Five Themes for the Next Five Years
It's been a tenuous calendar year as a lack of motion on the market surface has masked the movement in select sectors.
Asset Class Deflation vs. Dollar Devaluation
This is a theme we've touched on often as the commodities (as measured by the CRB index) have recently violated the uptrend that's been in place since 2002. The post-bubble reflation effort by the Federal Reserve has created a rising tide that's lifted most boats at the expense of the US dollar. Viewed through this lens, equities, metals, energy, agricultural products and basic materials have all been a part of the very same trade. During that time, the greenback has fallen 29% as liquidity was injected into the system with hopes that debt-induced demand would morph into legitimate economic growth.
This dynamic has existed largely unnoticed---green screens tend to do that--but there are signs that the curtain is being pulled back to expose the wizard. Earlier this week, Yu Xuejun, director of the China Banking Regulatory Commission's Chenzhen Department, said the U.S.'s easy money policy between the start of 2001 and the middle of 2004 helped to inflate asset prices globally and pushed China's foreign exchange reserves higher. "China, in reality, has become the biggest victim of the global over-liquidity of the U.S. dollar," said Yu, "and the decisive power to control liquidity no longer rests in the hands of (China's) Central Bank."
The joke likely won't be on Yu. Given that the majority of US debt is in the hands of foreigners, there's a real chance that our central bank policy has already begun catering to those holders. While short-rates have been ratcheted higher to appease the global audience, the inversion of the yield curve is proof positive that something is already amiss. The devaluation of the US dollar has been a stealth bear for many US citizens, particularly those who don't often venture abroad. That should resolve itself in short order as the other side of globalization comes to bear.
If the greenback continues to debase, countries will hoard natural resources as a self-defense mechanism. Bolivia, Brazil and Venezuela have already taken steps in this direction although this dynamic is in its infancy. Several events during the last few years have planted seeds of US isolationism that continue to sow. The scuttling of CNOOC's (CEO) acquisition of Unocal, for instance, sent a clear message to multinational corporations that when the going gets tough, the tough will look out for themselves.
The brunt of this evolution will likely be felt in the mining and energy spectrum, which could lead to further decoupling of the commodities and their equity brethren. While US corporations have become synonymous with exposure to their underlying assets, in part because they are the default vehicle of individual investors, we could experience an unpleasant wishbone as heretofore third world countries begin to protect their assets.
One possible scenario involves the establishment of a North American community, one that marries Canadian natural resources with cheap Mexican labor under the directive of a US initiative. Given the current global evolution, including the European Union and the fortification of the Middle East, this solution seemingly makes sense. More likely than not, however, politics and agenda will shelve this initiative until it becomes all too apparent that we need it to compete on a global basis.
The Erosion of the Middle Class
Caught in the chasm between the "haves" and "have nots," the middle class is already on its last legs. With inflation in things we need (education, healthcare, energy) and deflation in things we want (plasmas, cars, laptops), mainstream America is stuck in the middle with Yu. While this dynamic is well established, it's been masked by the benefits of home equity in a finance-based economy. The fork in the road will become entirely more obvious as adjustable rates mortgages begin to reset in the months and years ahead.
The attendant societal acrimony should galvanize as this dichotomy is unmasked and we turn to face our debt obligations. As a result, risk appetites will likely abate and begin to ripple through the pond of our collective spending habits. With total debt more than 300% of GDP, one could argue that the wiggle room is already in our rear-view. There is a massive difference between hypothesis and application, however, and we'll feel the pinch as this perception and reality meet in the middle.
The definition of frustration is repeatedly doing the same thing and expecting a different outcome. The more things change, however, the more they stay the same and that will become painfully obvious as we unwind the real estate bubble. Granted, there is a marked difference between housing stocks, real estate and land. And while the homebuilders seem "dry" after their 50% correction this past year, we mustn't confuse these disparate elements if and when a relief rally unfolds.
Real estate, as we know, is a lagging indicator in the realm of a business cycle. As the normalized cycle was augmented by central bank agenda (fiscal and monetary policy), the end result will likely be magnified as a result. A correction, as we're seeing now, is one thing, but a regression to the historical mean is another conversation altogether. If excess indeed breeds excess, as we saw with many of the dot.com stocks on the back of the tech bubble, real estate prices, particularly in high-end realm, should overshoot to the downside.
Composition of the S&P
Perhaps my most lucid thought for the last few years has been the inevitable repositioning of the sectors within the S&P. The financials, due in large part to the rising tide of liquidity in a finance-based economy, have been the primary beneficiary of the aforementioned environment. As of June 30th, they continue to boast the top weighting in the S&P with 21.4% of the total index weight.
Energy, as it stands, currently holds a 10.2% weighting, which is a far cry from their moxie in decades past. Materials, for their part, represent a paltry 3% of the total index composition. These rankings should flip within the next five years, with energy assuming top weighting in the index and financials falling far from grace.
Trading is a relative game and it's my belief that a "paired book," one that is long energy and metals vs. short positions in tech and financials, will boast superior returns when the dust settles and the chips fall where they may.
Thanks kindly for listening. We now return to the regularly scheduled summer doldrums.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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