Thursday, December 31, 2009

Four Extraordinary Financial Predictions for the Coming Decade

As we leave the year of the "Great Recession" behind, knowing four likely financial outcomes will show us how to position ourselves for financial prosperity in the coming decade.
1) Global growth
Emerging economies were economically superior in the last decade.  Without the effect of the tech and housing bubbles in their past, their demand is not hampered by enormous public (and private) debt.  The better run of these economies will prosper in the coming decade, and provide markets for economies weakened by the lingering effects of the recent recession.
2) Inflation
As we emerge from the Great Recession, the reality of the damage is becoming more clear.  Without government support, we'd be in a Depression.  While the steps taken by G-20 nations were inarguably necessary, it effectively covered old problems with  borrowed dollars, while keeping interest rates artifically low in order to give life to a near-death economy.
As more countries take on huge amounts of debt, the numbers of lenders who have the money and motivation to lend decrease.  It's a simple formula that we all know:  less demand for a commodity causes the price of that commodity to fall.  If nobody is buying the farmer's apples, the farmer lowers her prices.
In the case of our debt (in the form of bonds), when bond prices fall, yields go up.  Here's an example
Maturity Date - One Year.  Price of bond - $1000.  Interest paid by borrower - 4%  Yield to lender - 4%
If the price of that $1000 bond falls to $980,
Maturity Date - One Year.  Price of bond - $980.   Interest paid by borrower - 4%  Yield to lender - 6.1%
Higher interest rates mean higher inflation.  The Fed can't keep rates artificially low forever.
3) The mortgage market
We have just seen the effect of lending to less-than-qualified-borrowers in the recent mortgage meltdown.  You may be able to cut mortgages into little pieces and sell them to Iceland, but in the end, the mortgages will still go bad if the borrower can't pay it back.  Since the crisis, financial reform has stalled.  Mega-banks are repaying taxpayers for the money we spent keeping them alive, and, while lending standards have tightened, the genie has been let out of the bottle.
Investment bankers now operate under commercial bank charters.  Structure finance has diminished the barrier to entry to the mortgage market.  This demand, together with stricter lending practices, will provide additional upward pressure on interest rates.
4) Wealth transfer
Over the last decade, emerging nations have produced good for the insatiable US consumer, who bought with abandon.  Now debt laden, US consumer growth is diminishing.  Emerging nations, however, have newfound wealth.  Those nations now lend money to our government, and have a huge and growing middle class.
China is the most obvious example, but there are others.  These nations, assuming that they avoid the pitfalls of asset bubbles, will provide the majority of global growth in the early part of this decade with their newly acquired wealth.
Before the effects of globalization, all but those who ascribed to "Modern Portfolio Theory" (those who invested a set percentage of their money in various asset classes) were confident in keeping their money largely in US equities and bonds. 
With future diminished US growth prospects, however, this investment strategy is unlikely to be as successful in the next decade.  History has shown that this strategy has not been effective in the past, as well.  Investment veteran Art Cashin, Director of Floor Operations at UBS, recently  reiterated his "theory of the 17.6-year cycle." He pointed out that the periods 1966-1982 and 1929-1947 were "lean cycles," and predicts that we are entering another such cycle at this time.
Consequently, the old benchmark of "Subtract your age from 100, put that percentage of your portfolio in high quality US stocks, and the remainder in bonds" may well be over.
What now?  If you agree with the four assumptions discussed above, Pimco's Emerging Market fund manager (and former Harvard Endowment fund manager) Mohamed Il-Erian proposes the following portfolio:
STOCK  15% US, 15% Non-US Advanced Economies, 12% Emerging Markets, 7% Private Equity.
BONDS  5% US, 9% International, 5% US Treasury Inflation Protection Securities.
REAL ASSETS  6% Real Estate, 11% Commodities, 5% Infrastructure.
With an increasing investment in fast-growing emerging markets, with an emphasis on TIPS and real assets, this portfolio seeks growth with protection against inflation.  If you agree that inflation will cause rates to rise, you'll want to delay your US bond purchases until rates are higher, and wait until gold prices fall before investing in that commodity.  Depressed real estate prices, other than commercial property, show good value now. 
Of course, as we've learned through the painful correction in the last decade, this portfolio does not include cashflow you will need in the next five to ten years.  That is best kept in short-term Treasury issues or insured savings.  Yes, rates are low now.  But, they're likely to rise, as inflation picks up, and for this money, you want return OF capital more than return ON capital.
Have a safe, happy, healthy and prosperous new decade.

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