What this topsy-turvy economy means for your investments
Gold prices have plunged lately even though the precious metal is supposed to be a safe haven when the stock market is in turmoil. The dollar’s value has jumped against most foreign currencies even though the US government’s debt has topped $10 trillion. And nearly all types of investments have tanked this year, defying the common wisdom that it pays to diversify your portfolio.
What’s going on? Why are markets behaving in such a topsy-turvy manner? To explain why they are confounding expectations and what it means for your investments, Bottom Line/Personal spoke with top economist and market trend interpreter Bernard Baumohl.
GOLD
COMMON WISDOM: Gold is supposed to soar when stocks plummet, and it’s thought of as a good hedge against inflation.
Reality: It’s a misconception that gold necessarily thrives whenever there’s any kind of chaos in the markets. After reaching a record above $1,000 per ounce in March, gold prices have fallen below $750 per ounce.
Typically, investors tend to buy gold in two circumstances — when there are threats of geopolitical instability, such as a major new war or oil blockade that could destabilize the world economy… and when investors lose confidence in major currencies, such as the US dollar. Neither of these circumstances has occurred recently.
Also, big investors (including hedge funds) that invested in gold and other commodities with borrowed money have been dumping them to raise money to pay off debts, helping to drive down prices.
Although the price of gold can soar at times, especially when investors are worried about inflation, the fact is that gold has had only a spotty record as an inflation hedge.
THE DOLLAR
COMMON WISDOM: The dollar should be weakening at a time when the federal government has a $10 trillion debt and is spending hundreds of billions of dollars to rescue the financial system.
Reality: After a long slide, the dollar has rebounded in the second half of 2008, hitting a two-year high against the euro. That’s partly because during times of severe financial crisis, US and foreign investors have sought the safety of the US dollar rather than other currencies, even though the roots of this financial crisis stem from US financial policies. Foreigners have been buying up US Treasury bills despite their low yields.
Also, foreign central banks have been lowering their interest rate targets along with the US to bolster their financial systems and ease the worldwide financial crunch. As a result, it is hard to find higher, safe returns in foreign bonds.
However, I think this strong-dollar phenomenon will be short-lived. Looking out over the next two or three years, global investors will realize that the US has to deal with massive deficits not only to finance the emergency rescue package but also to fund the huge liabilities coming due on Medicare and Social Security.
Will foreign investors happily purchase all this new US debt as they have in the past? I doubt it. Thus the dollar will likely resume its decline against other major world currencies, which began in 2002.
COMMODITIES
COMMON WISDOM: Strong growth in emerging markets, such as China and India, still should be putting upward pressure on prices of commodities, including steel, copper, wheat and oil.
Reality: Since the summer, prices for industrial metals and agricultural goods have dropped by about 40%, on average. The economic slowdown in the US has meant fewer imports from China and India, so the need for raw materials in those countries has dropped. Still, I think the overall trend in commodities is upward for the next decade, but it won’t resume until countries get past the current recession.
This year’s historic collapse of oil prices — down by about 60% since their July peak — is more complex than the movements of other commodity prices because oil is greatly affected by factors in addition to supply and demand, such as geopolitics. In 2007 and early 2008, the risk of terrorism, the extreme instability of Pakistan and the fear that Iran would block the Strait of Hormuz, where oil tankers sail out of the Persian Gulf, all contributed to soaring oil prices. Those risks all have moderated for now.
In the next six months, I think oil prices may continue to drop even when OPEC cuts its daily production levels because demand will continue to fall amid the global recession. Also, increased exploration and development by major US energy companies will increase supplies.
FOREIGN STOCKS
COMMON WISDOM: Foreign countries — especially fast-growing emerging markets in Europe, Asia and South America — should be insulated from a US recession, so their companies’ stock prices should follow a different path. This process is called “decoupling” and usually helps investors to shape a diversified portfolio.
Reality: Foreign stock markets, on average, have dropped even more than US markets. Emerging-market stocks generally are down by 50% or more this year as economic growth slows in emerging markets.
It wasn’t just the slowing of the US economy that derailed other economies. Many foreign-based financial institutions bought the same supposedly low-risk mortgage-related securities that the giant US banks did. In a matter of months, write-downs on the value of those investments spread throughout the global credit markets. Banks became reluctant to lend money to consumers or one another, quickly stunting economic growth. Foreign-stock investors stampeded for the exits, just as US investors did.
I believe that the US economy will hit bottom first and then gradually recover. As that happens and the bank credit freeze starts to thaw, consumer and business confidence will improve globally.
Even though US and emerging-market stocks have behaved similarily during this crisis, I believe that they will decouple over the long term, as they did before the crisis.
Long-term investors would be wise to anticipate this decoupling. I believe that the economies of Brazil, China and India will grow much faster than those of the US, Europe and Japan in the next 10 to 30 years.
DIVERSIFICATION
COMMON WISDOM: A well-diversified portfolio that includes not only stocks but also bonds and other types of investments is supposed to protect you in a volatile market because these asset classes move in different directions.
Reality: Despite a drop in bond prices and various other types of assets this year along with the plunge in stock prices, the common wisdom concerning the importance of diversification still holds true. Investors who held a variety of assets — including defensive stocks, Treasury notes and cash — were not hurt nearly as much as those holding mostly stocks.
