Investing in the New Decade

Introduction

My first note of the year, written in conjunction with Gillian Findlay, considers some prospects that investors might face as they head into the new decade. The noughties turned out to be a decade filled with bubbles and euphoria - technology, commodities, credit, oil, real estate and more. Whilst these bubbles now are in the rear-view mirror, the policies that have been put in place to address the collapse of the most recent bubble series suggest that fresh caution is needed in considering investment prospects. As I argue below, the fat lady may not yet have sung.

I look forward to sharing the successes, opportunities, challenges and lessons of the new year and the new decade with you, and wish you all the best for 2010.

Investing in the New Decade

Making long-term predictions is as difficult as making short-term ones. There really is not greater certainty at the turn of a decade than at any other time; and regardless of the starting point, forecasting always is a complex issue.

Given this caveat, there are things which one can anticipate with a greater degree of confidence than others given the behavioural traits of investors and the likely impacts on and responses of capital markets. For instance, there are aspects of history which repeat themselves, albeit with differences, and one of these is asset price bubbles.

"History Doesn't Repeat Itself, But It Does Rhyme." – Mark Twain

However, whilst asset bubbles recur with surprising frequency, no-one has ever built a career out of predicting bubbles as investors seldom like a party pooper. It can take years before a bubble bursts, making the predictions of collapse look increasingly foolish despite their ultimate accuracy. A good example of this was Alan Greenspan’s 1996 remark “irrational exuberance” to describe high stock prices. Yet it was only in 2000 that the tech-stock bubble burst.

In short, it is particularly hard to predict when a bubble will collapse. They exist because people are behaving irrationally and it is almost impossible to determine when they will come to their senses.

Against the backdrop of the above observations, I don’t believe that the asset price bubbles of the noughties have worked their way out of the system notwithstanding that the recently collapsed real estate, credit, emerging market and commodity bubbles brought the world to the brink of economic depression. Indeed, my sense is that there are at least two more bubbles on the horizon that need to be worked through the system.

Sovereign Debt

The risk in the 1990s was that of emerging market debt defaults. In the noughties, risk migrated so that it was companies that would default and in the teens, the risk is that the developed countries will default.

Advanced governments have taken on unmanageable levels of debt, which in itself is a form of asset bubble. The unfortunately-termed PIGS countries (Portugal, Ireland, Greece and Spain) fall into this category, as does Iceland. But, there are much larger economies, with far greater absolute and relative levels of debt. This will lead to a greater degree of unmanageability and greater debt repayment problems, notable cases are the world’s three largest economies, namely the United States, Japan and, to a lesser extent, the Western European area, including England.

From this, there is a range of implications for investors looking to invest for the next decade. One thing is that investors should think very carefully before lending money to an advanced economy’s government. In short, buying government bonds is unlikely to be a risk-free exercise. Historically, though, we have been encouraged to believe that such governments will not default on their debt, but I believe that there is a risk of this happening.

China

China, as an investment destination, has many of the markings of a home for asset bubbles:

• reported economic growth is exceptionally strong;
• analysts see the country as having extraordinary prospects to the extent that China will change the world;
• there is an expectation that this growth and change will continue unabated, and that China is a one-way bet which can only succeed;
• credit growth is rampant; and
• asset prices are expensive. For example, the Shanghai index is trading on a p:e of more than 30 times, while property in the country’s capital city is changing hands at a price:rent ratio of 500 times. To put this ratio into perspective, this would be equivalent to buying a Johannesburg property which attracts a monthly rental of R10,000 for R5m. Regardless of location - Manhattan, London, Johannesburg or Shanghai - the inferred pre-tax yield on such a purchase price is a meager 2.4 percent per annum.
  

To put this into context, while China is experiencing excellent economic growth, it is a mistake to confuse economic growth with investment success. China will change the world, of that there is little doubt. But this fact does not mean that investing in China will be the route to financial success. We only have to look at the tech-stock bubble to raze that myth. The internet has been instrumental in bringing about a new world order, but as an investment in the 1990s, it was disastrous.

Investment Themes To Consider

The current high levels of government debt mean that investors must equip themselves for higher inflation than in the noughties. Experience shows us that some asset classes are reasonably well placed to deal with this tough environment. In particular, portfolios that hold physical and productive assets – which include commodities, such as platinum, real estate investments and equities – are better equipped to deal with the debt, deficits and potential default than the purported safe haven asset classes of cash and government bonds. In this vein, investors should put a question mark over any exposure that they may have to debt. Equally, not all productive assets will translate into investment success, the case of China being an obvious example.