From an international investment point of view, the US has some fundamental strengths that give it an advantage over other major economies:
– It has the cohesion that comes from being one nation with one language, a single legal system and a powerful central government, unlike Europe with its divisions and rivalries.
– It has much greater actual and potential domestic demand than Japan, with its static and ageing population; it has transparency, minimal discrimination against foreigners and the intellectual vigour that comes with an open society, in contrast to China.
– It has the freedom-of-action that comes from its superpower status, with the global dominance of its currency, international trade flows and armed forces.
– And Americans have a gung-ho, can-do mentality that, as a South African, I always find a refreshing contrast to attitudes of most other nations. All this suggests that international investors will continue to favour US assets as the global recession gathers pace, as they have done for many years.
So what are the threats to that scenario?
The first is a sharp rise in long-term interest rates in America relative to those on offer with equivalent risk elsewhere. This could happen if foreign central banks and other foreign investors cease to pour money into Treasuries and other low-risk bonds.
However, it is now clear that the Americans are prepared to use aggressive money-creation policies to prevent Treasury yields rising until the deflation dragon has been slain. If foreign buyers do go on strike, the ‘printing press’ will replace them. (Apparently, buying up government bonds in this way with created money is called ‘hard monetarism’, although I would think investment strategist Christopher Wood’s description ‘monetary terrorism’ would be more appropriate).
Second, a collapse in the dollar. This could come about if foreigners lose their enthusiasm for subsidising American consumption – sending their capital to cover the country’s foreign trade deficit – for any reason.
Ironically, if the Americans are successful in stemming the downturn and economic recovery begins, there will be a huge inflation risk. That will pose an immediate and terrible threat to all holders of traditional bonds.
Professor Willem Buiter of the London School of Economics, predicts “a global dumping of US dollar assets” that will happen “before long (my best guess is between two and five years from now).”
Although the US government is not likely to be worried about some weakening in the dollar, a collapse would be another matter. History suggests that the American authorities could react very nastily to such a development, even going to extremes such as imposing a freeze on foreign-owned assets in the US.
Other currencies will have their own problems as governments struggle to prevent exchange-rate appreciation worsening their own economies, and having less freedom to ignore the perceptions of international investors.
Britain, Australia and many emerging economies are likely to find they have no choice but to keep their real interest rates relatively high (or raise them), so they can attract foreign capital. Otherwise they will face seriously disruptive domestic inflation driven by the collapse of their currencies.
‘Sovereigns’ (government bonds) are likely to remain attractive for a while, despite abundant supply, central banks’ ultra-low policy rates, global lack of confidence in any except the safest assets, and high risks in corporate bonds because of deflation-driven corporate collapses.
That will change when the markets clearly signal the return of inflation.
Does this mean that gold will become a more important alternative asset of choice? Almost certainly.
Gold has reasonable defensive characteristics in seriously troubled times – and best of all in times of extreme stress.
Its price could well continue to trend lower in the immediate future because of dollar strength, absence of inflation risk, weaker demand for gold jewellery and further distressed selling.
If that happens, it will offer a good opportunity to accumulate more gold in your global portfolio.
If things go seriously wrong in the world economy, governments are likely to view gold as a dangerous competitor to their increasingly discredited fiat currencies. That would suggest eventual co-ordinated central bank action to drive down the price, and perhaps even outlawing of private gold ownership, as the US did in the 30s.
Private investors may take the view that physical metal (bars and bullion coins) could be preferable to gold-backed paper, where they are able to hold the metal securely… and secretly.
• This article is taken from Martin Spring’s On Target, a private newsletter on global strategy.