Thegreatenigmaunveiled

2007wasaverytrickyyearindeednotsomuchthefirsthalfwhichofferedmostlyfairweathersailing;however,thesecondhalfremindedmeofwalkingthroughaminefield(notthatIhaveactuallytriedit,butlet’signorethatfornow)。

Tome,thegreatestenigmaof2007wastheresiliencedemonstratedbyglobalequitymarkets。

AsthewheelscameoffvirtuallyallpartsofthecreditmarketsbackinJuly,oneofthesurestbets–orsowethought–wastheimminentdemiseoftheequitybull。

Ithappenedeventually,butittooksixlongmonths。

Now,withthewoundswideopenafterfourweeksoffallingstockmarkets,itistimetoreflect。

Largesumsofmoneyhavebeenlostinrecentweeksandevenlargersumsofmoneycanbemadeinthemonthstocomeifonecanreadthesituationcorrectly。

Wehumanstendtobehavelikesheep,though。

Wheretheleadergoes,theflockwillfollow。

Havingsaidthat,thebiggestfortuneshavebeenmadenotbysheepbutbyinvestorspreparedtowalkwheretheflockwouldnevergo。

Wehaveidentifiedanumberofinvestmentthemeswhichwebelievewilldefinetheinvestmentyear2008。

However,wecannotpromiseyouthatother,moreimportant,issueswillnotsurfaceduringthecourseoftheyear。

Investmenttrend#1:bankcrisistorunandrun

Let’sbeginourlistwithwhatwebelieveisthemostdelicateproblemtheworldhasfacedforyears–thebankingcrisis。

Wepredictthatthecrisiswhichhasengulfedlargepartsoftheworldinrecentmonthswillrunforlongerthanmostpeopleimagine。

Therearetworeasonsforthis。

Firstly,thereisnowclearevidencethatthecreditproblemsarespreadingwellbeyondsubprimemortgages。

Primemortgagedebt,creditcarddebt,autoloansandcorporatedebtcouldallbehit–andnotjustintheUS。

Thisisfastbecomingaglobalcrisis。

Sadly,itisallafunctionofgreedbecausemoneywastoocheapfortoolong。

Arewrite-offs‘managed’?

Secondly,wesuspect(buthavenoproof)thatconventionalaccountingstandardshavebeensuspendedinanumberofcases。

Ifbanksweretofollowstandardpractise,baddebtswouldbewrittenoffassoonastheywererecognised。

However,wehearfromwellinformedsourcesthatactuallossesfarexceedwhathasbeenwrittenoffsofar。

Sinceitisinnobody’sinterestthatoneortwoofthelargestfinancialinstitutionsintheworldkeelover,somebankshavebeengrantedpermissionto‘manage’theirwrite-offs,allowingthemtimetoraisefreshequitycapital。

Ifthisiscorrect,bankswillcontinuetowriteoffbaddebtsfortherestof2008andpossiblyinto2009。

Investmenttrend#2:recessiontospread

Partlyforthatreason,wepredictthatitwon’tbelongbeforeahostofcountriesotherthantheUSfacetheprospectofrecession。

Infact,itisconceivablethattheUSmightjustescaperecessionasitistypicallydefined(twoconsecutivequarterswithnegativeGDPgrowth),whereasanumberofothercountriesmayhavealreadybeensuckedintoit。

Furthermore,theU。

S。

equitymarkethasnowlargelydiscountedarecessionbasedonvarioussentimentindicators(seeanexamplehereofinchart1)。

Unlesstherecessionturnsouttobemuchmoreprolongedand/orseverethangenerallyexpected,muchofthedamageinUSmarketsisprobablydoneatthispointintime。

Chart1:%ofStocksonNYSETradingAboveTheir200DayMovingAverageSource:FusionIQ

IsJapanalreadyinrecession?

Notsoinotherpartsoftheworld。

WhereasUSpolicymakersarebusyaddressingtheproblemsconfrontingtheUSeconomy,manyEuropean(andtosomedegreealsoAsian)leaderscontinuetobeindenialanddonotseemtohavenoticedtherapidgatheringofstormclouds。

LeadingrecessioncandidatesincludeJapan,whichisverydependentuponexportstokeeptheeconomyafloat。

Astrongyencombinedwithslowingexportmarketsisadeadlycocktail。

Meanwhile,theJapanesehousingsectorisweak,albeitnotforthesamereasonsasintheUS。

Itis,infact,quitelikelythatJapanisalreadyinrecession。

Singapore,SpainandtheUK?

AnothercountrycurrentlyflirtingwithrecessionisSingapore。

GDPactuallyturnednegativeinthefourthquarteroflastyearandrecentbulletinsfromSingaporesuggestnoimprovementintradingconditions。

InEurope,Spainassumesthedubiousroleasbeingthemostlikelycountrytoenterintorecessionfirst。

Withalmost20%ofGDPcomingfromconstruction,theSpanisheconomyisinaleagueofitsownintermsofbeingexposedtotheslowinghousingmarketwhichisrapidlyturningintoaglobaldisease。

TheUKcouldbethenextinline。

TheUKhousingsectorisstartingtoshowsignsofindigestionandlet’snotforgetthatthecurrentcrisisisfirstandforemostabankingcrisis。

OtherthanSwitzerland,nocountryintheworldismoredependentonthefinancialservicesindustrythantheUK。

USstockslikelytooutperform

Tosumupitup,whereastheUSmayberesponsibleforputtingtheworldintothemessitcurrentlyfindsitselfin,therestoftheworldmayendupsufferingmore。

Itwon’tbethefirsttimethathashappened。

Blessedwithmoreflexiblelabourandmoneymarketsthanmostothercountries,theAmericanswillprobablydealmoreswiftlywiththeproblemsfacingthemthanmostothercountrieswillbeableto。

ForthisreasonwepredictthatUSstockswillactuallyoutperformmostothermarketsthisyear(withthepossibleexceptionofemergingmarketswhichtraditionallyarehighlycorrelatedwiththeUSmarket)。

Investmenttrend#3:USsavingsratiotorise

Thedramaticslowdownineconomicactivityandfallinpropertyandequityvalueswillhaveanotherimplication。

Inordertounderstandhowthingswork,let’sre-visitachartproducedbyoureconomicadvisor,Dr。

WoodyBrock。

Woodyhasmaintainedforawhilethat,overthelongrun,assetpricescannotgrowanyfasterthantheunderlyingeconomy。

IntheUnitedStates,thehouseholdnetworthtoGDPratiohasaveraged3。

4timessince1950and3。

6timessince1981。

Now,witha25yearequitybullmarketbehindus,assetpricesarewellaheadofeconomicfundamentals,notjustintheUSbutglobally。

WhatneitherwenorWoodycantellyouishowlongitwilltaketounwindtheexcessesbuiltupsincethemid1990swhentheratiowentdecisivelyaboveitslongtermmeanvalue(seechart2)。

However,judgedbytheseverityofthesell-offinequitiesoverthepastthreeweeks,wecouldverywellbebacktothelong-termaveragewithinafewweeks!

Chart2:Mean-RevertingDynamicsofNetWorthSource:StrategicEconomicDecisions,Inc。

Shoptillyoudrop

Jokingaside,manycommentatorshavelongmaintainedthatitisintheDNAofAmericanstoconsumeandthatthepropensitytoshopisessentiallytherootoftheAmericaneconomicproblemtoday。

ThepointoftenmissedbythecriticsisthatAmericanshavehadnoneedtosaveinrecentyears,asrisingpropertyandequitypriceshavedonethejobforthem。

Nowwiththeretirementsavingsdwindlingbytheday,manyAmericansarefacedwithtwooptions–eitherworkafewmoreyearsbeforeretiringorstartsavingbyconsumingless。

Wethereforepredictthat2008willlikelybetheyearwherethetrendoffallingsavingsratiosintheUnitedStatesfinallyreversesitself(seechart3)。

Americanswillstartsavingmoreoftheirincomenotbecausetheyhavesuddenlylosttheirappetiteforconsumptionbutbecausetheyhavetounlesstheywanttospendretirementinpoverty。

ThishasprofoundimplicationsfortheUScurrentaccountandthereforealsoforthevalueoftheUSdollar(moreaboutthedollarlater),aswellasthestockmarket。

Source:StrategicEconomicDecisions,Inc。

Investmenttheme#4:dollarsv。

euros

NextonthelististheUSdollar。

WepredictthattheUSdollarwillsurprisemostinvestorslaterthisyear–bystartingtoappreciateinvalueafteryearsofdepreciation。

Therearethreereasonsbehindthisboldprediction。

Firstly,astheUSislikelytobeamongstthefirstcountriestoenterrecession(orsoitlookslike),itisequallylikelytobeaheadofmostothercountriesasfarastheinterestratecycleisconcerned。

Thiswillstarttoworktothedollar’sadvantagelaterthisyear。

Thetradedeficitisimproving

Secondly,thetradeimprovementisinfullswing。

Althoughithasgonelargelyunnoticed,theUStradedeficithasimprovedsignificantlyinrecentquarters(seechart4below)。

ThelatestUSGDPreportwaspublishedearlierthisweek。

ItshowedthatexportsmadeanetcontributiontoUSeconomicgrowthof0。

55%inthelastquarterof2007。

ExportshavenothadsuchapositiveeffectonUSgrowthsince1991。

Assumingthetrendcontinues,itwillprovidestrongsupportforthedollarlongerterm。

Chart4:USTradeBalanceSource:GaveKalResearch

Theeuroisinherentlyunstable

Thirdly,wearebecomingincreasinglyconcernedaboutthefutureprospectsfortheeuro。

2008couldverywellbetheyearwhereitsrobustnesswillbetestedforthefirsttime。

TheEuropeanmonetarypactisinherentlyflawed。

Macroeconomicconditionsacrosstheunionaretoouneventomaketheeuroworksmoothly。

TheECBhasmanagedtogetawaywithaflawedconceptforanumberofyearsbecauseeconomicconditionshavebeentoobenigntoseriouslyunderminethestructure。

However,witharecessionlooming,theappetiteforharshmeasuresamongsttheweakercountrieswithinEurolandwillbetestedforthefirsttime。

PerhapsthatiswhythespreadbetweenItalianandGermangovernmentbondshaswidenedtoanalltimehighofabout35basispointsrecently。

Forthatreasonweexpectaeurocrisisatsomepointinthenextyearortwo。

Thatwillobviouslybenefitthedollar。

Theonlycaveatwithrespecttoourdollarforecastistheneartermvisibilitywhichisverypoor。

Itisquitepossiblethatyoumayhavetowaituntilthesecondhalfofthisyearbeforetheuptrendisestablished,andtherecouldverywellbemoredownsideriskintheinterim。

Investmenttheme#5:bondsv。

commodities

Movingswiftlyon,webelievethereisaseriousdisconnectbetweenbondpricesandcommodityprices。

Monetaryauthoritiesaroundtheworldarefacingaclassicdilemma–dotheyfocusonthebankingcrisisandsteepentheyieldcurveinordertoimprovetheoperatingenvironmentforbanksordotheypayattentiontothenagginginflation(whichjustwon’tgoaway)andkeepratesstabledespitetheweakmacroenvironment?

Arebondyieldstoolow?

Marketparticipantshaveuntilnowassumedthatinflationarypressureswillgraduallyfadeawayastheglobaleconomylosesmomentumand,ifhistoryprovidesanyguidance,thatisindeedthecorrectassumptiontomake。

However,manyaspectsoftheglobaleconomyaredifferenttodaywhencomparedtopriorrecessions。

Mostimportantly,wefaceglobalcompetitionformanycommoditiestodayaphenomenontheworldstillhastoadjustto。

Chart5:USInflationExpectations

Source:TheCapitalSpectator

Lookingatchart5,inflationexpectations(theredline,definedasthedifferencebetweentheyieldon10-yearTreasurybondsand10-yearTIPS)havebarelychangedoverthepastyeardespitethefactthatinflationhasactuallyrisenafairbitanddespitecontinuouslyhighcommodityprices。

Somethinghastogive。

Eitherbondyieldswillhavetoriseorcommoditypriceswillhavetocomedown。

Orboth。

Makeyourpick。

Investmenttheme#6:sovereignwealthfunds

Let’sfinishwherewebegan–withthebankingcrisis。

Theso-calledsovereignwealthfundshaveplayedapivotalroleinthecrisisbyprovidingfreshequitycapitaltobanksinneed。

Sovereignwealthfundsarefundscontrolledbyvariousgovernmentorquasi-governmentinstitutionsaroundthewordwherevastamountsofmoneyhavebeenstackedawayasaresultoflargebudgetsurpluses(oilmoney,etc)。

Duringthepastfewmonths,asthebankingcrisishasunfolded,thesefundshavecometotherescueofmanyacrisishitbank。

Asyoucanseefromchart6,despitehavingcoughedupwellover$100billioninordertorescueCitibank,MerrillLynch,UBS,etc。

thisislittlemorethanpocketmoneyfortheseextraordinarilywealthystateownedfunds。

Chart6:TotalAssetsinSovereignWealthFundsNow,wepredictthat,beforethiscrisisisover,thesefundswillincreasinglybeperceivedasthethievesofundervaluedUSassets。

Asthingsstand,USbanksandpolicymakersalikecanhardlyaffordtoalienateanyoftheseknightswhohavecometotherescueatatimewhenquiteafewlargereputablebanksarelookingintotheabyss,buttherewillcomeadaywhenforeignerswillbeaccusedofhaving‘stolen’UScorporateassets(memoriesareshortinthisbusiness)。

Tooearlytobuybankstocks

Sincewepredictthatmostlargebankshavemorewrite-offsinthepipeline,therisktoinvestorsisthattherelationshipbetweenrescuersandbanksturnsourbeforethismessisover。

Thebanksneedthefunds。

Therearenottoomanyinvestorsyoucanapproachfor$10billionormoreoffreshequitycapital。

However,inaUSelectionyear,withabunchofnarrow-mindedcongressmendesperatetopleasethemanonthestreet,wewouldn’tbetagainstthisturningintoahotelectiontopicwiththeshareholdersofthebanksbecomingtheinevitablelosers。

Putslightlydifferently–itisstilltooearlytopickupbankstocks。

Conclusion

Addingitallup,wepredictthatitwillbeatrickyyearbutalsoayearthatislikelytoendonamuchmoreupbeatnotethanitbegan。

USdollardenominatedassetswill,tothesurpriseofmanyinvestors,performbetterthanmostotherassets,andtheeurowilldisappoint。

Commodities(withthelikelyexceptionofagriculturalcommodities)couldquitepossiblyhaveasurprisinglyweakyear。

Socouldbonds。

Enjoytheyear。

Theonethingwecanguaranteeyouisthatitwillnotbeboring。

ByNielsC。

Jensen,chiefexecutivepartneratAbsoluteReturnPartnersLLP。

TocontactNiels,email:njensen@arpllp。

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