2010 Asset Allocation Update

We are focused on investing in areas of the world where we find the following:

  • Growing populations
  • Good savings and good capital investment
  • Good manufacturing and/or resource extraction
  • Healthful banking systems
  • Low deleveraging requirements
  • Low probability for ‘fat left tail’ events

In 2009 the world saw the darkest so far of the “great recession”. Only Asia and parts of Africa exhibited economic experiences (orange) associated with healthy economies. Of interest here is our idea of economies based in emerging, rather than mature, bureaucracy. Most of the orange areas have somewhat “recently” emerged to stand on their own, and have established lean organizational structure over the past 50 years. Traditionally, these transitional economies do not provide for education, health care or pensions. Generally, the more developed areas (much of the green), do.

Real GDP Growth 2009

2010 growth expectations in Asia, the Pacific Region and South America are likely consequences of healthful banking systems showing appropriate low levels of leverage, and the elixir of growth (growing populations, increasing savings and increasing capital investment). Of note, a number of the countries in orange saw their recoveries internally generated. Interestingly, these types of countries and the areas they are in account for more than 30% of global GDP (PPP adjusted) and should continue to grow to ~ 40% of global GDP by just 2015.

Real GDP Growth 2010

Additional forecasted growth appears in 2011. Note that two ‘westernized countries’, Canada and Australia, as well as Russia and the balance of Africa join fully in the recovery. These are places where substantial manufacturing and/or resource extraction will take place. We can think of them as providing what “Asia needs” – and thus add another layer from which to allocate assets for investment.

Real GDP Growth 2011

Riding Ripples on the Tsunami
Growth :: Regionalization :: Deleveraging :: The ‘flation

Growth: As mentioned previously, growing populations coupled with good savings and good capital investment lead to wealth creation. Mature economies are struggling with labor shortages from aging populations and declining immigration in addition to surging government spending. Additionally, according to the OECD, higher taxes are directly correlated with higher unemployment rates across the globe. Finally, we note that at no prolonged time in history have people moved to, or continued to invest, where the debtors are.

Regionalization: Now that the globe has begun to emerge from recent financial shocks, a recovery can continue where economic growth and profits are found. The New Year’s Eve free trade association created amongst China and the Association of Southeast Asian Nations is interesting because it may signal a new trend to regionalization rather than globalization. A common or basket of currencies in this region may emerge to challenge the US$. One effect of would be to insulate the region against possible western ills associated with the current crisis.

Deleveraging: Areas of the world laden with debt have been consistently more affected by the “great recession” that began in 2007. They appear to further express this burden in forecasted substandard economic performance. The leverage allows economic shocks to become economic catastrophes. Periods of deleveraging since the great depression generally last about six years. We are in year three but have not yet found data to support net country deleveraging.

Duration & Extent of Deleveraging Following a Financial Crisis

The ‘flation’: Inflationary economic shocks have become catastrophe when countries finance 40% or more of a budget through debt issuance (Source: University of Basel). Shocks also become catastrophes when governments attempt to increase debt as compared to GDP at a rate of more than 8% per year (Source: Strategic Economic Decisions). Deflation is unlikely to occur in countries with large budget deficits, long term depreciating currencies, and monetary growth. Finally, according to Alan Greenspan, countries that have externally financed debt that amounts to more than liquid assets on hand encounter mounting difficulty in refinancing those debts as they come due. The US and many European countries possess these attributes.

Growth of Mature Market Debt

Expectation -Vs- Reality (Fat Tails)

In investing, there is a central marketing assumption that returns “average” a certain amount (between grey lines). This certain amount is then shouldered on either side by an expectation of equal possibilities (black bell shape). In fact, as the past 130 years show, the negative returns that occurred (blue points left of the red line), did not occur as “expected”. i.e. the size and frequency of losses were radically unexpected. This is referred to as a ‘fat left tail’. Based on the idea of ‘riding ripples on the tsunami’ detailed above, we note that a number of countries are vulnerable to a continuation of a fat left tail events. This is one more reason to focus on opportunities in the ‘orange’ economies.

Expectation vs. Reality

In closing, focus on those areas with:

  • Growing populations
  • Good savings and good capital investment
  • Good manufacturing and/or resource extraction
  • Healthful banking systems
  • Low deleveraging requirements
  • Low probability for ‘fat left tail’ events

He who is drowned is not troubled by the rain.
~ Chinese Proverb

It’s a race between the inflation rate, the tax rate, and controls, and all three are going to win.

~ Alan Meltzer

Ignoring the macro economy and assuming that things will continue more or less as they are doesn’t mean a big bet hasn’t been made.
~ John S. McCallum

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