A Simpleton's Guide to Economics and Investment Markets, Part II

I WOULD LIKE to remind our readers that Mr. Bernanke, when confronted with declining asset prices sometime in the future (the Dow Jones and housing market are down around 10% from their highs), will ease massively in order to support the asset markets. After all, it was Bernanke who said, in a 2002 speech given in honour of Milton Friedman, “I would like to say to Milton and Rose: Regarding the Great Depression. You’re right, we [the Fed] did it [caused the Depression]. We’re very sorry. But thanks to you [Friedman], we won’t do it again.”

The problem, however, is that common sense would show that it is impossible for a monetary authority to support all asset classes in a country with a large current account deficit. If the central bank decides to support asset prices such as stocks and homes with easy money and by cutting interest rates aggressively, it is the currency that will tumble.

If, on the other hand, a central bank decides to support its currency by implementing tight monetary policies and by increasing interest rates, stocks and home prices will tumble. So, whereas the Fed indeed has two options — print money and support asset prices at the cost of a weak dollar, or keep the dollar strong at the cost of weak asset markets — US assets, as Bridgewater argued above, “will continue to decline in value relative to those abroad”. As indicated, this adjustment process will occur either through the value of the dollar or through the pricing of asset markets.

Now, it should be clear that in any society, but especially in democracies, the necessary adjustments are less obvious and initially less painful to the people who vote when they occur through a weakening currency. This is particularly so in a country where most people have little interaction with foreign countries and where asset prices are, if not grossly inflated, then at least – by historical standards – elevated and highly leveraged.

But what if all the central banks of the world were to embark on easy monetary policies simultaneously in order to support their elevated asset prices (since all assets around the world are high)? In such an instance, there will still be relative adjustments. Assets in current account deficit countries will likely decline in value relative to countries with current account surpluses. At the same time, most financial assets (especially bonds) around the world will decline in value relative to precious metals.

So, in any kind of scenario, we should be prepared to see a continuation of the trend of the last four years, whereby US assets will continue to lose value relative to those abroad as well as against precious metals.

From an investment point of view, this leads me once again to advise our US readers to shift more of their assets overseas and into precious metals (although, right now, precious metals are very overbought). Moreover, as indicated in earlier reports, a true asset diversification can only be achieved if a portion of the assets are held by a custodian located overseas. (The same is recommended to European investors.)

Are Indian Equities Still an Attractive Asset Class?

Personally, I find the Indian equity market to be currently overheated and vulnerable to a sharp correction, which may arise from tighter international liquidity. Morgan Stanley’s Ridham Desai notes that the bubble in equities is unmistakable. According to Desai, “India’s GDP is where the US GDP was in 1964. On a per capita basis, India’s GDP is comparable with the US level in the 1930s.

In contrast, India’s stock market trading volumes are where the US markets were trading in the early 1980s. Even more stark is the comparison of trading volumes to GDP; India is where the US was only 10 years ago….” (Andy Xie, Morgan Stanley’s Asian strategist, seems to believe that India’s stock market, along with China’s H-shares and Japan’s TOPIX, are “where risk-takers have been congregating” and feels that the Indian stock market is about where the Nasdaq was in 2000.)

Still, as I have indicated in earlier reports and above, I regard the Indian economy as having the greatest potential of any emerging economy in the years to come, which should, despite these near-term concerns, amply reward long-term equity holders. (I disagree that Indian stocks are where the Nasdaq was in 2000, because, in US dollar terms, Indian stocks are only about 60% higher than in 1994.)

In fact, if a gun were put to my head and I was asked to choose between two options — putting all my assets into the US or into India — I would choose Indian equities, Indian real estate, and Indian art. The reason behind this choice is partly my strong conviction that US assets will continue to decline relative to assets overseas, and partly because I can see that India may be at the beginning of a lasting economic take-off phase.

A few years ago, I constructed a simplistic life cycle of emerging economies with different phases of economic and financial development. In economic terms, having been a regular visitor to India since 1974, I sense that the country has entered, in the last couple of years, phase one of the life cycle of emerging economies.

At the same time, I admit that its stock market is showing many symptoms of phase three of the life cycle of emerging stock markets, which always precedes a big correction or a bear market. The principal reason for my long-term optimism about Indian equities (ideally, bought 20% below today’s market prices) is that foreigners are still grossly underweight in India.

While foreign equity investments have increased considerably in the last few years, these equity investments are tiny when compared to global capital flows and global stock market capitalisation. Moreover, in terms of economic development, while India is probably somewhere near where China was in the 1980s or early 1990s, the later a country develops, the faster it can grow, as it can take advantage of all the innovations and inventions that were carried out previously by other nations. (This is particularly true since the introduction of the Internet.)

I would like our readers also to think about the impact India will have on global commodity markets and on its domestic real estate market if it really embarks on a trajectory of rapid growth à la China over the next ten years or so. India has a lower urbanisation rate than China at present (about 30%, compared to 38% in China). However, China only exceeded an urbanisation rate of 30% in 1997.

Therefore, it is entirely conceivable that urbanisation in India could also climb to around 38% in the next ten years or so, which would imply an annual migration from the countryside to the cities of more than 10 million people. That this would be favorable for the property market of Indian cities should be evident (not to mention that, as was the case for China, entire new cities would have to be built) – particularly in view of the current horrific under development of India’s property market when compared to other Asian countries. (Compare, say, Singapore with Mumbai!)

In addition, as Matt Fernley notes in his report on India, “after studying a number of economic take-off events (US 1900s and 1950s, Japan 1950s, Korea 1970s), we believe that they all share similar stages of development and similar drivers. The major earlystage driver of economic take-offs is urbanization.”

According to Matt, the usual stages of development are: “infrastructure development”, offering, in my opinion, a huge growth opportunity in India since its physical infrastructure is so poorly developed; “development of manufacturing and the export economy”, and the “take-off of domestic consumption”.

Based on these stages of development, and comparing India’s development with that of China, Matt then calculates that demand for materials will likely treble over the next ten years. So, if Matt Fernley’s growth scenario really comes to pass — and the likelihood of that happening is, in my opinion, rather high — combined with the propensity of Mr. Bernanke at the Fed to use his money printing press around the clock, I believe that another 10- to 20-year commodity bull market is highly probable.

One of my more successful friends, Robert Lloyd George, sent me recently the updated version of his original book, which is now entitled The East-West Pendulum Revisited, published by Lloyd George Management (Europe) Ltd. In it, Robert argues that “Asia is once again on the move” and that it has “replaced the United States as the locomotive of the world economy with its new spending power, its new technology and its growing capital resources”.

I find Robert Lloyd George’s book to be very interesting and easy to read. A figure that caught my attention shows how China and India’ share of global manufacturing output collapsed in the 19th century. While the figure hasn’t been updated, I estimate that, between 1980 and 2005, China’s share of global manufacturing output has more than trebled. Moreover, it is probable that in ten to 15 years the combined share of India and China will rise to over 30%. (I find the figure fascinating because it shows how changeable economic geography is over time.

As such, it is a reminder to Westerners not to remain complacent about the changes that are well under way in Asia and South Asia and which, thanks to the instant communication and efficient transportation systems we have today, could continue at an even faster pace than ever before.)

There is a last point I should like to add regarding the Indian stock market. After a base-building period between 1978 and 1985, the Asian emerging markets took off and rose by between 10 and 25 times between 1985 and 1990. The Latin American stock markets built a huge base between 1982 and 1988.

During their subsequent 1988-1994 bull markets, they rose by between 15 and 30 times (admittedly from incredibly depressed levels). So, if we consider that the Indian stock market built a huge base between 1995 and 2003 in local currency terms, but declined by 70% in dollar terms over that period (because of the weakness in the Indian Rupee, a fact that Andy Xie doesn’t take into account when comparing Indian stocks to the Nasdaq in 2000), a secular bull market that could lift the index between five and ten times (though, naturally, interrupted by some vicious corrections) wouldn’t be entirely surprising.

Vicious corrections would cool the excessive speculation on the Mumbai Stock Exchange and could be caused by a worsening of India’s current account and trade deficit, which rose last year to 0.8% and 5.3%, respectively, of GDP. (Also of some concern is the budget deficit, which exceeds 8% of GDP.)

Marc Faber
May 1, 2006

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