2009 Global Market Forecast

December 31, 2008 · Posted in Strategic Insight · Comment 

As investors it is important that we take stock periodically of the major themes that are influencing the global investment environment. These themes represent the strategic rather than the tactical. They address the major forces that are present and that are expected to influence the prices of financial assets but they do not provide the tactical guidance of when and how a trade should be initiated or closed. Nonetheless, it is critically important that investors in the global economy understand the broad spectrum of forces that are in-play allowing themselves to anticipate tactical situations and understand when a change leads to risk or opportunity.

The following is my strategic overview of the economic, financial, political, and international security forces that I anticipate will be drivers in the coming year. The list is inherently incomplete as I am fallible. What is not on the list can kill us if we are not careful but what is on the list can set us up for substantial profits if we remain alert.

The report begins with an overview of my key market trades and economic views for the coming year followed by in-depth analysis.

Market Overview:
1) Long S&P into January in anticipation of an early year, sharp and short rally. Once evidence of a peak is seen go to cash in 401k and look for potential short on S&P. Whether we short or not will depend on how the market behaves and how the news is evolving. Short S&P through ETFs such as SH or SDS.

2) Long agricultural commodities through RJA and adding to positions in first quarter on weakness

3) Short US dollar (UDN), long Australian dollar (FXA), add to positions on weakness

4) Look for evidence of a peak in the bond bubble and short US bonds. This is a major bubble and should present an excellent opportunity for shorting. Short using an ETF like PST.

5) Look for entry points in oils, coal, industrial metals, and Chinese markets as the year progresses. This is the year to establish core holdings at rock bottom prices in these areas. Key ETFs to consider: RJN, RJI, PKOL, FXI, GXC, PGJ

Economic Overview:
1)    Expect inflation to become ascendant due to the extreme volumes of currency being pumped into the system by the Fed and other central banks – this will torpedo bonds
2)    The dollar will drop substantially as capital moves away from America – this will impair the equity markets and any recovery
3)    Unemployment will rise substantially, likely above 9% and possible above 10%
4)    The US equities market will make new lows. Predictions of 500 on the S&P are not impossible

Fundamental Global Economic and Financial Themes

US economy:
The US economy will weaken substantially during 2009. This weakening will be highlighted by corporate failures, corporate bond defaults, further failures and unanticipated blow-ups in the financial sector, defaults at the state and municipal level and unemployment rising well past 8%. Jim Rogers and Nouriel Roubini each put forth some interesting views on the years ahead.

Analysts will be surprised repeatedly at how bad it gets just as they have been continually surprised at the violence of the crisis so far. This “continuing surprise” stems from two sources, the first is the overwhelmingly US-centric/stock-market-centric view that 98% of US analysts and financial media have – they simply are blind to inter-market and international market forces. The second is the tendency to expect a reversion to business as usual. During the 1990’s and early 2000’s we saw the market come back quickly, often with Greenspan intervention. I note today that even the formerly most bearish commentators who have now seen their giddiest fears realized seem to be of a mind that “well we got that over with now things will get better”.  I think this ignores the fact that we have done deep structural damage to the economy and international financial structure that will take much longer to fix. I also think it assumes that all the shoes have dropped – I’m quite sure they haven’t.

Though I anticipate a bear market rally in US equities in January it will be short lived followed by further significant weakness. Despite the raft of analysts who are now seizing on any bit of good news to say that the next bull market has started or that 2009 will be better, I do not believe we have hit bottom yet. Most analysts look only at their sector or at the US in isolation. In the current crisis and in this interconnected world, looking at the US in isolation is a recipe for financial disaster.

US equity weakness will be fed by poor corporate earnings, the above mentioned failures and defaults, a collapsing consumer base, continued de-leveraging by funds as redemptions again take hold in the first quarter, and a complete lack of trust in US financial assets.  As I write this the net flow of foreign money into the US has ceased. The flight to US treasuries is being driven by domestic money and domestic funds. It is only a matter of time before that flow reverses and we see net foreign and domestic outflows of cash from the US to just about anywhere else. This will drive the US dollar substantially lower and will in the process drive interest rates up.

The US Government financial position will be seen to deteriorate sharply adding to the dollar weakness and the flight of capital. The Fed is in the business now of printing money, executing a strategy of “quantitative easing” which means buying US bonds (with the money the are printing), and loaning banks money with dodgy assets as collateral (note that the European Central Bank is doing the same thing and will experience equally destructive results). This next year will see a clear tension between the Fed’s quantitative easing driving rates to zero and the dollar’s trajectory. Economic stimulation and quantitative easing will have the unintended consequence of driving investors out of the US market prolonging and deepening the economic recession and the bear market in equities.

Ultimately this strategy destroys the credit worthiness of the country. Our national debt will rise significantly beyond the current levels as the stimulus packages, there will be a series of them, add to the debt while having less impact than hoped for. For years the US, the world’s richest nation, has been accumulating the wealth of the remainder of the world through the financing of our current account deficit. Foreign cash has funded our dollar, stock, and bond markets. Even during the 1990’s dot com bull market there were a number of years when the net new money coming into the stock market was foreign, not domestic. We glibly think that somehow we earned our prosperity. Certainly we earned much of it but we also borrowed and leveraged much of it. The realization over the next few years will be how little the US actually has relative to what we thought we had.

Faith in our financial position is also undermined by the galloping lack of faith the world has developed in our political leadership. Free market capitalism and especially the paradigm that markets are self-regulating has been called into question. At best we can say that a market can self regulate, i.e. is inherently stable, for a period of time but letting the markets regulate themselves has been shown to be a complete failure. Other nations, especially developing ones now look on our free market ideologies as a bad joke and one that they are paying the price for.

This destruction of our economic credibility will impact globalization as well. I am a believer in the power of global trade but we have not globalized in a manner that has proven the case to the rest of the world or indeed, even to our own workers. Expect that there will be an assault on free trade and an increase in protectionism from both the new administration and from foreign countries. Be aware also that the introduction of protectionist laws is widely regarded as being one of the key failures that led the 1929 stock market collapse to turn into the Great Depression.

The destruction of the US fiscal position and the coming dollar collapse will have a significant, negative impact on our national security posture. A military as large and expensive as that of the US that relies on military bases in foreign lands and force projection around the globe will be hard pressed to fund it’s activities with a depreciating currency and explosively rising debt. A major foreign military challenge during he next few years must be avoided. Failure to do so could set us up to fail militarily due to economic factors and further weaken our position in the world.

The severe recession in the US economy coupled with the expected collapse in the dollar will put heavy pressure on exporting nations such as China and Japan and will cause unwelcome rises in foreign currencies for Japan and Europe.

To a degree never before seen, China is key to how this global economic crisis works itself out. If China can keep domestic activity strong and take up the slack of the contraction in their export economy then they will be able to weather the storm well and continue to provide strong demand for global commodities and for imports from other Asian economies. If on the other hand their economy heads south, the Chinese government will be dealing with a number of serious issues.

First among these will be the threat of civil disturbances as unemployed workers take to the streets. China has been struggling for some years now with increasing peasant and worker unrest. This has largely been confined to the rural areas but a significant downturn in the economy could easily bring unrest into the major cities. Such a challenge to the Chinese regime would be met with force, which could in turn lead to widespread social conflict. It is in no ones interest for China to become internally unstable so my hope is that the strong domestic Chinese economy scenario plays out but I have insufficient information to handicap the odds.

As the US dollar falls other currencies will rise. Foreign exchange is a zero sum game. Further rises in the Euro and the Yen are likely but un-welcomed by their respective economies. Both economies are struggling now; an appreciating currency is the last thing they need. Consequently, look for both the Bank of Japan and the European Central Bank to intervene periodically in an attempt to slow the rise of their currencies. Also look for some of the other smaller, but better managed countries to see rapid appreciations of their currencies as capital flight from the US looks for a home. Likely candidates for significant upside this year include the Swiss Franc, Australian Dollar, and the Canadian Dollar.

The international situation is the wild card as always. In the following I will discuss a number of key situations to be mindful of.

Russia
Russia appears to be in for a bad time economically. Russia has been on a path towards significant anti-Western, anti-American nationalism for some time and has shown itself willing to take international military action to bolster its self-image and interests. Vladimir Putin enjoyed wide popularity as President when the standard of living was growing and oil revenues were high. Now, as Prime Minister he is facing his first real test in an economic crisis and is being found wanting. Doubts arose during last summer’s oil price spike that Russian oil output had peaked largely due to poor maintenance and lack of investment. Russia’s joint venture with BP is a shambles of political infighting, which has, on occasion, dragged in the Russian and UK governments directly. Russia has devalued the Rouble in incremental steps multiple times since the crisis began (after Putin stated that there was no crisis) and is expected to continue devaluations in the New Year. The government’s “rainy day” fund built up from oil receipts has been drained by over 25% in three months in attempts to shore-up the ruble. Unemployment is rising. Anecdotal evidence that the whisper mill has started vis. Putin has to go. Last week there were demonstrations in Vladivostok against a luxury car tax. The shipyards there handle the imports. Of significance is that it was riot police from Moscow, as opposed to the local authorities, that came to “restore” order. Former Soviet President Gorbachev in a rare public statement said that meant the locals were not following orders. Investors also need to keep in mind that Russia has a demographic time bomb ticking. Their population is dropping. It is projected that within about 10 years they will no longer have the conscripts to fill their army. Finally, we see almost weekly evidence surfacing of a continued assault on democracy and the rule of law.

Investors need to keep a close eye on Russia and on Russia’s relationship with the west.  Social disturbances in Russia or further military adventures could cause oil shocks. I do not recommend investing in Russia.

China
As stated above China is key in how the international credit crisis plays out. China’s ability to keep it’s domestic economy running full tilt and absorb the slack from the export economy will play into the commodity, currency, and international security situations. I do not believe they will be able to do it. While the domestic economy will likely continue to run hot and while the central government will pump stimulus into the economy it is unlikely that will prove sufficient to absorb the excess workers from the export industry. Indeed, as I write this, I have just read a report that claims mass numbers of workers are migrating out of the industrial coastal areas and back to their villages due to the global downturn.  This has the potential to exacerbate the social unrest emerging in the villages.

So what does hat mean for world markets? I believe that China will continue to be a solid market for commodities this year, energy and metals specifically as well as agriculture as it seeks to keep it’s domestic economy growing and likely level loads the refineries and smelters to keep them running in anticipation of the eventual upturn. This will put a floor under prices but will not cause such demand that price appreciation will occur in those commodities (agriculture’s aside). That will also keep the commodity price appreciation low the start of the next upturn. China can buy cheap now and stockpile waiting for the future.

Of concern though is the currency. As the US dollar falls China will be under increasing pressure to support their export industry by devaluing the Renminbi. China’s currency valuation has been a sore spot for years between Washington and Beijing. China has been allowing a gradual appreciation of the currency for some time now partly in response to US and Western pressure and party for their own reasons. Tensions could increase substantially if China were to embark on a course of devaluation while the US and Western Europe are attempting to get their financial mess in order and jump start their economies. Investors need to watch for trade friction developing on this front.

Also with respect to China we need to consider what the global crisis and attendant export market retrenchment will mean to China’s purchases of US debt. While I do not foresee a mass selling of US debt, no country, China included, wants to hold significant reserves of a depreciating currency. Further, the drop in exports means that foreign currency earnings will be down substantially. That tells me that we will see substantially less support for new US debt from China going forward (note much the same can be said for Japan). As those two nations account for the largest purchasers of US sovereign debt the Fed’s quantitative easing will require more money printed to buy more of our own debt. The days when the rest of the world could be relied upon to finance our errors look to be ending.

As for investing in China watch the Shanghai stock index, the US dollar, and commodities.  Looking at the Shanghai composite SHGIDX (you can get plots of all of these on CNBC – Markets – World Markets) it looks like it has flattened out into a bottom. Volatility has dropped and the motion appears to be fully sideways. Looking at the Hang Seng in Hong Kong, it looks almost identical to the S&P.  The Shanghai will show more of the local activity while the Hang Seng has more international participation. Keep an eye on these and invest slowly when you see solid signs of a new bull starting. I agree with Jim Rogers that investing in China now is like investing in the US in 1907.

Industrial commodities form a natural China play.  I do not see world demand lifting the energy and industrial metals markets significantly this year. A war in the Gulf/Middle East, internal or external conflict with Russia or other political event that chokes or threatens to choke supplies will cause a spike in oil. Instead, I see this year as the building year to acquire positions in the oils, coal, and industrial metals at bargain basement prices in anticipation of the recovery and in anticipation of the supply shocks that are coming due to inadequate investment and natural diminution of reserves. The credit crisis, by cutting economic activity and making it impossible to finance production expansion is now making the supply shock inevitable. When we come out of this crisis China will again be the world’s big consumer of raw industrial materials. Use this year to get those positions in-place. I will say more about this in an upcoming Strategic Insights post.

Both China and India, and indeed much of the developing world will still see a strong demand for agricultural products this year. Last year’s price spikes dissipated in the face of bumper crops in many areas and record acreage plantings. We can count on a few factors to change that picture this year. First the global credit crisis will cause restrictions on credit available for financing food production. Everything from loans for seed and fertilizer to loans for farm equipment to acres planted will be affected. Even in the US initial indications are that less acreage will be planted this year than last.

Secondly, last year saw excellent weather conditions. While we could get similar conditions this year globally it is less likely. Severe weather phenomena are also going to start entering the equation on a more regular basis. This cannot be counted on in any given year but over time the impact is certain to show. Agricultural commodities showed the same collapse in 2008, as did the oils and industrial metals. They have since bottomed and begun to turn up while the oils and metal are only starting to show signs of stabilizing at a bottom.  As I have stated in my weekly posts, I recommend taking positions in the agricultural sector through RJA as means of addressing an index of the actual commodities as opposed to specific companies whose stock price can be influenced by other factors.

Pakistan and India
Pakistan is probably the most dangerous country in the world with respect to what could happen if Pakistan goes wrong. The nation has struggled since inception with what Pakistan really is. The de facto conclusion is that Pakistan exists for the Pakistani army to uphold Islam and to be the anti-Indian. There is a saying that most states have an army, Pakistan is an army that has a state. Nothing that happens internationally involving Pakistan happens without Pakistan viewing it in the context of their strategic competition with India. Some years ago I attended a luncheon in Houston for senior members of the Pakistani diplomatic corps. What struck me was that they all had an overwhelming sense that war with India was inevitable, and I mean a major war, and that Pakistan would lose. That is not the mindset that one wants a nation with nuclear weapons to have.

Kashmir remains the flash point between the two rivals and is the prime excuse given for Islamic terrorism originating in Pakistan and directed at India. The terror attacks in Mumbai have heightened tensions. This is not helped by a general conviction in India that “Pakistan must be punished”.

Pakistan has lost virtually all control of the tribal areas bordering Afghanistan. Indeed, major fighting with the Taliban has occurred within a few hours drive of the capital. The Pakistani Intelligence Service – ISI created the Taliban so there is some Franensteinian irony in the current situation. However, the Pakistan government remains weak. Their new Prime Minister is making valiant attempts to get the army and ISS under civilian control and re-take control of the countries borders but he has limited control in the face of external threats. Until he is successful though, Pakistan represents a serious threat to world peace should he Taliban prove ascendant and a serious threat to India’s prosperity should war break out.

I have written a detailed analysis of India fairly recently. Suffice it to say that my view of investing in India has only hardened. Since that article we have seen the continuing evidence of major Indian International corporations running into difficulties. Overreaching growth and poorly thought-out acquisitions – like Tata motors buying Jaguar – are throwing light on the weakness of the Indian economy and corporate structure. Remember, it s a country of 100 million consumers and 900 million in abject poverty with an active Maoist insurgency and Islamic terrorism.

Investor’s also need to keep in mind that India has been sanctioned multiple times in the past for military actions – everything from testing a nuclear weapon to war with Pakistan.

While India may hold great opportunities at some point I do not believe hat point is now. Stay clear.

Brazil
I will say up front that I have done no real research on Brazil yet but the country intrigues me. It used to be that their economy was a shambles with currency crises, massive devaluations and bond defaults occurring every few years. Now things seem a lot more stable. Their economy has converted largely to ethanol but using a process that does not impact the food supply and is rumored to be much more energy efficient than that used in the US. Having managed that conversion they then go and find massive oil deposits in deep water off their coast! I get a sense of a country that could really come into their own internationally in the next few years.

Brazil is worth keeping an eye on. I don’t have a financial position at the moment but have resolved to do a lot more investigating in the next few months. This could turn out to be a significant commodity play for the turn around in both oils, agricultural, and minerals. Look for a post on this in the future.

Middle East and Iran
Middle Eastern economies are encountering difficulties due to the oil price collapse and the credit crisis. We have seen the first big deal canceled by Kuwait this week as they ditched their joint venture with DOW Chemical. There will be others.  I expect retrenchment across the region with these states that have set themselves up as regional financial and entertainment centers – Dubai for example, taking it on the chin the hardest. This economic downturn and credit shock may well cause social unrest in some of these nations including providing more fuel for terrorism. Saudi Arabia in particular remains at its core an Islamic dictatorship with a royal family that is distanced from the political and social aspirations of its people. I cannot help but believe that we will see revolution sweep one or more of the Gulf States one day. When that happens the international supply of oil will be disrupted with a price resulting shock of enormous proportions.

I am not looking at any direct investment opportunities in the Gulf States. Rather, this is an area to keep a close eye on due to its growing wealth and impact on oil prices.  As with China, building up a long position in oil is a de-facto Middle East play.

Iran is a different situation. There are no real investment opportunities open to Americans nor do I believe the time is right for them. What I do expect to happen is a more open engagement to begin between the United States and Iran during the first year of the Obama administration. This will tend to be bearsish for oil and gas prices as it opens the door to Iran developing their oil an gas fields more rapidly and improving supply.

We should not fear Iran as a nation. We should be wary of a government that is rabidly anti-western, anti-Semitic, and is attempting to posses nuclear weapons.

There are a couple of points that need to be made about Iran that get insufficient exposure in our domestic press. The first is that their leader Ahmedinejad, is regarded as a crazy by the west but is also not well liked by many of the power brokers in Iran and amongst the average people. He is an elected official. It is far from certain that he will be elected again.

The second point is that Iran and the Middle East cannot be understood or analyzed properly without understanding the Shia/Sunni dynamic. The majority of who we think of as the Arabs are largely Sunni. The rift between the two dates back centuries and colors the daily political landscape between them. Further, we, the United States act like the issues are all centered on us when in fact too much of the time we are really more of a pawn in inter-Islamic power games than the focus.

I strongly recommend readers pick up a copy of “The Shia Revival”. It will change your outlook and make you a more savvy international investor.

Finally, America will come back from this crisis. The inherent American strengths of resourcefulness, inventiveness, drive, and yes - risk taking, ensure that we will come out of this crisis stronger than before. As a nation we will have learned some very hard lessons and, I expect, re-discovered our pragmatic roots.

In summary then, 2009 will present investors with a volatile, wild ride of global change, risk and opportunity. Understanding the fundamental macro forces are the key to success. I wish all of you a prosperous New Year and hope that you will continue to follow Murdock Global Insight.

Kel Murdock
December 31, 2008
St. Louis

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