Sent: 14-12-2010 12:13:02
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What Have We Learned?
At the end of each year, we need to ask what we have learned. In doing so, we can decide whether we need to cast aside existing decision-making frameworks as being outmoded or use them as ongoing guideposts.
The emergence of China as an economic power, an unstable north Atlantic financial system, huge fiscal and trade imbalances, the apparent ineffectiveness of monetary policy in many advanced economies and record commodity prices are some of the economic outcomes prompting a rethink of previously held views about how economies and markets should work.
If these emergent trends are inconsistent with what has gone before, we need to develop new models and decision making frameworks before we can decide how to react. In the hiatus, investors are left potentially isolated analytically. Nonetheless, advisers could legitimately be wary about urging any action on clients before a more fully developed understanding of what is happening becomes clearly evident.
If, on the other hand, current day events are a logical extension of historical outcomes with simply a different cast of characters and on a different scale, the argument for caution is less compelling. Advisers will be doing clients a disservice by assuming a change.
During 2010, these weekly emails have frequently referred to similarities between circumstances today and what has gone before. On 9 November, for example, the article drew attention to the parallel between Australia's rise from recession in the 1990s and the current experience of the USA. Despite differences in orders of magnitude, the nature of the adjustment process appears very similar and, according to the article, some conclusions about the likelihood of a recovery in the USA can be inferred from the Australian experience.
High commodity prices stand out as a global phenomenon with a profound impact on Australian economic performance. Many have referred to a new paradigm as the source of these high prices. Yet, a model which describes US dollar denominated prices as a function of physical market balances, the U.S. dollar exchange rate and financial market liquidity conditions seems to explain outcomes just as well today as at any time over the past 40 years.
This framework suggests that prices are so high today because all three of these market drivers are acting simultaneously whereas, in the past, they were less synchronized. Tight market balances would have pushed up prices to some extent in any case. A weaker U.S. dollar would have always aggravated the rise. Strongly growing money supply - in excess of what is required for the real economy - is an ideal backdrop for speculators thriving on cheap funds.
Looking ahead, even if the physical balances stay the same, lower prices could be expected if a strengthening dollar and a cut in liquidity (higher interest rates) were to prevail. If commodity prices still rose under these circumstances, we might have the evidence to say that the model has broken down. So far, however, there is nothing to suggest a paradigm shift. Orders of magnitude may have changed but the same factors are at work as in the past.
In recent years, investment strategists have created a strong body of opinion in favour of investing in markets based on their relative GDP growth paths. An article in the ATC e-mail for 23 March 2010 suggested that the emerging market phenomenon was actually not so new.
China's race to catch up to the USA and become the world's largest economy has its parallel in the emergence of the USA itself and Britain's relative decline as an economic power.
There is less historical and analytical backing than usually realized for expecting superior returns from emerging markets. Recommendations favouring emerging markets run the risk of putting too much emphasis on the other man's grass being greener and underestimating the importance of individual company returns in established equity markets.
At a time when confidence in established markets has been more than usually shaky, this year's e-mail commentaries have tried to highlight some guideposts, such as the link between GDP growth and investment returns and the sources of high commodity prices, around which to wrap investment decisions.
By and large, the argument has had a conservative tilt: many of the guideposts that had applied in the past seem worthwhile keeping. The world has not changed as dramatically as many investors fear.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.