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Within six months global stock market performance will diverge--where do you want your money?
07/05/2010 11:30 pm EST
That’s certainly not at all clear now. Most days recently all the world’s stock markets have moved in the same direction—DOWN. On June 29, for example, the U.S. Standard & Poor’s 500 Index dropped 3.1%, Germany’s DAX Index fell 3.3%, and China’s Shanghai Composite Index plunged 4.3%.
But I think sometime in the not too distant future—somewhere in the next three to six months would be my best guess—the stock markets of the developed and developing world will start to diverge. Six months from now—or less—stocks in China, Brazil, India, and many of the other developing markets will be in clear up trends and stocks in the developed economies of Europe and Japan will still be stuck in decline. The United States will be left in the middle, straddling the divide between the two groups.
Because the underlying economies are headed in radically different directions within that time period. And where the economic fundamentals go, stocks, eventually, follow.
If I’m right, this divergence should be the cornerstone of your investment strategy over the next year or longer. And, if I’m right, how you allocate your portfolio between these two diverging blocks of economies and markets will determine how well your investments perform during that period.
Let me lay out the case for this divergence in the economic fundamentals-and stock markets. And then you can judge for yourself if I’m right or not.
The recent G20 meeting of the world’s 20 largest economies marks a good starting point for looking at the economies of the developed world.
And when we look, what do we see?
Annual government budgets that are deeply in the red. The U.S. budget deficit is forecast at 10.6% of GDP in 2010. The United Kingdom is forecast at 10.1%. Spain is forecast at 9.1%. France is at 8%. Japan at 6.4%. Germany at 5.5%.
How bad is that level of deficit? Economists estimate that a budget deficit of 3% of GDP is sustainable. Above that a country is piling up debt that it can’t repay under reasonable assumptions of growth (and manageable inflation.) In the long run that leads to falling growth rates, climbing interest rates, and finally fiscal crisis.
That’s why the final communiqué from the G20 made such a big deal of two deadlines. First, leaders of the G20 agreed that they would aim to cut their annual deficits in half by 2013 and, second, to stabilize or reduce the total government debt to GDP ratio by 2016. That’s tantamount to a call to reduce annual budget deficits to 3% of GDP or less.
The leaders of the G20 were careful not to call any of this an actual agreement or even a promise. These were goals, aims, expectations. (For more on exactly what the G20 meeting did or didn’t achieve see my post http://jubakpicks.com/2010/06/28/dobt-expect-the-bond-markets-to-cheer-the-g20-results/ )
But still, as loose as the timing in these aims is, as vague as these promises turn out to be, as good as the odds are that no country in the group will actually achieve these goals, the agreement does indeed describe a broad economic trajectory that goes like this: high-deficit developed countries will cut government spending over and over again during the next five years or so. The cuts aren’t likely to be serious enough to end the debt crisis in these economies so the total package over time will include less government spending, higher taxes, slower economic growth, and rising interest rates.
As a fuel for stocks, that’s got about as much bang as a wet squib a week after the Fourth of July. But that’s the course that countries such as France, Spain, the United Kingdom, and maybe even Germany, have chosen.
Contrast that to the path that the world’s big developing economies are headed down in the years between now and 2013 or 2016, the years in the G20 press release.
Brazil, India, China and other developing nations don’t have huge debt from the financial crisis and subsequent stimulus spending to pay off. For example, in Brazil the government deficit is currently running at about 3.24% of GDP. The IMF (International Monetary Fund) estimates that the ratio of government debt to GDP in developed economies will rise to 110% by 2015 from 91% at the end of 2009. In comparison in April 2010 Brazil’s government debt amounted to just 42% of GDP and is headed down to 30% of GDP by 2014, the Brazilian government estimates.
That’s not just the stabilization that the G20 aimed for as a goal by 2016 in its recent press release—it’s an actual decrease in the burden of government debt on the economy. And the decline in debt and the restrained spending pattern is one reason why a country like Brazil earned its first ever investment grade rating from Standard & Poor’s this year.
Not to say that the world’s developing economies don’t have problems. China has got an asset bubble in real estate and a run away money supply that threatens to send inflation soaring. Inflation in Brazil is running at better than 5.2%, way above the government’s target of 4.5%. India is facing similar inflationary pressures.
And there’s a very real possibility that measures to control inflation—interest rate increases or increases in bank reserve requirements—will overshoot and, combined with the slowdown in growth in the developed world, send economic growth rates in China, Brazil and the rest of the export-oriented economies of the developing world lower than expected. That's certainly what the market is afraid of at the moment. (For more on the current state of fear see my post http://jubakpicks.com/2010/07/01/markets-get-spooked-now-that-china-is-delivering-exactly-the-slow-down-they-wanted/ )
But look at the very different nature of the problems facing the developed and developing groups. Too little growth and the possibility of even more slowing in the developed world versus too much growth and the possibility of a stumble as governments there try to keep growth under control.
And look at the very different time frames for working out those problems.
In the developed economies we’re looking at a very long, slow grind back to fiscal stability. Years. 2016. Even if politicians and voters decide to take the pain that doing what’s necessary will entail.
And in the developed economies we’re looking at a very real possibility that in the time period I’m talking about—now through 2016—things will get worse before they get better. More unemployment. Slower growth. Goodies like that.
And that’s not even considering the very real possibility that we’ll all—politicians and voters—decide to shirk the hard work and opt for the easiest short-term solutions. That puts us in the developed world in a truly horrible position to face the really big problems that will arrive by 2030 when an aging population catches up with all of the world’s major economies (with the exception of Brazil and India where demographics don’t get nasty quite so quickly.)
In the developing economies, we’re looking at relatively short-term risks of lower than projected growth, the bursting of an asset bubble or two, and higher interest rates. But the worst of that will be over by the beginning of 2011 in all likelihood.
Brazil, for example, looks like it will stop raising interest rates in 2010. (For more on how this schedule is playing out in Brazil see my post http://jubakpicks.com/2010/06/29/looking-for-good-news-today-try-brazil/ ) India too. China is well on the road to refinancing its banking system (using techniques for burying bad debt developed in the late 1990s to fix the excesses of the Asian currency crisis). If not this year, then next. And that will put worries about a real estate bubble to rest. (For more on why China might really be broke—if the accounting were honest—and how China plans to bury the problem see my post http://jubakpicks.com/2010/03/12/despite-those-huge-reserves-china-could-be-gasp-broke/ )
In other words developing economies still face pain but it’s short-run pain. And it’s likely to be over by the end of 2010 (or sooner in some cases).
So by the last quarter of 2010 the world will look like this, in my opinion:
In the developing economies, promising signs that worries about slower than expected growth can be put to rest, an end to interest rate increases, and increasingly solid-looking government finances (at least relatively.)
In developed economies, worries that growth is still very slow—so slow that a slide back into recession remains a possibility—and a background of budget cutting and rising deficits (as the budget cuts turn out to be less than advertised as they always are.)
The United States will fall somewhere in between the two groups although obviously much closer to the developed economy track., The Obama administration hasn’t yet drunk the Kool-Aid of budget cuts ala Germany and the United Kingdom but Congress isn’t likely to pass any more stimulus. And I doubt that the administration will be able to avoid major budget cuts, even if economic growth is anemic, after 2011. So the United States might grow more strongly than the rest of the developed world in the near term but eventually it too will have to deal with its fiscal mess.
Now like biology, macroeconomics isn’t destiny. But I’d sure much rather have my money in stocks with the fundamentals of developing economies behind them than in stocks with the fundamentals of developed economies stacked against them.
See a hole in that argument? If not, you know where to put your money once the sell-off in global stocks is complete, and developed and developing stock markets start to diverge.
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