Summer & Fall Outlook – 7-27-2009

August
In the short run, we will continue to see risk appetites increase and opportunities over the next month or so will be in US equities, commodities, and overseas holdings. The reason for this upward continuation is the belief that things are getting better, despite my view that all the good news has already been priced in.

We’re Not Finished Deflating
As we wind down the summer months, we will witness more asset deflation (contraction of available credit and decline in asset prices). Equity markets could retest recent lows as market participants realize that “green shoots” are not the indication of an end to a recession, but evidence of unparalleled governmental interference and manipulation. Residential foreclosures and falling commercial real estate prices will continue to drag on the ability of banks to recover. Corporate defaults will continue to rise and a consumer led recovery will fail as the market adjusts to the new normal of consumer spending. Interest rates will remain in a trading range in the next year or so and corporate bonds will be a place to obtain opportunistic yields of 4% to 6%. Individual name selection will be tremendously important in this asset class because lower consumer activity will be the death blow to under capitalized firms. In addition, sectors like REITS and financials with commercial real estate exposure will be areas to avoid. We will want to try to keep the maturity of the bonds as short as possible, but take advantage of the return of fear that will push yields back up to extreme levels.

If the US federal government can guide us out of the deflationary cycle, we will be fortunate to enter a period of much greater inflation. In fact, this is the direction that the FED prefers now and is attempting with all of their might. Again, if the FED can break the deflationary cycle by prolific "electronic printing of dollars", deficit spending, and debt issuance it will lead to a significant devaluation of the US dollar. A decline of the dollar will usher in increased commodity prices, and future asset bubbles in other sectors. Investments to consider putting on eighteen to twenty-four months from now will be those that bet the on a US dollar decline; ETFs (exchange traded funds) that invest in the currencies of Canada, Australia, China, and Brazil, investments in food or agricultural production, natural resource companies and commodities, and treasury inflation protection securities. Domestic equity markets in general may go up, but will actually under perform on a relative basis those assets in commodities.

Everyone Sees Inflation - Everyone is usually wrong.
We remain watchful as the results play out in front of us. Although the inflation trade seems logical, we have an current example of deflation in our midst. Japan has existed for almost two decades in a deflationary environment. Interest rates have been at near zero, growth has been absent, and the equity markets languished at points as low at 75% below the market highs. Interest rates have remained low because a large supply of currency has been stuck in banks despite the desire to give money away. Further contributing to this is the "carry trade" where very low interest rates create demand for the YEN. Hedge funds and other Investors then take the borrowed YEN and buy other investments. These investors look to borrow cheaply and profit from the low cost money. The increased value of the YEN creates a difficult operating environment for exporters as their goods and services are priced abnormally high due to demand from speculators. If the deflation trade comes to the US, we can look forward to the carry trade trapping us as well.

While there are many differences between our economies, it is wise to consider that we may be doomed to the same fate. If the inflationist's consensus is wrong, we will have a strong dollar, lower equity markets, commodities will be depressed (more driven by over supply and low demand), and overseas investing will present better growth opportunities. Even though faster growing countries present better prospects for capital appreciation, currency risk will be significant.