As we enter 2011, the world’s economies, and in particular the economies of the developed world, continue to be affected by the global financial crisis we experienced in 2008 and early 2009. The global financial crisis led to a global recession, and during 2010, we started to see signs of a recovery, albeit at a very slow pace.
By Greg Farries, BSC, The Nakamun Group, Calgary
Governments and central banks around the world responded to the recession by using all the tools at their disposal. The dynamics and interrelationships of the world economies can be very complicated, but at the end of the day, in simplified terms, most governments and central banks have three tools they can use to stimulate economic expansion:
1. Lower interest rates
2. Devalue their currency to make their exports more competitive
3. Provide fiscal stimulus by increasing government spending and tax cuts, or, as we have recently found out, printing more money — “quantitative easing” is the term being used
US “Quantitative Easing”
In early November, the US central bank announced an additional $600 billion in stimulus by way of “quantitative easing”. During the subsequent six months, the central bank intends to buy virtually all new debt that the US Treasury issues to finance the country’s obligations.
Normally when the US issues debt through the sale of t-bills or government bonds, third parties such as individual investors, financial institutions, or other countries purchase them.
The net effect of the latest “quantitative easing”, the US central bank hopes, is to flood the system with liquidity, keep interest rates low by creating artificial demand, and likely keep their currency low, to stimulate the economy. The risk is inflation. However, at the moment, the bank is more concerned with deflation and the need to stimulate the economy.
Governments and central banks appear now to have done all they can to stimulate the economy. However, the US is prepared to provide further “quantitative easing” if necessary.
What This Means to You
Investors are worried. Unemployment is high, government and consumer debt levels in developed countries are near record levels, and the housing market in the US and most other countries — excluding Canada — has plummeted. Government stimulus efforts have driven interest rates to historic lows.
The challenge for investors is to find reasonably safe investments that will provide the income necessary to meet their needs now and into the future.
Most investors perceive cash to be safe. Right now, though, short-term rates are only about one percent. For most people, a one-percent return is not sufficient to meet their needs.
Recent data from both Canada and the US shows that during the last year, investors have been taking money out of equities and pouring money into bonds. At first blush, this seems to make sense — see accompanying chart. During the last decade, investors would have been far better off owning bonds than stocks.
Some investors do not realize that bonds have an inverse relationship to interest rates. In other words, when interest rates go down —as they have for the last 30 years — bonds go up in value. When interest rates go up, the value of bonds will go down.
Right now, interest rates have nowhere to go except sideways or up. While government bond yields are still at historic lows, corporate bond yields are still relatively high.
Bond investors could be disappointed in the coming years when interest rates go up. To quote one of the grandfathers of investing, Benjamin Graham, “The investor’s chief problem — and even his (or her) worst enemy — is likely to be himself”.
Real estate has also been an attractive investment. However, according to the International Monetary Fund (IMF), residential real estate in Canada is approximately 60 percent above its historic average, and on a price-to-rent basis, is the most overvalued in the world.
With the crash in the equity markets still fresh in everyone’s minds, coupled with the reality that over the last ten years, on a global basis, equity markets have been basically flat or down, people are justifiably fearful of investing in equities.
However, I would argue that investors should take another look at equities. Stock market valuation measures such as price/book and price/cash flow are below long-term averages. Corporate balance sheets have not looked better in decades and most corporations are flush with cash.
Although prospects for growth in revenues in the developed world are worrisome, demand from emerging markets is strong and growing fast and exponentially. As the Plenty of Purchasing Capacity, Developing World is Unencumbered by Debt chart illustrates, the emerging market consumer is not subject to the same debt levels as the consumer in the developed world. This should keep commodity prices strong, as these countries need to build the infrastructure to support their economies and help companies that do business there.
You don’t have to invest directly in the emerging markets to benefit from their growth. What many people don’t know is that the 500 largest US corporations that comprise the S&P 500 Index, now derive more than 50 percent of their revenues from outside the US. With a declining US dollar, overseas revenue could also be subject to currency gains.
Key to Successful Investing
As always, the key to successful investing is to make sure your investments are properly diversified and designed to meet your goals and objectives. Contact your Nakamun Advisor to review your investment portfolio.