Back in January this year, we said that the US dollar would be the one to watch out for in 2007 (see One potential trouble-maker to watch out for in 2007). Indeed, 2007 is the year that we see the rapid fall of the US dollar and the rise of gold. Just as we explained last year in What can we expect in a US dollar decline?, a sustained decline in the US dollar will let loose the demon of price inflation. This is what is happening right now in the US. At the same time, we are seeing a serious deflation of housing asset prices and liquidity contraction due to the rise of bad debts (i.e. the implosion of the infamous sub-prime loans).
Right now, there are two opposing macro themes at work- as we can see by the fact that central bankers are fighting on two fronts simultaneously, namely monetary deflation and price inflation. Thus, as 2007 draws to a close, we will refrain from any prediction in our outlook for 2008. However, we would like to highlight some possible risks:
- Further corrections in the global stock markets We had explained our reasons for this in Marc Faber on why further correction is coming?Part 2. The credit crunch is one of the manifestations of the liquidity contraction in that article.
- Global price inflation Central bankers will want to pre-empt any liquidity contraction as much as they can. The only way to do that is to debase the currency further. The manifestation of such is being elaborated in Is holding cash very risky?.
- Debt deflation Currently, Australia’s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia’s economic propsperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust. One outcome, will be as explained in Can Australia?s deflating property bubble deflate even further?.
- Will Australia escapes the effects of a recession in the US? See Is Chinese growth ?de-coupled? from the US economy? and China at turning point?.
What should equity investors focus on in 2008?
At this point in time, it is unclear which front (deflation or inflation) central bankers will be victorious on. Currently, there are signs of both- asset price deflation in the US and UK and food and energy price inflation i.e. stagflation. Investors should hedge their bets both ways.
First, avoid businesses that are too dependent on debt. In light of the global bear market in credit, such businesses can be easily caught with their pants down. Businesses that have strong cash position should be favoured. In times of deflation, the real (as oppose to nominal) value of cash increases. Also, look for businesses that have strong pricing power as well- that would be handy in times of price inflation.
Finally, we favour hedging of financial well-being with gold. More explanations on Why should you invest in gold?. For those who know what they are doing, they may want to consider gold mining companies- but be aware of the potential pitfalls as explained in Can Australia?s mining boom turn into bust?.
