Well thank you very much for the kind introduction, and first of all I’d like to thank the organisers very much for having put this event together. It’s an unbelievable amount of work to have an event like this. And I should also like to thank you all that you came so numerous to this presentation.
In fact as a contrarian it’s very disturbing to have a large audience. I remember very well when I started to speak – I was younger than now! I was invited to a seminar in Hong Kong, it was around 1981. In the morning they had sessions about gold and oil, and there were about 5,000 people attending and I had the great honour to speak in the afternoon about the bond market. There was just one participant that came and he said he was embarrassed because he wanted to leave, but he was too polite to leave so he had to stay on for my hourly presentation. So I felt very sorry for him but at that time; obviously bonds were not popular.
I am actually glad that Pierre spoke first because he spoke from the bottom of my heart.
Now, I want you to imagine the following. You have a rich uncle and he just passed away and he left to each one of you $100m. Your rich uncle was a bit of an odd character. He retired in the late 60s and lived on one of the islands of Pacific. He didn’t read newspapers, he didn’t have a fax machine, no telephone and he was, however, a smart investor. In fact he corresponded with his bank by mail and in the 30 years before he passed away he sent out four letters.
In 1970 it had occurred to him that gold at $35 was relatively inexpensive compared to the rate of inflation one had experienced in the 50s and 60s. oil at $30 per barrel struck him as very, very inexpensive so he put all his assets, then about US$1m into gold and oil and he took a 10 year holiday.
Then by accident he came back in January 1980 and saw the gold price around $800 an ounce and oil close to $50 per barrel on the spot market. He also realised that then the Dow Jones was not higher than it had been in 1964 and he felt that financial assets were relatively inexpensive compared to commodities so he sold commodities and he looked at the economies and studied a little bit for a week.
He worked a week in 10 years so he decided with some good luck to invest all his proceeds into the Japanese stock market.
Then he took off again for 10 more years. He came back in 1989 and saw that the Japanese market had gone up seven times and that the whole world was in love with Japan and that Japan would take over the world financially.
So he decided to sell his Japanese shares and at the time the world was quite down on the US and to reinvest his proceeds in US stocks and some tech stocks because the Nasdaq didn’t exist then yet.
And so again he took 10 years off and came back in 2000 and he saw this mania in Nasdaq stocks and of course he sold out. But as I told you, unfortunately, he died shortly thereafter, that’s why you get the $100m each and your uncle – oh I forgot to mention something. There is one condition attached to you getting the $100m each. You are only supposed to choose one asset class and you have to invest it for 10 years, you cannot change in between. You can choose between US real estate or gold or bonds or equities or equities in Asia or equities in Europe or collectibles or whatnot; but you have to choose one investment and leave it for 10 years.
The uncle was well meaning and so he left you some guidelines.
One of the guidelines obviously is the good news for all of you is that something somewhere in the world always goes up; that was his experience.
Secondly, he observed that if you have say four asset classes, real estate, bonds, equities, commodities and in this room you have the Federal Reserve, Mr Bernanke flying around with his helicopter dropping dollar bills on you, then he can control the quantity of dollar bills that will come into this room, but what he doesn’t control is where it will go to.
It can go into real estate at times, it can go into commodities at times and so forth. And so each is an asset class that over an extended period of time – like Nasdaq in the 1990s – goes up at a faster pace than other asset classes,.
inevitably this entire room will invest in the asset class that will go up the fastest because university professors will then write books, why this asset class will always rise at a faster pace than something else and the media will have long, long programmes about this asset class and an investors’ conference such as this will also focus on that asset class.
So the likelihood that if one asset class outperforms others over an extended period of time it will end up in a bubble is very, very high. The beauty of the bubble, and this is the last observation your uncle made, is not to invest in the bubble factor but imagine if all the money of this room flows into one sector – into Nasdaq – by definition there must be other sectors that are undervalued compared to the overvalued asset.
Eventually when the money flows out of the inflated asset and every inflated asset, every bubble eventually bursts, when that money flows out it will flow somewhere else so there is a shift, there’s a new asset class that comes about; there is a shift in leadership taking place.
I’d like to talk very briefly about the opportunities that you have now for investing your $100m.
The first: be well aware and never overestimate the intelligence of the Federal Reserve! They are well aware that they had created a bubble in the year 2000 in Nasdaq stocks. When they saw that the bubble was coming apart and that there was the threat of a recession they cut interest rates very aggressively after January 2001. In the process they pushed short term rates significantly below the rate of inflation.
In other words, they pursued a highly inflationary monetary policy. Pierre mentioned the 70s. The difference in the 70s was that America’s debt to GDP was 120%, but since Mr Greenspan came into power, the debt-to-GDP expanded very dramatically, it’s now at 300% and over. Since the year 2000 total credit market debt has increased by $7.6tr dollars whereas GDP growth was just $1.6tr. So in order to stimulate the economy you need to pump more and more money into the system.
I would like to mention that CNBC commentators speak about a Bush boom being similar to a Reagan boom. Yet the conditions; certainly from debt to GDP are totally different.
At the time of Reagan debt to GDP was just 120%, now it’s [over 300%]. So the Fed – knowing that in this situation deflation would be a catastrophe – they cut interest rates very aggressively and pursued an expansionary monetary policy which led to the credit expansion I referred to.
As mentioned earlier, the Fed maybe controls the quantity of money, but they don’t control where it goes and 80% of new credit went into the housing market, into mortgages. It led to a refinancing boom which came to an end when interest rates no longer fell. But in essence what it did is the following: credit expanded, it led to housing inflation, the housing inflation allowed people to take larger mortgages and to extract money from their homes and to go and spend it.
Over the last four years consumption as a percentage of the economy reached a record level. Again, at the time of Reagan, we had pent up demand but not now. We are at the highest level of consumption as a percentage of the economy ever.
US borrowings led to asset inflation, thence to consumption, but production and investment activity somewhere else.
In China, industrial production until recently was growing at 20% per annum. Trend line growth is around 12% per annum in other words we have over done it. Investment activity, where trend line growth is usually around 15%, where capital spending, net capital formation was growing at 15% annual rate until recently.
So what we have is all the spending in the United States, but production and investment and capital formation in China which leads to an interesting situation.
You have the growing trade surplus of China, obviously everything is produced in China and consumed in the US. The Chinese have a growing trend for business in the United States, and it is not that the Chinese pursue unfair trade practices – they import goods – they just don’t import them from the United States. You have the Chinese imports from South East Asia which are growing at a very rapid pace.
In other words the Chinese probably pursue kind of a political agenda. They export to the United States but they want to strengthen the other Asian countries in order to have strong neighbours that will depend in future more and more on the Chinese economy as an engine of growth and less on the US.
Korean exports to China today are larger than to the United States, Japanese exports to China are growing at around 30-40% annual rate, whereas to the US they are falling. Japanese exports to Taiwan, Hong Kong and mainland China are larger than to the US so you can see the Chinese economy is growing rapidly, and I will return to this subject in a minute.
In essence the Chinese have had imports growing at about the same rate as their exports over time and in fact in the last two years frequently import growth has exceeded export growth with the result that the Chinese trade surplus has been diminishing. In the first four months of this year they had a trade deficit; recently it is positive again. But I hope that you can see what the problem is, which is reflected in America’s net asset balance.
The newest net asset balance will tell you how many assets the US has overseas compared to assets foreigners have in the United States. All through the 70s we had a positive net asset balance in the United States. In other words Americans had more assets outside the country than foreigners in America. But after 87, as a result of the growing trade and current account deficit, this net asset balance has been deteriorating with the result that today foreigners have assets in the US equivalent to $9tr and Americans have assets in foreign countries equivalent to $6tr which is a negative net asset balance of around $3tr. That’s around negative 30% of US GDP.
By the way, you can see here that is gets worse with Bush policies. Bush combined with Greenspan? Recipe for disaster
So now you have to see that this has got to grow by the annual current account deficit which in the second quarter of this year was running at an annualised 6% of GDP.
So every year the deficit grows until you eventually get to a negative net asset balance of 50% and one day to 100%.
Now you have to ask yourself. “Are the Chinese out of their minds to still buy US Treasury Bonds?” They can also see that the US is in deep problems. Here again the Chinese pursue an agenda, they know very well that with the economy growing at around 8% per annum they are on collision course with the United States for a variety of reasons. They also know that militarily they are inferior to the United States. However, they can harm the US economically very badly by keeping the dollar relatively strong.
Production and investment will shift to China and other Asian countries and you have to also see that as a result of modern technologies a larger and larger portion of tradable services can now be transferred to countries like India. And ideally you would also outsource the CIA to Bangladesh!
This is a trend that is here to stay.
The Chinese also supported the dollar for a long time because they love President Bush and his administration! Because with the continuous human rights abuses, suddenly in the eyes of the African continent, Latin America; the Chinese leadership looks like Cinderella and finally, this is a sign, the Chinese showed all the presidential debates in the Chinese media. This is the first time it has happened because they wanted to, the people of China to see what kind of quality of presidential candidates democracy generates. Now nobody in China wants democracy!
The dollar will obviously go down.
Now the question is if the Chinese revalue, say by 50% - they double the value of the currency. Would anything change? I don’t think so. If you have factory wages of $100 or $200 nothing will change, they will go to 300 or 400. But they don’t have healthcare expenditures, they don’t have pension fund liabilities, retirement benefits and so forth. Production will still shift to Asia and the investment activity will be in Asia.
The only way in the long run that this imbalance will be corrected is that consumption in the United States will decline. It can decline if people will spend less or it can decline because inflation starts to exceed income gains and then the purchasing power diminishes.
In short, we have in the world five large currencies. We have the US dollar, the euro, the yen, the Chinese currency and gold.
Currency realignment won’t do the trick. All paper money will depreciate in time in its purchasing power. The only currency that will gain relative to currency will eventually be gold and silver, and precious metals and hard assets. But in the mean time what is happening here and this has to be clearly understood: there is a transfer of wealth from the Western World to Asia. The ownership of assets is shifting to Asia and in this environment we have to consider how to invest.
First of all, the Chinese economy is growing very rapidly and is very large. China produces more steel than the US and Japan combined and is still growing very rapidly. They produce five times more cement than the United States. Some consumer markets are much larger in China than in the United States. I have to explain that in China we have a deflationary boom.
Take a TV set that costs US$2,000. Then 1m Chinese households can buy it. If the price declines to say $200 then suddenly 100m Chinese households can buy it. Or take the motor cycle population, it grew in seven years from 12m motor cycles to now 90m motor cycles because prices were declining so more and more people can buy it.
Optically the US is a $11.2tr economy, China $1.2tr economy, GDP wise. But in physical terms adjust it for the difference in the price level I would say that the Chinese economy is already 60% of the US economy and still growing.
In the process of industrialisation there are certain things that happen, energy needs go up. China is a large oil producer but it has had to import increasing quantities of oil and let me tell you what happens in terms of industrialisation.
In the US from 1900 to 1970 per capita consumption of oil rose from 1 barrel to 28 barrels. In Japan industrialisation 1950 to 1970, South Korea 1965 to 1990 per capita consumption rose from 1 barrel to 17 barrels. In China we are at 1.7 barrels; in India 0.7 barrels. The whole of Asia has 3.6bn people including Japan and it consumes 20m barrels of oil a day. The US has 295m people and consumes 22m barrels of oil a day. For sure oil demand in Asia will double to 40m barrels of oil per day. Whether it takes six years or 15 years, that I don’t know, but it will double.
So the demand side is very strong, the incremental demand lead to rise in oil price as you can see. By the way, in your lifetime you won’t see oil at $12 a barrel again ever. That is finito, over.
Now we had some inventory accumulation this year, In the first nine months the Chinese imported 34% more oil than last year. I think they didn’t need 34% more oil so there has been some inventory accumulation. So oil prices could easily, in my opinion, go anywhere between $30- $40 in the months ahead when growth slows down, but the trend is definitely for oil demand in Asia to rise as people go from the bicycles to the motorcycles to the cars. Once they move from the countryside to the cities they need the refrigerators, they need transportation, heaters and so forth and so energy demands rises a lot.
On the supply side world supplies today are 80m barrels of oil a day. In the US oil production has been down since 1971 and elsewhere in Indonesia, Venezuela, and Oman it’s also been down.
The structure of the oil industry is interesting. You have 4,000 small fields producing 53% of total oil production of the 80m barrels, slightly more than 40m barrels. They have an average daily production of 9,000 barrels. Then you have 14 large fields, they’re large designed by fields producing over 500,000 barrels a day. All these fields were discovered before 1965 and six of them are in the Kingdom of Saudi Arabia. The six in the Kingdom of Saudi Arabia they have an unusual structuring to think that one field produces more than half the production. It used to produce more than 5m barrels; it’s dropped to 4.7m.
What I want to say, it’s very difficult to replace these 14 fields, none of which was discovered after 1965. So I think the total oil supplies at 80m barrels today cannot be increased much. In the 70s the oil shock was a surprise shock because Opec was cutting production, they noticed the price shooting up, but this time around Opec isn’t cutting production, it’s actually increasing production but it can’t increase it much more so I think in the long run oil will go up and not only oil. You can see that the demand for all commodities has risen.
The Chinese used to take 6% of the world’s copper market in 1990. 12% in the year 2000; now they’re the largest copper user, 21%. Iron ore, 27% of total production in the world.
The incremental demands coming from the industrialisation not only of China, but also of India, from rising standards through this wealth transfer from the Western World to Asia, will lift commodity prices.
You can see that although we’ve gone up since 2001 in real terms adjusted for inflation, commodity prices are still extremely low. So I think that we are at the beginning of a major cycle.
Some commodities may have overshot already, but agriculture is one of my favourites because food production in China has been declining. They have a water problem, and through the industrialisation and the construction of golf courses there’s less land available for agriculture.
So I would go and look at some agricultural commodity prices that haven’t moved much yet like corn, soya beans, wheat, sugar. The Swiss drink 50 times more coffee per capita than the Chinese, but the Chinese have a population 200 times larger than the Swiss so their market is already larger. If they go to the per capita consumption level of the South Koreans, Taiwanese, Japanese – non-traditional coffee drinkers – they will take up three times the coffee crop in the world.
The point is not to plan to invest the inheritance that you got from your uncle, but if commodity prices go up then usually it creates an unfavourable environment for financial assets, certainly for bonds.
The 1970s were a hostile environment for equities. Secondly and more importantly, economies have business cycles there are war cycles and usually when commodity prices start to go up international tensions increase. I think that tensions will increase over oil in future. Rising commodity prices lead to international tensions and then at the end of the rising commodity price when countries really go to war for commodities, commodity prices go through the roof.
So you may have to wait some time until the next war will lead to gold prices that will be at least as high as the Dow Jones or higher. In the meantime this wealth transfer will lead to an unusual situation.
At the moment, the Japanese market cap is 9% of total market cap in the world. The US is 52% and the rest of Asia is 3.5%. So for 12.5% you get the whole of Asia’s 3.6bn people will the fastest growing economies of China, Vietnam and India but for the US you have to pay 52% for a country that is economically doomed.
So I think this will change in next five to ten years time the US will be anywhere between zero and 20% and Asia should be between say 30 and 50%. By the way, in 1990 Japan was more than 50%. This can happen in many ways, it can happen both go up, Asia goes up more than the US. Both goes down Asia goes down less than the US or the US goes down, Asia goes up or it can happen both stay at the same level but through currency realignments. That is quite possible that the dollar goes down, it could be that the Dow Jones goes to 100,000 but the dollar drops by 99.9%. It happened in Latin America. By the way the apostles of the new economy they are right, the US has a new economy, it resembles Mexico and Brazil.
