Global outlook: 5 things to watch

Here are the five key macro themes I am following—and how they have shaped my investment strategy. 

• Stocks: The sustainability of China’s secular growth story and its impact on the rest of the world.
• Currencies: The ongoing hangover from the credit crisis and its implications for monetary policy and the U.S. dollar.
• Bonds: The value proposition of sovereign debt in the developed world against a backdrop of high debt and negative real interest rates.
• Commodities: The increasing scarcity of the world’s natural resources and its implication for the commodity super cycle.
• Precious metals: Their role as a store of value (i.e., a currency).

Let’s look deeper at each.

1. China and stocks

As I recently wrote in Viewpoints (read "A report from China"), I believe that China is largely responsible for pulling the global economy out of the dumps following the credit crisis in 2008. Yes, TARP (Troubled Asset Relief Program) and QE (quantitative easing) helped, but I believe it was China’s massive fiscal stimulus and emerging middle class that restarted the global growth engine in 2009.

Now I see two economic stories in China: the infrastructure boom and the rise of the Chinese consumer. The infrastructure boom has been a clear plus for commodities and the countries that produce them, and for the makers of capital goods. The Chinese consumer story is even more impressive and has had implications for the makers of consumer goods, especially European luxury goods and cars.

But I believe there has been a price to pay for that growth, and that price has been inflation and misallocation of capital. As a result, Chinese regulators have been aggressively tightening policy. The reserve requirement ratio among China’s banks is now 21%, and the regulators have all but shut down the residential property market. The question now is, can China engineer a soft landing or will years of capital investment within a command economy structure end in tears.

My sense is that eventually, when the growth stops, there could be tears, namely from the misallocation of capital that sometimes comes from a closed capital system. It is often said that when you restrict the flow of capital, it will eventually end up in the wrong place, and the same could happen in China. However, it’s my sense that these problems may not surface until China’s economic growth stops. As Warren Buffet said, “Only when the tide goes out do you discover who's been swimming naked.”

I don’t think the Chinese tide is going out yet. It’s a tough call, but I personally think that China will be able to engineer a soft landing over the intermediate term, because it still has ample fiscal resources to create more growth as part of its 12th Five Year plan. But China is slowing and it is doing so by design.

If China’s growth continues, even though at a slower pace, the demand for certain raw materials, capital equipment, and consumer goods could continue as well. To me that means a continued bullish stance on certain commodities affected by scarcity concerns such as copper, coal, and oil, and the countries or sectors that produce them. It could also mean a continued bullish stance on Europe’s exporting core (e.g., Germany). Finally, it could mean a bullish stance on precious metals as the Chinese middle class increasingly turns to gold and silver to protect its newfound wealth.

2. The credit crisis and the dollar

The credit crisis has ongoing repercussions for global investors. I believe the household debt bubble masked a structural issue in the United States, namely, a stagnating labor market. Now that the bubble has burst, the labor participation rate has plummeted to levels not seen in three decades. The Federal government has tried to make up for the hole in household balance sheets with massive fiscal deficits and, as a result, the U.S. has now “maxed out its credit card” (has hit its debt ceiling) and is seeking a bigger credit line. At the same time, the Federal Reserve has had to resort to unconventional ways to ease monetary conditions, resulting in zero rates and a large balance sheet.

The result, in my view, is slow and uneven growth and a structurally weak dollar. With a new soft patch in the U.S. economy only a year after the last soft patch, it seems unlikely that the Fed can exit its loose monetary stance any time soon. This may mean ongoing weakness in the dollar over the long term, which has implications from an asset allocation perspective. A declining dollar has tended to mean reflation (risk on) and a rising dollar deflation (risk off). Obviously a weaker dollar means higher currency-adjusted returns elsewhere (all else being equal, of course), and it also suggests higher commodity prices (as commodities tend to be priced in dollars and tend to be part of the risk-on trade). 

But perhaps most important, a falling dollar has tended to boost the relative performance of emerging markets (EM) because many EM countries have their currencies tied directly or indirectly to the U.S. dollar. That means that America’s accommodative monetary policy gets “exported” to the emerging world via a weaker dollar, boosting growth prospects and relative performance. The downside, of course, is that it can also lead to inflation and credit bubbles.

So, the direction of the dollar is of paramount importance to global asset allocation. And that means having a good sense for Fed policy going forward, relative to those of the European Central Bank (ECB), Bank of England (BOE), Bank of Japan (BOJ), and the People’s Bank of China (PBOC).

What about QE3? The Fed has been adamant that it is not going to happen, and the markets have been going through a painful adjustment period as QE2 is about to end.  But the Fed said the same thing after QE1 a year ago, and eventually they did QE2 anyway. So I, for one, am not willing to write off QE3 entirely just yet.

But the larger point here is that, even without QE3, I think there is still a lot of ongoing monetary stimulus available to support the U.S. economy, and therefore, stock prices. And I don’t think this stimulus is likely to be removed any time soon.

3. Sovereign debt and its impact on bonds

Tied directly to monetary policy are the levels and direction of real interest rates, which in turn tie into the value proposition for sovereign debt. Real rates are negative in most of the developed world. At the same time, debt levels are sky high. The debt-to-GDP levels in Europe, Japan, and the U.S. are either approaching or exceeding 100%. Put high debt loads together with negative real rates and I don’t see much of a value proposition for government bonds (prices generally fall as interest rates rise). This is especially true in the United States, where we also have a weakening dollar. 

What about the European debt crisis? In my view, this has significant potential to undermine the weaker dollar thesis described above. In Greece, the crisis is raging right now, and has the potential to spread to Spain, and indeed Europe’s entire banking system if a solution is not found soon. If that happens, the euro could decline sharply (as it has done in recent days), and that could be deflationary. Every day, the market is on pins and needles waiting for the “Troika” [the European Commission, ECB, and International Monetary Fund (IMF)] to come up with a plan to let Greece carry on, and for the Greek government to agree to an austerity program. The idea is to engineer a “soft” restructuring while at the same extracting more concessions from Greece. I think Europe is only a few good decisions away from a long-term resolution, and only a few bad decisions away from failure.

4. A commodity super cycle

Commodities are about supply and demand. I covered the demand story in the China section above, but the supply story is equally compelling, at least for certain commodities. It seems almost every day that when we turn on the news there’s another story about hurricanes, floods, droughts, or volcanoes. Mother Nature sure seems to be playing tricks on us, and the implications are real, especially in terms of agricultural supplies. On the demand side, the Chinese are eating more protein and that means more livestock and therefore more feedstuffs and therefore more water. All are in short supply.

At the same time, the world seems to be running ever lower on the kind of sweet light crude that most of the world’s refineries need, especially since Libyan production has been down. Meanwhile, China has gone from having three cars per thousand to 30 cars per thousand (the U.S. has 500 cars per thousand).  And copper is getting harder to source, as is coal, and both commodities will remain in high demand as China continues to build out its infrastructure as part of its 12th Five Year Plan.

All in all, commodities as an asset class remain to me a compelling long-term theme, although the trend is certainly more mature than it was two years ago.

5. Precious metals as currency

Most investors might consider precious metals to be part of the commodity spectrum, but I see gold and silver more as currencies these days. They have become a store of value in a world where debt-burdened countries are printing excess monetary reserves, which are being held at central banks.

As long as the Fed and other central banks remain at risk of monetizing their countries’ debt, and real interest rates in the United States. and elsewhere remain negative, and the Fed continues to debase the dollar’s purchasing power, and Chinese consumers seek to protect their wealth through gold and silver, I see a reason to own precious metals as a store of value. At some point this may change, such as through a China hard landing, a Goldilocks economic environment, or aggressive tightening, but for now I don't think any of these seem very likely.

Piecing together the global puzzle

Right now there are many crosscurrents out there and it is tough to make sense of it all. Stocks have been correcting on the back of a slowing China, the looming end of QE2, and fears about Greece imploding and taking Europe’s banking system with it. This is why I have been somewhat neutral in my risk positioning in recent weeks. Treasury yields have fallen as investors have turned away from risk, but neither nominal yields nor current yields are compelling, and the U.S. has a little debt situation of its own. Commodities have sold off as part of the risk-off mode that now prevails on Wall Street, but economically sensitive copper has actually held up pretty well in recent weeks. And throughout this two month correction, gold has been amazingly steady, almost acting like a reserve currency.

What to do? With stock markets around the world correcting sharply, I am now on the lookout for opportunities to add exposure to “risk,” because I believe that the economic slowdown in the U.S. will prove to be transitory, and that China will be able to engineer a soft landing. I also believe that despite all the missteps, Europe will ultimately muddle through with Greece and that the contagion will not spread to Spain and elsewhere. The price of failure is one that no one will be able to afford, so that’s a powerful motivator to get this done. A resolution could in turn reassert the dollar’s structural decline, and that would be bullish for commodities and emerging markets. So, I am viewing the current correction in risk assets as a buying opportunity for stocks, credit, and commodities, and am maintaining my relative value theme of owning precious metals at the expense of sovereign debt.

- BY Jurrien Timmer, Director of Global Macro and Co-Manager of Fidelity^® Global Strategies Fund, Fidelity Viewpoints — 06/22/11