s government debt is financed domestically. In Japan the number is even higher.

How public debt is financed therefore becomes the main question. Preferably, as much as possible should be financed by the country and its citizens. The higher the share of a country’s debt financed by foreigners, the worse the situation becomes. This is, in my opinion, the reason the euro and Japanese yen have outperformed the U.S. dollar recently.

From that point of view, the U.S. debt problem looks even more alarming than the situation in most European countries. When will the focus of financial markets switch back to the U.S. debt crisis?

Restructuring Western Economies A Must

Only three years after the world’s financial crisis in 2008, the global economy is slowing down again. At the start of the year, most forecasters expected global gross domestic product to expand in the range of 4.3 percent to 4.5 percent, it probably will only be around 3 percent.

While economic growth in many Asian and Latin American countries remains relatively strong, Western countries are hit much harder. Economic growth in Europe as well as the United States has slowed significantly in recent quarters, and it looks like many countries will experience little to no growth this and next year.

Even harder hit are the “problem” countries like Greece, Italy and Spain, just to name a few. Many of these nations have slipped back into an economic contraction, and negative growth will become even worse next year as the austerity measures in many of these countries will exacerbate the situation because governments are forced to cut spending. There is simply no easy way out of this challenge; Western nations have lived above their means for too long.

Since there is no easy solution for today’s problems, what can be done to manage and improve the situation in the future? Clearly, in a difficult situation like this, it takes a lot of hard work and a sound plan to restructure Western economies. It means that people from different political parties have to come together and work for the mutual benefit of a country. What bothers me about today’s situation is the fact that no one seems to be willing to listen or work together. This is very obvious in politics, where either that or this party claims to have the answer to today’s challenges.

Just think of the long fight between Democrats and Republicans about the increase of the debt ceiling. It was an almost endless discussion that, in the end, only hurt the American people. The real damage was done to the creditability of the United States as a country, in a time when foreign capital is needed more than ever before.

A similar fight currently takes place in economics. There is a big fight between so-called Keynesians (followers of economist John Maynard Keynes), typically liberal-minded economists and the Austrians (Austrian school of economics), a much more conservative-minded school of economics. Keynesian economics argues that private sector decisions sometimes lead to inefficient outcomes; therefore, the public sector needs to actively balance the economy. Austrians blame the Keynesians for today’s economic problems, because in their view there is simply too much money printing going on today and the government gets involved way too much. On the other hand, the Keynesians believe that in today’s situation, it is absolutely critical that governments keep spending money in an effort to balance the lack of economic growth in the private sector.

The long-term goal of the “Keynes” principle is to smooth out economic cycles by acting counter cyclical. When demand is low, increase spending. When demand is high, reduce spending. At first glance, that’s not a bad idea. However, today’s situation is different. Keynes’ model probably works in a more normal world, one in which governments are not already carrying such high levels of debt.

Most large central banks in the world today have a very expansionary monetary policy. This shows up in the fact that interest rates have been trending lower for many years and have now arrived at virtually zero. Also, central banks are providing extra liquidity to the financial system in different ways in order to ensure that the world financial system keeps properly functioning. The real problem with today’s situation is that the increased liquidity is not helping the economy. It’s not creating jobs or producing investments; therefore, it will not create any meaningful economic growth.

A central bank like the Federal Reserve in the United States or the European Central Bank can theoretically expand its balance significantly above today’s already inflated levels. It just means that more U.S. dollars and euros will get pumped into the system. Today, the main function this liquidity has is to calm the system and stabilize the banks. This money printing will weaken these currencies, which is already obvious with the U.S. dollar and the euro being among the worst performing currencies in recent years.

Money printing will create some inflationary forces that help stabilize the deflationary tendency coming from the slowing global economy. This inflationary impact will get stronger the more the currency depreciates. However, the real danger is that eventually, the economy picks up again and the incentive for the banks to lend money increases again. Then, a lot of excess liquidity in the system will find its way into the real economy. Typically, at such time, the velocity of money is increasing again, resulting in a strong increase of the monetary base. Unless a central bank acts very quickly and withdraws some of that excess liquidity, the consequences can be severe, creating asset bubbles and high levels of inflation, possibly hyperinflation.

The situation today is challenging for a number of reasons, and it’s certainly much more complex than many people think. That’s why I think this is not so much a matter of selecting the superior school of economics, but taking the strong points of each and combining them for a sound economic recovery plan. Unfortunately, the dilemma is that advocates of each school of economics often don’t respect the other’s approach.

The same is true in politics; that’s why we never get solutions. It’s not about change in general; it is about a change in the way we work together and communicate with each other. Republicans and Democrats in the United States, as well as other major political parties in other countries, often fight each other for the sake of fighting. They forget the fact that they all need to work for the benefit of the country and its people.

I don’t consider myself a follower of any school of economics, but I see that each has strong and weak points. There are certainly some principles which are generally applicable, but every economic problem is unique. In order to solve an economic problem, one needs to go beyond the limitations of certain frameworks. Applied to today’s difficult economic situation, it means the Western world needs to understand that it lived beyond its means for too long. Today’s welfare system is not sustainable. Generally, people are asking for too much from the government, and politicians have chronically overpromised for so many decades that the government simply can’t foot the bill anymore.

The solution to today’s economic and political changes is not about Keynesians vs. Austrians or Republicans vs. Democrats; it’s about working together for the best possible result for the country. What we need is more respect, especially respect for different views and opinions and a better sense of cooperation. This is what true leadership is all about, and this is how governments can regain people’s trust. Trust and increased confidence will eventually trigger investments and spending and get the economy going again. True leadership means respect and the ability to listen to other opinions and acknowledge the value of true cooperation.

A Great Year For Stocks Ahead?

As I write this article, global financial markets and the world economy are at a crossroads; some people even believe it is a one-way street to an economic collapse, especially in the Western world.

Most major stock markets are down between 10 and 20 percent this year; and, even worse, most markets are trading below the levels we had 10 years ago. Generally, the past 10 years were a lost decade for most equity investors. But even for people who did not hold equities and put money into real estate instead, the past decade was a disaster, especially the past couple of years. It seems that only precious metals and bonds generated satisfactory returns.

Long-term Equity Prices -- The World Market Index(Long-term equity prices – The World Market Index)

Now that most Western economies are at risk of slipping back into recession, it is hard to convince anyone to put more money in stocks; yet there are several good arguments that now is the time to diversify globally and allocate more funds to stocks, especially after the events we all witnessed so far this year. Global equity markets were hit hard early in the year by events such as the flooding in Australia, the earthquakes in New Zealand and the nuclear disaster in Japan. During the summer months, the attention turned again to the sovereign debt problems in Europe and the United States.

It’s been a very volatile year for financial markets and equity markets in particular. However, the increasing uncertainty helped precious metals. Gold briefly touched $1,900 per ounce a few weeks ago. In the meantime, the price corrected to about $1,650 per ounce. Now, with the outlook for only very modest growth in Western markets (with a mild recession quite likely in a number of European countries) and high uncertainty regarding the sovereign debt problems in Europe and the United States, it is very hard to find a bright spot in markets and become more optimistic that 2012 will bring better returns for equity investors.

While the economic fundamentals are clearly very weak, a severe recession is probably not going to happen; but we have to get ready for a prolonged period with disappointing economic growth. However, economic fundamentals are one thing; the stock market is quite another. Therefore, despite the challenging outlook for the global economy, certain factors point to an improving outlook for global equity markets.

Here is why I believe that global stock market prices could rise significantly in the next 12 months:

  • Valuation: Stock market valuation for most companies has come down significantly. This does not take into consideration that most companies are operating with a significantly higher efficiency, generating healthy profits in a time when economic activity is modest at best.
  • General exposure to the stock market: Generally, private investors and institutional investors are holding very low equity exposures. The primary reason for this is that many got burned in the past decade, either by the bursting of the tech bubble some 10 years ago or by the very sharp, temporary sell-offs in 2008 or 2011.
  • Relative attractiveness: With central banks printing record amounts of money, keeping funds in cash is a bad idea longer-term. What other options are there? Bonds? Interest rates are close to zero, so that’s not attractive either. Precious metals? This should be part of every investment portfolio, but buying more at elevated prices may be a bit risky. Real estate? Oh no, too much pain in the recent past; it’s too early to jump back into this market.
  • Inflation protection: While inflation destroys the true value of savings and bond returns, stocks do adjust to an increase of inflation, at least to some extent. With the huge amount of liquidity being created by central banks, risks are increasing that we will see a prolonged period of inflation, similar to the 1970s.
  • Increased payout ratios: There is a clear trend that dividends are becoming more important to investors again. Therefore, a growing number of companies are increasing their dividend payouts. Dividends used to be much more important in the old days and, after touching an all-time low a few years ago, the dividend yields are on the rise again.
  • Relative pricing: Most major stock markets are still trading at levels seen 10 years ago. However, most companies are much leaner today, carrying lower levels of debt, and the size of the global markets has increased significantly in the past 10 years. This gives companies, which operate globally, new opportunities to sell their product and services. In view of this, today’s equity prices are offering compelling value.
  • Higher growth in emerging markets: While economic growth in the U.S. and Europe will remain very disappointing in the near future, other markets are doing significantly better. China, India, Brazil and other emerging markets are showing a much more dynamic economic picture. We have to expect a temporary slowdown in emerging markets as well; but in the long run, capital will flow to markets that experience higher economic growth in the years ahead. Emerging markets will remain the growth engine for the world. We expect global gross domestic product growth to be around 3.5 percent in 2012. Despite the positive outlook for emerging markets, investors need to realize that volatility is typically higher than for Western markets and picking the right stocks is a more tricky exercise.

While we see an increasing chance for positive equity market returns in 2012, we remain cautious in the long run; and we are convinced that the time to buy and hold equity investments is over. Therefore, managing equity investments and investment portfolios in general will become much more challenging in coming years. Also, we think that certain sectors will still see disappointing returns even if the broader market outlook is improving — a good example being financial stocks, especially banks. Changing regulation and capital requirements will cause financial stocks to underperform in the near future.

For the coming weeks, we expect market volatility to remain high and stocks to continue to be under pressure, due to the uncertainty surrounding the European debt problem and the U.S. deficit problem. Although the market focus is on the European situation, we expect the U.S. crisis to become the dominating problem again. Most likely, this is going to happen once the European countries have reached an agreement on how to restructure Greece’s debt and/or to enlarge the European Stability Fund. An agreement would contain the problems for now and give European states much needed time to bring the finances in proper order.

On the other hand, there seems to be less progress in the United States in resolving the debt problem. The intense fight between the two main political parties has resulted in a deadlock, which is a very dangerous situation. One similarity between the European and the U.S. debt problems is that in the long run, spending cuts are not going to be enough. Also, the real value of future obligations needs to be reduced. This is most likely going to happen through increased levels of inflation in coming years.

The Year 2012: A Turning Point

The global economy is facing one of its most challenging tests today. Structural problems are obvious, everywhere we look. European States and the United States of America are dealing with serious and growing debt problems. And despite the recent debt deal in the U.S., the agreed-upon spending cuts will do very little to restore financial stability.

Not only are the agreed-upon spending cuts too little too late, the timing of these spending cuts is of concern. At a time when private households are in the process of de-leveraging and businesses are not willing to make investments, a significant cutback of government spending will significantly increase the chances of a recession in coming months. For many people in Europe and the U.S., today’s sluggish economy already feels like a recession. And when we look beyond the official statistics, economic growth is already stagnant or even negative.

After a small recovery last year, jobless rates are already on the rise and will likely climb higher in coming months. There is just not enough economic activity to create jobs, and a growing number of people have pretty much given up looking for jobs. The likely response from central banks will be more stimulus programs, but it is unlikely to change much. The coming year 2012 is a true election super year. Several major countries will hold elections; and with the global economic outlook turning increasingly negative, we could see some huge changes next year. In total, countries holding elections next year make up almost 50 percent of world gross domestic product (!!).

The stimulus packages introduced by many Western countries in the past two years have all failed to revive economic growth because most of these measures look to create liquidity and reduce the cost of borrowing by lowering interest rates. However, most of these measures can’t solve the main problems such as the huge debt dilemma.

In the past two decades, the common response of governments and central banks has been to introduce tax cuts and reduce interest rates temporarily. The problem is that all of these measures can only help to smooth smaller fluctuations in economic activity. Now, most major governments have accumulated such a huge amount of debt that they are not able to add (and finance) stimulus anymore; the market just won’t tolerate it any longer. Lower rates alone are not helping to solve structural problems; in fact, they might even make things worse and create asset bubbles.

The general uncertainty and the lack of visibility directly result in lower economic activity by depressing consumption and investment. Less consumption, lower investment spending and a reduction of government spending will likely result in a recession. This is true for the U.S. and most parts of Europe today. The fact that exports are on the rise in these economies, primarily because of the falling values of the U.S. dollar and the euro, will do very little to improve the situation.

It is possible for a country to create and sustain economic growth which is primarily driven by exports (for example, China), but neither Europe nor the United States is positioned to benefit enough from exports. So there is a growing risk that the West will yet again fall into a recession going into 2012 and the likely increase in jobless rates, the forced reduction of government spending (especially reduction in social benefits) and growing uncertainty about the future political and economic outlook have the potential to make 2012 a real turning point. I think the chances that we see rather large changes in next year’s election are significant.

With these changes it is also very likely that for the first time in a long time, we are starting to see the influence of governments being reduced. The past few decades have seen an almost never-ending increase of government spending, especially in the area of social security and welfare. I think that some of this spending had good intentions, but now it becomes increasingly hard to finance it. With the huge number of baby boomers that have recently started to retire (and many more will be following incoming years), there will be fewer and fewer young people that can finance government spending.

The growing scarcity of labor in Western countries might help to bring down unemployment somewhat, but the problem is that we are dealing with high levels of structural unemployment and it will be hard to reduce that. Structural unemployment refers to people who have either dropped out of the workforce or young people who have never really entered the workforce. Many of them have no prospects for a better life in the future, and this is adding to social tensions and has the potential to cause social conflicts. The riots seen in London last week were primarily caused by young people, many of them unemployed and without any hope that things will get better for them. This is not only the case in London, but for many major cities in the West. These riots could also take place in New York, Paris, Los Angeles, Madrid and many more.

These problems will intensify in coming years. The enormous amount of outstanding debt, the aging of Western societies and structural changes in the economy will be a huge burden for younger generations. With a growing number of people retiring and more and more people living off some kind of governmental help, it will become impossible to continue to fund the current social systems in the West. To make things even worse, many people in the West are not willing to work beyond a certain age. Just think of countries like France when most people retire between the ages of 58 and 62. But since life expectancy has increased dramatically in the past 50 years, people would need to work until the age 70, at least.

The current economic situation gives a lot of conflict potential for the coming years and will most likely result in significant changes on the political level. Governments have no other choice than to downsize and get leaner. It also means governments will be able to afford only smaller financial aid for its people. The common response in the past couple of decades has been the exact opposite. However, this was done under the assumptions of only minor changes in demographics — a huge mistake, as we know today.

What we will see in the West in the coming decade is a breakdown of the welfare state as we know it. With that will come some huge changes, both politically and economically. This will be a real stress test for every nation in the West, because the problems are very similar. These changes will not come smoothly. They will most likely create enormous tensions among societies and also create conflicts between the different generations. Too many young people are without jobs and without hope today. And many older people will be frustrated because the governments is not able to provide them with the kind of benefits they were promised. The uncertainty created by this will not be good for the economy, since people will be reluctant to spend and invest in such a climate.

So in my view, we are already in the middle of the first phase of the adjustments, and the current political fight about social welfare spending is a clear sign. But eventually, we have to face economic reality that in the long run we can afford only what we can finance. It would be the logical consequence to see strong shifts within the political landscape next year, and I think the chances for it are increasing rapidly. The year 2012 could be a real turning point for many Western countries.

–Daniel Zurbrügg

A Debt Deal That Will Not Change Anything

Congress approved a last-minute deal to raise the U.S. debt limit and avoid a catastrophic, technical debt default. The deal will raise the U.S. debt limit by at least $2.1 trillion and significantly cut Federal spending in coming years. Agreed-to spending cuts will amount to at least $917 billion over the next 10 years. On top of that, a Congressional committee will work out a plan that would cut the deficit by an additional $1.5 trillion. The additional funding provided with the increase of the debt limit should give the U.S. government enough funding to operate until 2013, which means that a new debt deal needs to be made after the next election.

It was a very intense battle between Democrats and Republicans, and the possibility of a debt default created a lot of uncertainty in recent weeks. This uncertainty was felt very directly in financial markets and caused global stock markets to move lower and the U.S. dollar to lose further ground against most major currencies. With the debt deal now in place, can we expect a recovery rally in the weeks ahead and hope that everything will be just fine again? What is needed to improve things in the long run?


US Dollar Index

Unfortunately, there are a lot of factors that suggest we have to be prepared for more market volatility and economic uncertainty. The problem is, in my opinion, not so much the debt limit and the spending cuts that now have been agreed to. The main problem is that the latest battle about the debt limit has caused severe damage to the confidence international investors have in the U.S. This comes at a time when the need for foreign investment and capital is bigger than ever before.

Also, it seems that neither Republicans nor Democrats are truly happy about the deal negotiated, although each party tries to sell it as a victory. But clearly, the spending cuts are not enough for Republicans, and Democrats are not happy because there are no tax hikes included in the deal.

While the problem can be viewed from different angles, the actual public debate about how to solve the debt limit problem is what’s causing real economic damage. For a few weeks, investors around the world kept their eyes on the U.S. debt crisis and the political fight about it. Raising debt limits is something that has happened many times in the past few decades. Just since the early 1960s, this happened more than 70 (!!) times, and most of the time it was not a big deal. But this time it was a different situation. The sheer debt number, which has now exceeded $14 trillion, is scary enough; but it always needs to be seen in the overall context, that means in comparison to the size of the gross domestic product. Here, the story gets really alarming.

The size of the overall Federal debt has now exceeded the size of GDP and continues its strong upward trend. It is now approaching levels not seen since the late 1940s. In the ’50s, ’60s and ’70s, the size of the debt burden fell to levels of less than 40 percent of GDP, but since the early ’80s, this trend has reversed. The only time since then when the debt level (as percentage of GDP) was falling was in the late ’90s, primarily driven by strong economic growth.

The current debt level ranks among the highest in the world. Of course, there are other nations that look even worse — for example, Japan (225 percent); or economic heavyweights such as Saint Kitts and Nevis (185 percent), Lebanon (150 percent) or Jamaica (123 percent). Other major economies such as Germany and France do not look much better with debt levels of about 80 percent. The difference to a country like Japan is that most of its debt is being held by Japanese investors; therefore, it is able to finance that debt domestically. Also recently, China has started to make significant investments in Japanese government bonds while cutting back heavily on its purchases of U.S. Treasury bonds, a further indication that investors are becoming reluctant to buy additional U.S. debt.

Despite the fact that the U.S. debt deal is a step in the right direction, the problems are far from over. The deal reached now is not perfect, but it was the best possible compromise that could be made given the current circumstances. But in the future, further spending cuts will need to be made, and the debate about future tax increases will most likely be the next big battle in Washington. The problem now is that the increased spending cuts will hurt the economy even further at a time when the economy is not able to generate enough jobs and prevent the jobless claims from going up. Also, private households are in a long-term process of deleveraging, which will keep consumption growth at moderate levels.

In order to bring down the unemployment rate, the economy would need to grow at a rate of at least 3.5 percent. Right now, it looks like GDP growth is going to drop below the 2 percent mark in the near future, possibly dropping back to zero later next year. A lackluster economy will also result in lower tax income, which will make it harder for the government to service its debt.

How can this problem be solved? Is it even possible to do something about it? In my opinion the answer is “yes.” This situation can be improved dramatically in the next 10 years, if Republicans and Democrats work together to define and execute a plan that makes sense economically and truly works in the best interest of the people. The problem with the current discussion is that very few people differentiate between spending and investment. Investment means spending money on something that adds true economic value over time. People are willing to pay taxes, but they need to see benefits for it in return. Foreign investors will keep lending money to the U.S., but they need to see that this money is spent wisely and not just wasted.

For example, let’s look at the enormous cost of defense. The U.S. is currently spending about $700 billion per year for its armed forces. In total, the wars in Iraq and Afghanistan have cost almost $3 trillion in recent years and, at the end of 2010, almost 5 percent of GDP was defense-related spending.


Figures based on 2010 budgets (SIPRI)

That is more than 10 times what Russia spends on defense, although in terms of percentage of GDP, Russia spends more than 4 percent. Most major countries today spend between 1.5 percent and 2.5 percent for its armed forces.


Therefore, it is not surprising that a big portion of the agreed-to spending cuts come from defense, but even after these cuts the amount of money spent on defense is enormous. It is understandable that a growing number of Americans disagree with this spending policy and feel that money should be used to improve things at home rather than spending it on wars in countries like Iraq and Afghanistan.

While the U.S. is spending too much in some places, it is not investing enough for other items, especially infrastructure-related projects. Infrastructure is the kind of investment that tends to truly add economic value in the long run and provide benefits for everybody. Clearly, looking at the condition of today’s infrastructure (roads, bridges, electricity grids), it becomes obvious that there is tremendous need for such investments. Also, finding investors for such projects will be a lot easier.

What the United States needs is a sound long-term economic development plan, much like the Marshall Plan in the late ’40s. It has to be a sound economic development plan that cuts spending in areas that do not make sense economically and encourages spending in areas that result in true economic value long-term (infrastructure, education, etc.), and such a plan needs to be supported by both major political parties. The investment spending created through such an economic development plan would immediately provide benefits for everybody, increase economic activity and, therefore, also create jobs and eventually increase tax revenues without the need to hike rates. In order to work out and implement such a plan, Republicans and Democrats need to work together for the benefit of all Americans.

So, unfortunately, it doesn’t look like we see a strong positive market reaction to the announcement of the debt deal. The U.S. dollar is not recovering, and global equity markets are not rallying on the back of the news. The main reason is the lack of confidence people have in the future development of the economy. The deal reached now might look like a long-term deal to politicians; but from an economic point of view, it is another quick fix that fails to address the structural problems of the economy. For this situation, there are no quick fixes, only sound long-term plans. The execution of such plans will yield positive economic results in the future. Such a plan gives people a common vision of what can be achieved. This might be wishful thinking, but it’s the only real way to a better future.

–Daniel Zurbrügg

Switzerland To Introduce Gold Coins Again?

Switzerland has always been among the countries with the highest gold reserves. Despite reducing its reserves in the past two decades, Switzerland still has the highest gold holdings per capita and its currency, the Swiss franc, has been among the top-performing currencies in recent years. The strength of the currency has many reasons, but despite the vast amount of gold reserves that Switzerland owns, even the Swiss franc is just a paper (fiat) currency.

In a previous article, I wrote about the many factors influencing the value of currencies. Today, all currencies are basically fiat currencies, so their relative value is determined by factors such as political stability and competitiveness of the domestic economy, just to name a few. However, in a time like today when many big governments are dealing with record amounts of debt, the incentive to “print” money is certainly a lot bigger.

The world’s two largest reserve currencies, the U.S. dollar and the euro, are currently in a process of structural devaluation, which has caused these currencies to fall significantly in value. More and more people in the U.S. and Europe would want to have a new type of gold standard, which would protect the purchasing power of their savings and incomes. This is very understandable, since a forced currency devaluation acts like an extra tax on every citizen.

In light of this, it seems surprising that in a country like Switzerland that has such a strong currency, a parliament initiative has been made that seeks to set up a new Swiss gold franc as a dual currency system. I personally think a return to a worldwide gold standard is unrealistic, but when I heard about the gold franc idea, I thought that would be a very interesting alternative. That’s why I would like to tell you how the gold franc dual currency system would work.

The plan is that private institutes/banks, with the permission from the Swiss government, would issue gold coins, so-called gold francs. Each coin would contain a core with a fixed amount of real physical gold; the rest of the coin would be made from a cheaper type of metal. For example, a 500 Swiss franc coin would contain 50 grams of real gold. With today’s gold prices, this would be worth approximately 2,000 Swiss francs (fiat currency).

The plan would be to also issue coins with smaller nominal values that have a lower gold content. The purpose of this would be to give everybody a cheap and easy way to purchase gold. Also, these coins would be easily tradable. The idea is not to have these new coins introduced as a replacement of the existing coins but as an alternative to the fiat currency Swiss franc, therefore introducing a dual currency system.

Another interesting point is that these gold coins would need to be issued by private firms/banks that have a license from the Swiss government. The gold needed to produce these coins would need to be bought on the open market by these private issuers.

What is also interesting about the idea is that this new gold currency would be independent from the Swiss National Bank. The reason for this is that the Swiss National Bank has recently come under a lot of pressure because of its investment strategy. Switzerland’s economy is heavily dependent on exports, which is why the recent Swiss franc strength is such a heavy burden for the domestic economy. In an attempt to weaken the currency and try to stop further appreciation, the Swiss National Bank sold huge amounts of its own currency against the euro. This strategy is highly problematic and led to an intense political discussion of what the role of a central bank should really be. But one thing is already clear, by investing heavily in the euro, the Swiss National Bank has accumulated giant losses. And with the outlook for the euro being more uncertain than ever, the chances that the central bank can recuperate these losses are very small.

The Swiss idea of introducing a gold currency comes at a time when more and more people are calling for a return to the gold standard, which would be a radical change from today’s system of fiat currencies. In my view and despite having some sympathy for this idea, this is a very unlikely scenario today. The old gold standard was brought down by politicians, and I don’t think politicians have any interest in reintroducing the gold standard. However, I think ideas like the Swiss gold currency system show that gold and other precious metals are becoming a much more important investment class, and many investors today already look at gold as a currency. Also, the fact that central banks worldwide have recently become net buyers of gold shows that there is renewed interest for precious metals.

Despite the fact that there has been a lot written about precious metals recently and the fact that these metals have shown such a strong performance, I think we are only in the early phase of a long-term upward trend for these metals.

I think it would really be interesting to have a gold franc in Switzerland that could be used as a legal tender, but I have my doubts that we will ever get it. So many people worldwide will seek to invest money in assets that are truly protecting the purchasing power of their money, and this will continue to create an enormous demand for precious metals. Ben Bernanke was recently questioned by Congress about the role of gold and why people buy gold. His answer was that they buy it as protection against tail risk: really, really bad outcomes. Well, Mr. Bernanke, maybe the chances of getting these really bad outcomes are bigger that what you may think.

–Daniel Zurbrügg

Investment Opportunities In The Asian Healthcare Market

Despite the outlook for U.S. and European economies being highly uncertain, the U.S. dollar and the euro remain the world’s dominant currencies. However, the importance of these two currencies is diminishing, which is not surprising given the huge debt problems in both markets. In order to hedge against a further devaluation of the two currencies, investors are increasingly looking beyond their own borders to find attractive investment opportunities. Currency diversification should be a key focus; that’s now obvious to everyone. But what should you do once the dollars or euro have been exchanged to Singapore dollars, Norwegian crowns or Swiss francs? While holding cash in those currencies certainly seems to be a short-term option, people need to find investment ideas where they can put their money to work in the long term.

It is admittedly a rather difficult task to find good investments today; this is especially true for equities. With the U.S. and Europe looking less attractive for the reasons mentioned above, investors naturally need to start looking at some emerging markets. There, they can still find good companies with excellent growth potential and attractive valuations. From a geographical point of view, it seems to make sense to diversify into emerging markets. But what industries are attractive in those markets? Selecting investments and looking for investment opportunities don’t get much easier if one compares different industries. For example, investing in banking stocks seems very unattractive in many markets given the fact that there is a global trend toward stricter banking regulations and requirements to hold higher capital reserves. Globally, regulators hope to make the world’s banking system more stable by requiring banks to hold more capital. From an investment point of view, this means that many of these companies will probably see a prolonged period of time with moderate or even disappointing profit growth.

In some of my previous articles, I have written extensively about some interesting markets and industries such as commodity- and agriculture-related investment opportunities. Today, I would like to make a strong investment case for Asian healthcare companies. I believe this is an industry with tremendous growth potential in the next decade (and most likely beyond that). However, few people are aware of the exciting opportunities there. And, yes, I know. Many people probably can’t hear the word “healthcare” anymore, because there has been too much negative noise about it in connection with the healthcare bill in the U.S. However, with Western countries struggling to control their rapidly increasing healthcare cost, the dynamics in the Asian healthcare market are very different. People in Asia have a fundamentally different relationship to healthcare. For many people, having access to good medical facilities is viewed as a prestige thing. This also explains why Asians spend so much money for lifestyle medicine and plastic surgeries. With fast-growing middle classes in many Asian countries, the demand for good, quality healthcare is rising very rapidly.

The global healthcare market consists of various subsectors that include pharmaceutical companies, hospital operators and biotech and medical technology companies, just to name a few. While growth rates in Western markets are slowing, the healthcare industry in Asia is growing at a rate of about 15 percent annually; some subsectors experience even higher growth rates. Healthcare penetration is still low in most Asian countries, and very few people have private health insurance. Also, healthcare infrastructure is well below Western levels. India, for example, has only 1.27 hospital beds per 1,000 people, that is less than half the global average of 2.6 and far away from the four beds per 1,000 people recommended by the World Health Organization. Demographic factors, as well as increased government and private-sector activity, will increase healthcare penetration. This will initiate a massive amount of investments in the sector. Again to take India as an example, it is expected that about $180 billion will be spent in the next five years on healthcare infrastructure alone.

There are enough positive domestic drivers that make the Asian healthcare market attractive. However, on top of the domestic factors, there is also increasing demand coming from other sources, such as medical tourism. With more and more people in the West struggling to afford medical costs, the incentive to look for treatment abroad is growing quickly. For example, a hip-replacement procedure costs between $25,000 and $40,000 in North America and Europe. The exact same procedure costs about $10,000 in places like Thailand or India. So for many people, this becomes a real option, maybe even the only option. Current data suggests the medical tourism market is growing at a rate of about 40 percent annually. This will add further momentum to an already booming market, and the underlying demographic trend suggests the Asian healthcare market will continue to grow at a rate of about 15 percent for at least another decade.

There are various ways investors can take an exposure to this promising market, but the most obvious way is to invest in Asian healthcare companies or Western companies with a high exposure to this booming market. In our view, it makes sense to select companies that have a diversified business model across several key markets in Asia. Given the fact that government’s role in regulating healthcare in each of these Asian countries is still very important, the political risk should not be underestimated. Also, investors should carefully review each company and its actual business. Here again, it is probably not ideal to select smaller companies with a very narrow focus on one small niche. This is often the problem with some of the medical-technology companies. Among our favorite investments are larger, well-diversified companies that can generate returns from a number of different markets and from various business channels. We currently view hospital and clinic operators as one of the best ways to invest in the growth of the Asian healthcare market.

The chart below shows the price development of two of the most popular Asian Healthcare market indices, the FTSE ST Healthcare Index (Singapore) and the BSE Healthcare Index (India). Both indices have rallied strongly after the sharp correction in 2008; however, both markets have achieved attractive returns in the past couple of years.


FTSE ST Healthcare Index (Singapore) and the BSE Healthcare Index (India)

This is in sharp contrast to most large-cap healthcare stocks that are primarily focusing on Western markets. The chart below shows the historical performance of three of the most popular healthcare stocks in North America (Abbott Laboratories, Pfizer, Medtronic). Many of these companies have performed very poorly in the past decade and have even generated negative returns for investors. Of course, the past decade certainly saw a time of disappointing stock market returns, but it is surprising that not even healthcare companies have been able to generate decent returns.


Abbott Laboratories, Pfizer and Medtronic Stock Performance

There are, of course, also Western healthcare companies, which will benefit from the growth in Asia and other emerging markets. Therefore, some of these Western companies could also see better times ahead, both in terms of their sales and profits and, hopefully for investors, in the form of higher stock prices. Investors have to realize that a direct investment in Asian healthcare companies has more risk. These markets and the individual stocks are usually more volatile than their Western counterparts.

The rise of Asia will be one of the dominant investment themes in the next 20 years. The increased political power, rapid population growth and rising income levels will present a large number of attractive investment opportunities. But with high return potential also comes higher risk. That is the reason investors need to carefully select their individual investments. The Asian healthcare market is one of the most interesting investment themes today, a structural trend that will go on for many years and presents a great investment diversification for Western investors.

Is Switzerland A Role Model For Democracy?

The world economy is in a very fragile state, despite the fact that world gross domestic product is growing at a rate of about 4.3 percent this year. Most of the growth comes from emerging markets like China, Brazil and India.

While these emerging nations have a lot of economic potential for the coming decades, most of them will have to deal with their own specific problems in the years ahead. What differentiates these nations from the West is they typically have much lower levels of debt; most of them have accumulated large savings surpluses. This is in sharp contrast to the West, especially Europe and the United States, where governments have accumulated large deficits by chronic overspending on social security, all sorts of subsidies and/or military and defense costs.

This is a very dangerous trend that can’t go on forever. Actually, I think we are witnessing the turning point right now and that coming years will bring huge changes to these economies. This will most likely result in a severe devaluation of their currencies and socioeconomic tensions. Remember, the euro and the U.S. dollar make up almost 80 percent of the world’s currency reserves, a percentage that will have to drop significantly in coming years.

In a world of ideal economics, these nations would address their problems by making structural adjustments to their economies, making investments that tend to increase true economic value and cutting spending on things that don’t make sense and only destroy value. However, this might be wishful thinking. One does not need to be a genius to see that the sovereign debt problem will, at least partially, be solved by a forced currency devaluation, meaning that the central banks, such as the Federal Reserve in the U.S. and the European Central bank in Europe, will continue their very expansionary monetary policies.

Despite the many advantages of democracy, there is tendency for politicians to overpromise, overspend and underdeliver in the long term. This results in huge deficits that must eventually be paid, either through higher taxes or significantly devaluing currency. In a democracy, governments eventually become too big and too powerful and spend too much money. Therefore, more and more people become directly or indirectly dependent on the government. That’s when a nation becomes a welfare state. The larger and more centralized a government becomes, the higher the risk that it will lead to a real disaster in the long run.

It is absolutely crucial that a democratic system maintain self-correcting mechanisms by keeping government size and control at reasonable levels. However, people must also be realistic about what they can expect from a government.

This is a long-term trend that can be observed in many Western countries with far-reaching consequences for people. From an investment-management point of view, currency diversification should be the key focus in coming years. It will be an almost ideal environment for precious metals and hard currencies.

In a previous article, I compared the performance of various foreign currencies against each other and against the two major currencies, the U.S. dollar and the euro. Many people say they do not understand currency markets. Keep it simple and look at foreign currencies like stock prices. The prices of currencies measure the performance of countries, just as the prices of stocks measure the performance of companies.

Looking at currency markets, especially their short-term volatility, people tend to forget about the main forces driving currencies. The chart below shows how the most common foreign currencies have performed in recent years. The best and most stable currency in the world has been the Swiss franc.


World Currency Comparisons

With a lot of money-printing going on in the world, it is not a surprise that the Swiss franc has kept outperforming all major currencies. The Swiss franc is, in my opinion, the strongest of all currencies. The chart below shows how much the U.S. dollar lost against the Swiss franc in the past 40 years.


In order to understand why the Swiss franc is such a strong currency, many factors need to be considered and understood.

Typically known for its famous chocolate, cheese and for being one of the world’s largest banking centers, Switzerland has much more to offer. Switzerland is a small country with a size of only 16,000 square miles. That’s only about one-quarter the size of Florida. With a population of about 8 million, it is also among the least-populated countries in Europe.

Despite being located in the heart of Europe, Switzerland is one of the very few European countries that have not become a member of the European Union. Because of that, the Swiss franc — not the euro — is Switzerland’s currency. Also, the Swiss National Bank is completely independent.

In order to understand why Switzerland has never joined the European Union, one needs to understand the culture and mentality of its people. Switzerland consists of 26 individual states called “cantons.” All of these cantons have a relatively high degree of independence, as do the smaller communities within each canton.

The roots of the country go back to 1291, when most of today’s territory was controlled by the Habsburg dynasty. Many people suffered under the Habsburg regime, since they didn’t have many rights and had to pay high taxes, usually in the form of agriculture goods, to their rulers. In 1291, three cantons started the Old Swiss Confederacy and began to fight for the freedom of its people and an end to the dark days of tyranny. More and more cantons joined the Confederacy.

In 1815, Switzerland’s independence was recognized by most other European countries. While the need for some centralized government was understood, Swiss people have always remained critical toward large, centralized governments. Democracy in the Swiss understanding means citizens and communities should act responsibly and take care of their own affairs.

Switzerland has also remained neutral during the world wars and kept a very large army for most of the past century. Today, about 100,000 soldiers serve in the army, which is still large, given the relatively small size of the country. The Swiss army is not and has never been a professional army; it is mandatory for Swiss men to join the army and serve the country.

I remember my days in the army. I was only 20 years old, and at that time I didn’t really like it or understand the sense of it. Only later did I start to realize what a great school of life my time in the army was, and how much it taught me about freedom and responsibility.

The events of recent years, especially the events in Europe, such as the war in former Yugoslavia or the increasing tensions among European countries, have made me realize things are a lot less stable than we would like. I think the strong sense for neutrality and freedom has remained one of the reasons Switzerland has always been so stable.

Another important factor is the kind of democratic system we have. The Swiss Parliament consists of two chambers, the Council of States and the National Council. The Federal Council, the “Bundesrat,” consists of seven members, each elected for a term of four years. What is unique about this direct democracy is that people can challenge any decision or law with a referendum — all it takes is for 100,000 people to sign such a referendum. This is a very important corrective mechanism in a democracy.

Switzerland was able to stay out of the two world wars by remaining independent. Despite the relatively large size of the Swiss army at that time, it would have been difficult to stop an enemy in case of an attack, especially from Nazi Germany. However, the Germans knew they would need to pay a very high price if they attacked Switzerland. Switzerland’s army was and is well-trained to fight and defend the country — especially in the mountains, which have hundreds of bunker systems, some so large that they look like little villages inside of mountains.

The fact that Switzerland’s infrastructure wasn’t destroyed in any of the world wars also meant the country had a competitive advantage during the rebuilding period after the war. Many large corporations established their international headquarters in Switzerland, and many have stayed here ever since. Today, the main advantages for corporations are the almost-perfect geographical location, a business-friendly tax system and the high level of internationalization in the economy. The tax system for corporations and residents is attractive no matter its level of profit or income. The European Union has called Switzerland’s low tax rates unfair, since taxes are much lower than in the European Union. How can a tax system, which encourages competition and ensures efficient use of taxpayers’ money be unfair?

This conflict with the European Union shows the fundamentally different approach Switzerland has taken. It is a country in which each canton and each community has a high degree of fiscal responsibility. It’s where people make the government, not vice versa.

I think many countries, especially large Western nations, can learn a lot from the Swiss system of democracy. Many Western nations are finding themselves in a difficult position today. The chronic overspending and wasting of tax money has resulted in a very heavy debt burden, which has become almost unbearable. Governments should always work in the best interest of their people and act diligently and responsibly when spending tax money. Governments should be lean and efficient, working for their people and not against them.

While it is in the best interest of any nation to have a social-security system that provides help to people who really need it, overextending welfare will give the wrong incentive to people who should never depend on a government to help them.

Precious Metals And Commodities: What’s Their Real Value Today?

A lot has been written about commodities and precious metals in the recent past. While some investors believe that we are in the middle of a super cycle for commodities and precious metals, others think that there is already too much speculation built into current prices — that we are in a speculative bubble that will have to burst eventually.

Since discussions about commodity and precious metals prices are often conducted with a great deal of emotion, I hope this article serves the purpose of rationally analyzing what is going on in these markets, what the fair value of precious metals and commodities is today and what the risks and opportunities are going forward.

The investment case for commodities and precious metals is a bit more complex than it looks at first, so let’s start with a brief review of the underlying drivers of these asset classes.

First, I would like to point out that I am not a “gold bug,” but looking to invest money in commodities and precious metals is part of our job, and we think that holding investment exposures in commodities and precious metals should be part of a well- and globally diversified investment portfolio.

In an ideal world, our allocation to precious metals would be very moderate. Unfortunately, we are living in a world that is far from ideal. With the economic and political changes we are facing today, I think we have to deal with a number of very big challenges in coming years. These challenges might be even greater than what we have seen in the last decade.

Ten years ago, precious metals were not a big investment theme. Gold prices had been falling for the most part of the 80s and 90s when central banks were selling huge quantities of gold. This pushed the price down to about U.S.$250 per ounce.

Today, this has changed completely. Central banks have become net buyers again, especially Asian central banks. This, together with investors’ growing concerns about government deficits and money printing policies, has resulted in an almost perfect investment case for precious metals.

The ongoing rally of precious metals prices in the recent past is showing us that there is growing concern among investors worldwide about the health and stability of the financial system and that there is also a lack of trust in central banks and governments. Investors worldwide are worried about future inflation and forced money devaluation. The chart below shows how much gold and silver have gone up in the past 10 years (please note that the blue line is showing the relative performance of silver) as a reaction to those concerns.


In order to protect and preserve capital, investors are looking for a safe and stable storage of value, which has led to the strong demand for precious metals.

The reasons behind the strong increase of commodity prices in the past two years are different, but to some extent they are related to the precious metal boom. The strong rally in commodity prices has been equally impressive, as the following chart shows.

Remember, despite the strong recovery of equity prices in the past two years, Western equity markets have been flat for the past decade, as you can see from the chart below.


So considering the disappointing performance of equity markets and the very low yields in fixed-income markets, investors have been looking to put money into alternative investments such as commodities. Here, rising prices are driven by rapidly expanding demand, while supply is only growing at very moderate levels.


The growing number of people on our planet, especially the rise of Chindia (China and India), is creating the increased demand for a broad range of commodities. Let’s not forget that despite slow economic growth in the West, world gross domestic product is still expected to grow at about 4.5 percent this year. Emerging markets, and especially the BRICs (Brazil, Russia, India and China) countries, contribute almost 80 percent of global GDP growth this year. Investors not only expect a good long-term profit on their commodity investments, they also hope to get at least some hedge against future inflation.

No question, the basic investment case for precious metals and commodities is as good as it can possibly get, BUT have prices gone up too far too quickly?

No matter how good an investment case looks long-term, investors have to realize that market prices can go down dramatically within a short period of time. When short-term capital flows go against the long-term investment case, investors can experience huge losses. Therefore, you always have to know where market prices are and what can influence them.

Let’s look for example at energy prices, in 2008 when oil was trading at U.S.$140 per barrel and people thought it would be at U.S.$200 per barrel soon. A very severe correction followed and prices fell to U.S.$40 per barrel within a few months:


Commodity prices (especially energy) have unique supply and demand curves which are steeper than normal. This means small shifts in supply and demand can cause very large price swings.

The increasing amount of investment and speculative money has made that problem even worse in recent years. While we think the days of “cheap” oil are probably behind us, we have no doubt that oil prices could easily drop U.S.$30-$40 per barrel again should we see increasing evidence that demand is slowing. This could be caused by lower growth in emerging markets, for example. On the other hand, should global growth be stronger than expected in coming years, prices of U.S.$200 per barrel are possible as well.

So what is the true value of commodities and precious metals today and what is the impact of increasing amounts of investment money that has been moving to these asset classes in recent years? Let’s try to answer these questions by looking at historical prices and pricing relationships with other assets.

One of my favorite charts you can see below. It shows the pricing relationship between hard assets (such as precious metals) and soft assets (for example, the stock market).

What is very obvious is that hard assets have become more expensive relative to paper assets after reaching a bottom in early 2000. This relationship had been falling for almost two decades starting in the early 80s, and it shows that these trends can continue for a long period of time.

The period between the early 80s and the year 2000 was also a time when globalization of trade and production resulted in strong deflationary forces, which brought interest rates to the low levels we are seeing today. However, there is increasing evidence that the days of record low interest rates in many parts of the world are over.

Actually, rates have started to go up in some parts of the world, including Europe, despite the sovereign debt crisis in a number of European countries. The Federal Reserve in the U.S. has not done anything yet. Actually, it is trying to keep rates at very low levels.

Rates are being kept low by ongoing monetization of debt, which means that the Federal Reserve is buying a lot of bonds that are issued by the Treasury Department. This has resulted in a mind-blowing expansion of the Fed’s balance sheet.

The investment community often refers to this mechanism as money printing. While rates could be kept low, this strategy has been the main driver behind the recent devaluation of the U.S. dollar.

The chart above makes it obvious that the pricing relationships between precious metals, commodities and “paper” money can experience large swings over time, and investors should always know about these relationships because it contains valuable information for investing. Today, gold is trading at about U.S.$1,500 per ounce and has had a very impressive rally in the past few years. It is a clear indication that investors globally are worried about the health of the international money system and currencies worldwide.

The expansionary monetary policies of most central banks are clearly lowering the faith of investors in fiat currencies. Therefore, investors have a real need for assets that are preserving the purchasing power of their assets, and gold and other precious metals are seen as the ideal solution.

The price of gold has gone up from about U.S.$300 per ounce to today’s price of about U.S.$1,500 ounce. That’s a very impressive rally. But is gold now overpriced or still too cheap considering all the money printing that is going on?

One way to answer that question is to look at the Fear Index, invented by James Turk of GoldMoney. This index compares the price of gold, multiplied by the quantity of gold a country owns, divided by the country’s money supply (M3). This index hit a 16-year high last year, but still stands way below its all-time high reached in the early 80s.

Gold also doesn’t look overpriced when compared to the stock market. The Dow/gold ratio, which compares the value of gold against the value of the Dow Jones Industrial index, currently stands at 8.3. That’s only slightly higher than the low reached in 2009, which was 7.1.

The conclusion is that precious metals and commodities have been a great investment in recent years and, considering today’s problems and challenges, the long-term outlook remains positive. But, investors have to be very careful as significant short-term price corrections are very likely in the future, no matter how good the long-term investment case for both might be.

The long-term investment case for commodities and precious metals remains positive, but investors should be careful and only make such investments as part of an overall, well-diversified investment portfolio.

BRICS Want To Rely Less On The U.S. Dollar

In the past few weeks, I have written several articles about the United States dollar and the driving forces behind the ongoing devaluation of it. After being the world’s main reserve currency for many decades, the game is finally changing, and it has far-reaching consequences for the world and your investment strategy.

In my previous articles, I wrote extensively about the reasons why there is a perfect storm building for the U.S. dollar and in the last few weeks the greenback has been losing further ground against other major currencies. It’s even weakening even against the euro.

We are witnessing the late stage of a U.S. dollar dominated global currency system, a system that is changing quickly. It remains to be seen whether there is going to be a smooth transition to a new global currency regime or an outright collapse of the current system.

In Europe, we are dealing with a currency crisis already and, despite the efforts to cut spending and fix government balance sheets, the bailout packages for countries like Greece and Portugal are causing longer-term damage to the creditability of the euro. Creditability, or better, a lack thereof, is also adding further pressure on the U.S. dollar.

Last week, U.S. Treasury Secretary Timothy Geithner said that a strong currency is and has always been in the interest of the U.S. and that the country will never embrace a strategy to weaken the dollar. At about the same time that Geithner made his statement, the U.S. dollar hit fresh all-time lows against a number of major currencies, a clear indication that the market doesn’t believe him. The lack of creditability and trust in the U.S. fiscal and monetary policy is driving an increasing number of foreign investors away from the dollar and it seems that this process is still in a relatively early stage and could continue for years to come.

This became obvious last month when the leaders of BRICS nations gathered in China for a one day summit. BRICS is an abbreviation for the five countries: Brazil, Russia, India, China and South Africa. They are seen as the dominant emerging markets today and discussions between them are important for various reasons, primarily because these meetings take place without any representation or influence from the U.S. or Europe.

The five BRICS nations make up about 42 percent of world population and almost 20 percent of global gross domestic product and these numbers are growing, making what they discuss very important. To make the numbers look even more impressive we should also say here that these five nations hold more than 40 percent of the world’s currency reserves.

The term “BRIC” was originally defined by Jim O’Neill an economist at Goldman Sachs. Currently, it is projected that the BRICS nations will be the dominant country block by 2050, with their economies expected to grow significantly in the next four decades. The following chart shows how the size of their individual economies will develop in the next 40 years, with China becoming by far the largest economy on the planet.

The 10 largest economies in the world in 2050, measured in GDP nominal (millions of USD), according to Goldman Sachs.

At their summit in Sanya, China last month, the leaders of the five BRICS nations discussed their involvement in world affairs. The main topic at this year’s summit was clearly their discussions about the future role of the U.S. dollar as the world’s main reserve currency and there was mutual agreement that their U.S. dollar dependence should be reduced going forward. This needs to be seen as another step away from the U.S. dollar as the main reserve currency.

The participating nations expressed their concern about the U.S. economy and the fiscal situation, which might become a large risk for BRICS nations that not only hold a lot of U.S. dollar reserves but also do a lot of their business and trade in U.S. dollars.

The chart above shows how the currencies of the five BRICS countries have performed in the last 12 months. The downward sloping lines mean that the U.S. dollar has been weakening against all of the BRICS currencies. This trend is expected to continue as trading restrictions are expected to diminish over time, making these currencies “real” currency alternatives for investors worldwide.

A good example here is the Chinese yuan, which is currently not freely convertible. However, it is not a question of “if” but “when” it will become freely tradable. We might still be a couple of years away from a freely floating Chinese currency, but the day will come and this will attract further capital flows away from the U.S. dollar.

The BRICS are now calling for a new global currency system to be established with a broader range of currencies involved in order to provide the necessary stability. This joint call for a new world currency reserve system only comes a few weeks after Chinese President Hu Jintao said, when visiting the U.S., that the days of U.S. dollar as the world’s dominant currency are over.

The participating nations also agreed to grant each other credit lines for trade between each other, and those credit lines are now held in local currency and not in U.S. dollars anymore.

We think that it is really important that people understand the potential long-term implications of this. The currencies of Europe and the U.S. make up about 90 percent of the world’s currency reserves but a growing number of countries, like the BRICS, are viewing them as weak partners because of their large debts and the monetization of those debts, therefore forcing a devaluation of their currencies. This acts as an extra tax on everybody holding euros and U.S. dollars.

It is almost a perfect storm brewing for the U.S. dollar here, with the fiscal deficit and debt situation being out of control, rating agencies finally willing to consider downgrading the credit quality of the U.S. and the BRICS wanting to diversify away from the U.S. dollar. Also the increased talk about the U.S. debt limit and its potential implications is adding more uncertainty.

There has been a lot of talk about the European sovereign debt crisis during the past 12 months. The chances are increasing that the next big market theme will be the U.S. dollar crisis, and this would have a much larger impact on markets than the European debt crisis.

–Daniel Zurbrügg

Global Update — Preparing For A Weaker U.S. Dollar

The global economy is in a state of stabilization rather than normalization and despite the various negative events in the first quarter (earthquakes, Japan, Middle East) the global economy is still set to grow at a rate of about 4.5 percent this year, only marginally lower compared to 2010

However, global economic growth is very unevenly distributed these days and emerging markets are growing much faster than developed markets like the United States and Europe. Emerging markets are expected to grow about 6.5 percent versus only 2.5 percent for developed markets.

In its recent update “World Economic Outlook”, the International Monetary Fund (IMF) writes that global growth has been gathering momentum in the past few months and that the economic recovery has broadened. Also, the IMF thinks that the risks for a renewed global recession have diminished. It also thinks that the sharp increase in commodity prices is not a real problem for the global recovery. In their view, even an increase of oil up to US$150/barrel would only lower global growth by about 0.75 percent.

The IMF, on the other hand, is concerned about the increasing debt levels of the U.S. and the fact that there has not been enough done to address the problem of rapidly rising debt levels. While we share some of the views in this latest IMF report, our own outlook is more negative and we think that the state of the global economy is still more fragile.

We continue to see higher growth rates in emerging markets that will offset at least some of the lower growth in the Western world, but in our view the outlook for emerging markets is a lot more uncertain. There are a number of factors that could impact growth in emerging economies very negatively.

We also can’t share the IMF’s view on commodity prices. In our view, rising commodity prices are a much bigger problem. While the fundamental supply/demand relationship is clearly supporting higher prices, the increasing share of speculative investment money that has come into the sector is creating new problems. The rapid increases among all sort of commodities has led to a very broad increase in global food prices.

An increase in food prices has a very direct impact on disposable income. Today we are seeing a growing number of people getting pushed to the limits because of higher food prices and that is, among a few other factors, contributing to political changes like we are seeing in the Middle East right now. These changes can have far-reaching implications in coming years, not only to the Middle East, but to all major economies in the world.

We think that the global economy can grow about 4.5 percent in 2011 and 2012. That is a very realistic assumption, but the fact that today we are dealing with many economic imbalances today and a much higher degree of interdependence among major economies is increasing the risks for the global economy.

The main risk factors are obvious. With the Western world experiencing sluggish growth and growing levels of debt, painful adjustments have to be made eventually. We think that it is highly questionable that the ongoing loose monetary policies among most major markets can bring these economies back to the growth levels seen historically.

Higher economic growth in developing economies is in sharp contrast to the very moderate growth in developed markets and there are also growing imbalances between them, mainly due to the fact that developed markets have been increasing government debt very significantly in recent years while emerging economies have been able to reduce their debt in the last decade.

The following two charts illustrate the current trends of debt levels and deficits in developed economies and in emerging markets:

Developed Economies

Developing Economies
Source IMF


Emerging Economies

Emerging Economies
Source IMF

The charts show that the situation in the U.S. and in Japan is bad and about to get worse. While most countries in the European Union have finally started to address the debt problem and the trend for them is improving, it might take many years to turn things around. The big difference between the U.S. and Japan is that the U.S. has a much higher percentage of the debt financed by foreign investors, as the following chart shows

Net Percentage Of Debt Held By Non-Residents

Net Percentage Of Debt Held By Non-Residents
Source: IMF

While the U.S. continues to increase the debt burden, emerging nations like China are accumulating foreign currency reserves and are reinvesting them in developed markets, a large part of it in government debt securities such as U.S. Treasury bonds. This can’t go on forever and it is clear that emerging markets are increasingly concerned about reinvesting their reserves in U.S. Treasury bonds. Actually, these investments are already declining.

While the attempt to provide the domestic economy with ample liquidity is certainly understandable, it is giving the wrong signal to foreign investors. And it comes at a time when the need for foreign investment is bigger than ever.

The Federal Reserve in the U.S. is currently trying to stimulate the domestic economy and to create jobs by providing the market with a lot of liquidity. We don’t think that liquidity alone will create jobs. In our view, the fact that job creation has been so disappointing has to do with a number of structural factors that are much harder to correct.

Politicians and central banks will most often do whatever serves them best, and when you have so many people looking for jobs and being unemployed, it’s natural that this is a top priority. However, by creating excess liquidity and therefore forcing a devaluation of the currency, the ultimate consequence is inflation. I think we are currently in the first phase of this development. This is going to get worse in coming months, and probably years, and we will hear and read about it much more in the future. Inflation will eventually become a much higher priority item and therefore policymakers will gain much more by fighting inflation.

Here history repeats itself. In the early 1980s, inflation was by far the biggest problem, peaking at more than 13 percent in 1981. The fight against inflation began in the late 70s with the appointment of Paul Volcker as the chairman of the Federal Reserve. He raised the Fed Funds Rate to 20 percent against widespread protests.

But inflation eventually began to slow and it fell back to about 3 percent in 1983. It was a matter of setting the right priorities at that time. Yes it was painful, but it was a much-needed measure. The economy began to recover and returned to healthy growth for much of the 80s.

In light of the lessons from the past, it is obvious that the current Fed strategy is not sustainable in the long run. However, even if rates eventually start to go up, we think it is highly doubtful that the value of the U.S. dollar will go up significantly. I think it might only devalue at a slower rate.

Remember, even in the last few weeks with all the negative events in Japan and the Middle East, the U.S. dollar has not benefitted. Historically in times like this there was always a flight to security, and that was usually positive for the U.S. dollar. But now not even all the bad news helped the greenback.

This should have been big headlines in financial news, but it wasn’t. However, it is a further sign that the U.S. dollar is about to lose its status as the world’s main reserve currency which will cause a large rebalancing of currency reserves in coming years.

The world has become increasingly aware of the declining status of the U.S. dollar in the last couple of years and it seems like the world is now accepting a weaker U.S. dollar going forward. This is a real game changer with far-reaching consequences for investing.

Fertilizer Will Grow The Profits Of Your Portfolio

Which investments have outperformed gold and silver in the last five years? A lot of investors are currently investing in precious metals, and gold and silver are especially popular. While this is in our view certainly a smart move, we feel that investors need to look beyond gold and silver and broaden their investment horizon to look for investments that might even outperform precious metals in the years to come.

In my view, the fertilizer industry is one area where a lot of value is being built in coming years and where investors can find attractive long-term investment opportunities.

Among the most important things in investment research is to identify global structural changes and the value drivers created thereof. Of course, investors can also make profits by short-term trading, but during my investment career I have not seen many traders consistently making profits this way. While I certainly do think that investors have to look at short-term opportunities, I strongly believe that in order to generate superior returns, one has to identify global structural changes in the world economy.

That’s what our team is doing every day. We have a true passion for analyzing structural economic changes and positioning our investments so that they will benefit from such changes. That means that our investment allocation is usually centered on a few core themes and therefore is usually less diversified in terms of industry allocation.

However, our investment allocation is spread among many countries, currencies and among a broad based strategic asset allocation. Investments in fertilizer companies seem to offer compelling investment returns which are tied to a very powerful long-term industry cycle that is relatively unaffected by short-term volatility in global economic growth. Also this is an industry group which has been able to outperform gold and silver over the last five years.

We think because of a further increase of global population, and therefore the need to feed more and more people, the fertilizer industry is poised to benefit significantly in the years to come. A growing demand for food will continue to drive prices and farmers around the globe will have a strong incentive to increase production. The higher prices for agriculture commodities will allow producers to spend more on fertilizer and crop protection, which will support higher prices. This should result in high and sustainable business growth for the potash and fertilizer companies going forward and we believe this is currently one of the most interesting sectors in the market.

According to a recent study of The World Bank, global demand for food is expected to grow by up to 40 percent until 2030 while world population growth is expected to grow by 23 percent, from currently 6.9 billion to around 8.5 billion people. The large increase in projected food demand is primarily coming from increased demand from emerging markets where an increasing part of the population is moving up to middle class and, because of a better lifestyle and higher income, will be able to spend more on food and many other products.

The chart below shows the anticipated growth in world population, with the yellow line being the most realistic scenario. An increase of global population by another 2 billion in the next two decades will have a number of very significant impacts on the world economy and will also increase the potential for geopolitical tensions given the fact that food and commodities in general will be scarce.

The recent crisis in the Middle East and Northern Africa show that a rapid increase of basic goods like food and energy will increase the conflict potential significantly. People might be able to accept a weak and corrupt government or even a dictatorship, but when people are starving they are willing to stand up and take control. This has been a very important driver behind the recent problems in countries like Egypt, Tunisia and Libya.

World population
*Source United Nations

So if the assumptions and projections regarding population growth are more or less accurate, one of the biggest challenges for our planet will be to increase world food production by 40 percent in the next two decades.  This is challenging, but not impossible.

According to various studies, productivity growth in the agriculture sector has increased by about 150 percent in the last 40 years and it seems likely that this trend will continue in the future, but probably at a slower rate. Also, the world’s reserve for agriculture land is relatively limited. While there are still land reserves in Latin America and certain areas in Southern Africa, it’s going to be difficult to expand the amount of agriculture land significantly, especially when additional factors like climate change and scarcity of water supplies are taken into consideration.

This points to the obvious fact that the largest increase to the world’s food production has to come from increased productivity that can only be reached by additional use of fertilizer products, crop and seed protection and the further industrialization of farming. This is in the eyes of many a real horror scenario, but the fact is that by only growing fruits and vegetables organically, we will not be able to solve the problem of a possibly severe future food shortage.

It is obvious that this creates a true super cycle for companies that are doing business in this area, and fertilizer companies, especially, will be able to significantly benefit from this development. On top of the very promising outlook for the industry comes the fact that the global fertilizer market is dominated by a small number of companies. Eight companies make up more than 80 percent of annual production which will give these companies good pricing power going forward.

Since the barriers for entry in this sector are very high and the fact that potash, the base ingredient for fertilizer, can only be found in certain parts of the world, future price increases could be very significant. The chart below shows that potash production only takes place in a relatively small number of places.

Potash productions center around the world

Currently, annual production is about 60 million tons and is expected to reach about 75 million tons in 2016. Today’s production is currently high enough to cover demand, but this could change in the latter half of the current decade and it is estimated that by 2020 global production will just be enough to meet demand. The outlook for the declining production overhang—and with that for rising prices in the future—has also resulted in additional takeover activity in the sector.

The recent bid of Australian based BHP Billiton for Canadian-based Potash Corporation and the acquisition of Potash One by Germany-based K+S are strong signs that the outlook for the industry is very promising.

Stocks of fertilizer companies have been doing well in the past two years, with many of them doubling or even tripling in price.  The chart below shows how some of the major companies in this sector have performed over the last five years. Most major markets have been flat over this period of time. In light of this, their performance is even more remarkable. Over this five-year time period, most of these companies have even outperformed gold and silver.

Potash performance compared to gold and silver

However, despite current valuations that look a bit rich based on commonly used ratios, the outlook for strong future profit growth, strong structural value drivers and the factors mentioned above should make investments in fertilizer companies an excellent option for years to come. Because of the growth prospects and as a way to protect the purchasing power of money, like gold and silver, investments in fertilizer are also linked to a commodity super cycle, which will not come to an end in the foreseeable future.

Rise And Fall Of Nations And Reserve Currencies

Among the “must reads” for people trying to gain insight into the long-term structure of economical developments is Mancur Olson’s book, The Rise and Decline of Nations, published more than 30 years ago. Olson was a great economist and social scientist who showed how interests and incentives of individuals drive and influence the development of a country. This often results in a less than ideal resource allocation and over time can result in very harmful effects for a country that can even lead to a complete collapse.

Olson’s findings help us to understand the problems of many Western nations today and how they will face a lot more headwinds in the future. Chronic overspending and changing demographics will cause many Western nations to “fall” or at least enter a period of deep structural change, thus bringing along many painful adjustments.

While today’s structural problems among Western nations are different than they were a decade ago or even centuries ago, the fundamental reasons that lead to a decline of a nation have not changed at all since the fall of the old Roman Empire,  the breakup of the Soviet Union or other troubled economies. However, today’s situation is more complex because of globalization.

Now the U.S. and Europe might be at the start of a long-term decline and with it their currencies, both of which are the world’s most important reserve currencies. The chart below shows that the importance of the United States dollar, measured as a percentage of global currency reserves, has been steadily declining since the late 90s.

Reserve Currency
*Source IMF

Almost 90 percent of the world’s currency reserves are held in U.S. dollars and euros, both of which are at risk to face a long-term structural devaluation. In light of this, it is obvious that a growing number of investors and governments with net currency reserves would like to diversify away from these two reserve currencies.

There are clear signs that this rebalancing has already started and that the combined percentage share of the two largest reserve currencies is going to fall further. How low can this go on in the next five or even 10 years is the question? My honest answer is that I don’t know, but I believe that even a shift of 15 percent to 20 percent would be enough to exercise serious downward pressure on these two currencies for years to come.

Besides the shift in the distribution of reserve currencies, which will have an impact on the value of individual currencies, there is another interesting development happening. The U.S. dollar seems to lose its role as a “crises” hedge; that means that even in times of falling markets or geopolitical turbulence, the greenback is not able to benefit, at least not as much as it used to, meaning investors are not looking to move funds back into the dollar in a flight for safety and liquidity.

Let’s look at the two recent examples: The first one is the situation in the Middle East and Asia, where tensions have been spreading in the last couple of weeks. The chart below shows the currency exchange rate AUD/USD. The Australian dollar is widely used as a carry trade by investors because of the significantly higher yields in Australia. So recently, despite the devastating damages by the flooding in Australia and the very serious tensions in the Middle East, the exchange rate AUD/USD remained relatively flat.


 The second example is from the terrible events in Japan in the past week. Despite the potentially far-reaching consequences of these events, the U.S. dollar has not been able to benefit because investors seem to be reluctant to move money to the U.S. dollar even when things look more uncertain.

And not to forget, in the case of the Japan earthquake, it was the third largest economy in the world that got hit along with the Japanese yen, one of the major currencies. It’s indeed very interesting and maybe even a bit surprising that the U.S. dollar has not been able to benefit much from this. It certainly tells a lot about the fundamental weakness of a currency.


The Chinese Premier Hu Jintao recently said that the era of a U.S. dollar-dominated currency system is coming to an end and that this will force a change to the international currency system. The recent structural weakness of the U.S. dollar and the euro shows that we are moving in this direction and that we are probably in a late stage of development of today’s world currency system.

The rise and fall of a nation and its currency follows a very long and powerful underlying cycle with very unique dynamics. While sound economic and political leadership can certainly dampen the negative effects, each prospering society will eventually enter a period of slow growth or even stagnation.  Also with the rise and fall of nations comes the structural appreciation or devaluation of these nations’ currencies. Depending on where they are in terms of their long-term economic cycle, it has very important implications for investors.

Today’s problems in Japan, Western Europe and the United States have a lot in common and, while we all hope for things to change to the better, it’s wise to prepare for the worst. In this case, that means a prolonged period of disappointing economic growth, large and growing debt burdens and increased social economic tensions between different nations and even within each nation. Even the tensions and the political turmoil in the Middle-East and the Northern African region can, to some extent, be attributed to such an underlying structural cycle. Things can only get so bad until people have nothing to lose anymore and start taking control of their own destiny.

In light of the comments above and the lessons learned from history, today’s financial and economical problems in the West need to be seen in a different context. The weakness of currencies like the euro and the U.S. dollar might not just be a temporary phenomenon, but much more likely the early phase of a long-term structural adjustment that will include below average growth and a devaluation of their currencies versus many other major currencies, including many emerging market currencies.

In regards to all of this, I think the question that we need to ask today is whether the current debt crisis in the U.S., Europe and other major economies is really indicating that things will worsen from here and that we have moved beyond the point of no return.

I think the problem today is that governments have spent way too much money in the last couple of decades and that today’s highly alarming debt burden in many countries are only the tip of the iceberg. Some people might argue that the debt in percentage of gross domestic product is really quite manageable but the problem is that on top of the current debt, we need to take into consideration unfunded future obligations that will drive up the government’s debt level even more. This is especially bad for some Western nations like Spain and Italy, who have a rapidly aging population and therefore fewer and fewer young people that can support retirees.

The conclusion of this article is that investors need to rethink their investment strategies, especially with regards to their currency allocation. The two dominant reserve currencies in the world, the U.S. dollar and the euro, are both showing signs of structural weakness, might both face significant devaluation in coming years and this will result in increasing money flows to countries that experience faster economic growth and lower debt levels. This will clearly be a benefit for emerging market currencies and currencies of major economies that have less structural problems.

Structural Money Devaluation In The West

When facing questions about foreign currencies, a common response is, “I don’t care about currencies. I buy my milk, butter and bread in United States dollars, I get paid in U.S. dollars and my mortgage is in U.S. dollars.” However, given the large and potentially severe consequences of today’s economic situation and global structural changes, everybody should be aware of the importance of currency diversification and how you can manage the risk of future currency devaluation.

Many Western nations have entered a prolonged period of deep structural change that will take many years to complete. For decades, Western nations enjoyed increasing prosperity and that resulted in a steep increase of government spending and a never ending increase in the build-up of welfare states. This has caused an accumulation of huge amounts of government debt in many major economies.

Now, changing demographics, chronic overregulation and the wrong economic incentives could make the problem even more severe. Therefore the ongoing liquidity injections, such as the European bailouts or quantitative easing in the U.S., could eventually force a further and potentially severe devaluation of money and currencies.

Loss of purchasing power affects everybody and almost everything. The chart below shows by how much the U.S. dollar has already devalued in the last 10 years against other major currencies: The euro, Swiss franc, yen and Singapore dollar.

*EUR=Euro / CHF=Swiss Franc / JPY=Japanese Yen / SGD=Singapore Dollar / Change in % vs. USD (Base 100%)


This chart illustrates how important currency diversification is and how global investments can help investors to protect against the adverse effects of the domestic situation.

Many investors underestimate the very powerful benefits of proper currency diversification, if they think about it at all, but recent history shows us how important a sound currency investment strategy is. Let’s look for example at the events in the global economy last year, they are highly alarming.

The sovereign debt crises in many countries have worsened significantly and we are facing a situation today where a large number of governments, countries and individual states are facing technical bankruptcy. The situation is most concerning in the U.S. and in Europe where there are plenty of reasons to believe that both regions, and with it their currencies, are heading for a long-term structural downward trend. Of course, central banks and the IMF can put together bailout programs and the Federal Reserve can engage in further quantitative easing programs, but all of these measures will come at a price.

It would be outright foolish to believe that all this liquidity can be created out of thin air without real economic consequences. These consequences do not come overnight but might actually take two to three years until we see the negative impacts — in this case rising inflation — in daily life. The price that needs to be paid longer-term is eventually borne by everybody through destruction of wealth and the loss of purchasing power.

It essentially acts like another tax on everybody at a time when tax rates are already at painful levels. This situation can only be avoided by governments gradually cutting deficits and redirecting spending into sensible expenditures that produce real economic value for its citizens.

Unfortunately, the deficits are increasing. The U.S. government’s debt is on track to reach $15 trillion by the end of this year and is therefore exceeding the size of U.S. gross domestic product for the first time since the years immediately after World War II.

In the absence of dramatic spending cuts, redirected investments and savings programs, this debt burden will most likely continue to rise because just servicing the large debt burden is a real challenge already.  The chart below illustrates the sharp rise of the U.S. debt burden since the mid 60s.

Despite the fact that European countries have announced large spending cuts, the situation is not better there than in the U.S. While the deficits might be smaller in the future, the European Union and the euro will face a number of serious challenges in the years to come that could even put the future of the European Union — as we know it — at risk.

 The recent bailout programs for Ireland and Greece and potential future rescue operations for troubled member states are a real stress test for the Union. It seems that there is an increasing reluctance among individual member states to help countries which are facing financial distress. This has lead to a rise in anti-Euro sentiment in certain states, especially Germany and France. In France, the far right wing party “Front Nationale” is becoming a lot more popular and their main political goal is to exit the European Union and its common currency system, not a very encouraging prospect for Europe.

The enormous liquidity injections that we have seen in the past three years are a very big and risky experiment, with the outcome remaining highly uncertain. It is understandable that today’s central bankers are very concerned about the reemergence of deflation and its destructive effects on the economy. One only needs to look at the situation in Japan, where the economy has been in deflation for most of the last 20 years.

However, Japan is a different situation given that its economy needed a lot of restructuring, a process that has still not been completed. Japan’s debt situation looks even worse at first glance; however, taking into consideration the large private savings of its people, Japan can better afford the significant debt burden because most of it is financed from domestic sources, a truly significant difference to the situation in the U.S. today.

The Federal Reserve will probably continue to keep rates at these very low levels in an effort to stimulate the economy as much as possible. But eventually the market demands a higher yield for U.S. government debt, given the fact that its financial situation continues to deteriorate. This could lead to a further decrease of the U.S. dollar and rapidly rising price levels through the import of inflation.

Don’t forget, many goods such as food, energy and commodities are priced on a global level. Given this situation, it is even possible that we might see stagflation (rising inflation with little to no economic growth) appearing on the horizon.

With the outlook for the U.S. dollar and the euro remaining quite negative, it is highly important to keep some savings and investments in other currencies which are stronger and might be gaining in value in the years to come. There are plenty of attractive currency investments to choose from globally.

Don’t expect central banks to print less money and don’t hope for governments to spend the tax money more wisely. The only way to protect against the forced currency destruction is to be proactive and start investing globally.

–Daniel Zurbrügg

China: Opportunity Or Threat

The recent visit to the United States by Chinese President Hu Jintao got a lot of attention and coverage in international media and the fact that so many important people showed up for this meeting shows how important it was for both sides.

For China, this visit was important not only for political reasons, but also for building its prestige on the global stage. From an economic point of view they are able to act from a position of strength.

Hu said a few days before the visit that, “the Dollar dominated currency system is a product of the past.” He also said that the Chinese yuan is not yet ready to take over as the new world reserve currency. It remains to be seen what “not yet ready” means according to the Chinese definition, but we think China will make a number of very significant changes in coming years that could have a lot of consequences for the West.

The strategy of China for the last 30 years has been to keep its currency artificially low in order to promote exports and the country has been extremely successful in doing so. However, this has resulted in significant imbalances in the world economy that sooner or later need to be reversed. China has been accumulating huge amounts of foreign currency reserves and a lot of it was reinvested to buy U.S. Treasuries, therefore financing “America Inc.” and other countries which are now running large deficits.

Let’s be clear, China has a number of very serious problems, different problems than Europe or the United States, but equally challenging. The growing imbalance between the booming cities and rural areas continues to drive more and more people to the big cities. This growing imbalance is increasing socioeconomic tensions and, coupled with strong inflationary pressure, makes it increasingly difficult for people to make a living, especially in more rural underdeveloped areas.

There is also a large infrastructure and pollution problem in China and these problems need to be solved in coming years. The key advantage that China has is that it is not a democratic system and that the ruling party can make and implement much needed changes quicker than most other countries. That should help China to continue to grow their economy and keep adding jobs for many millions of people.

I think we are at a very important turning point in the history of China. For the past few decades the focus was on producing and exporting goods, and at least in that context, China has been very successful. Going forward, China needs to focus more on securing a stable supply of energy, commodities and technology and therefore its interests are not so heavily biased towards keeping a strong currency anymore.

Imports are growing faster than exports, currently at a rate of about 25 percent, compared to export growth of only about 17 percent. The overall trade surplus of China has fallen about 9 percent from the previous year and about 34 percent from 2009.

There is another factor that needs to be considered. China needs to deal with its inflation problem and we think it will tackle it from two sides. They will continue to hike interest rates further and therefore control domestic growth and prevent the economy from overheating. At the same time, they will change their currency policy by allowing Chinese companies to hold large foreign currency balances abroad and use them for investment purposes. That will help the Chinese central bank because it is no longer forced to buy foreign currency reserves and issue cheap domestic currency, which had in turn caused further inflationary pressure in the past.

I think that this will help the Chinese central bank to bring inflation under control and will probably allow them to keep further interest hikes moderate and diminish the risk of them over-tightening, which should also be positive for Chinese stock prices. So even a small, controlled appreciation of its currency will help them eventually to bring growth and inflation at home under control.

That’s why we think that China will let their currency appreciate. But, as always, they will do it when it serves their purpose, and that might now be sooner rather than later.

At the same time, the effects from such developments would be negative for the West. In a time when Western governments are so dependent on countries like China to buy their debt, we expect the purchase of government paper to decrease in coming years, which will make it a lot harder and more costly for troubled governments to issue debt. This will eventually lead to higher interest rates in the West, and that would come at a time when inflation is already on the rise because of rising commodity and energy prices.

Central banks in the West will probably try to keep short-term rates low for as long as possible in order to stimulate their domestic economies. But the longer-end of the yield curve could experience a significant increase in yields. We feel that adding further exposure to Chinese yuan and possibly other Asian currencies is the right thing to do going forward, and also caution investors to hold bonds with long maturities.

–Daniel Zurbrügg, CFA