How to invest in the age of stagnation

Economists (specifically the US National Bureau of Economic Research) claim that the US Great Recession began in December 2007 and ended in July 2009.

But as far as I’m concerned, the Great Recession is still rumbling on. I’m far from alone. Nearly a third of Americans surveyed in a Gallup poll in April reckoned the economy was in a depression.

Small wonder Americans feel that way. 14 million of them are out of work. More than one in four homeowners are in negative equity, according to research firm Zillow. US house prices have fallen by nearly 50% in numerous states, including Florida, California and Nevada.

Britain’s hardly any better off. The International Monetary Fund has cast doubt on the chancellor’s deficit reduction plan, and manufacturing growth has all but ground to a halt. Cutting the deficit might well be the right thing to do – we can’t keep spending wildly – but the process will not be comfortable.

In short, the challenges are immense. So what’s an investor to do?

The East is rising as the West sinks

With Western economies weighed down by dangerously large debt burdens,  what does the future hold for the global economy?

To get a glimpse, look no further than recent results from HSBC, for my money the best-run bank in Europe. The bank’s European business saw its net operating income fall by almost 10%.

But in Asia-Pacific and in Latin America, net operating income rose by 20.6% and 24.9% respectively. So while debt-hobbled Western economies may have gone ex-growth, the emerging or newly developed markets of the world are in robust health, and I see no real reason to question that growth over the medium term.

Yes, if Western markets continue to slow, that will have an impact (especially on China). But over the medium term it will merely give developing markets, China included, an extra incentive to develop and nurture their own domestic demand.

HSBC isn’t stupid. While the bank has announced up to 30,000 job cuts by 2013, the axe will be predominantly swung in the US and Europe. HSBC will also be hiring up to 15,000 people over the next three years in emerging markets.

 

Faster growth doesn’t always mean rising stock markets

So should you pile into China then? It’s not that simple. Perhaps the most perverse thing in investment is that there is no proven correlation between economic growth and stock market performance.

That might sound extraordinary, but it is true. There is a particularly weighty book in my office entitled Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh and Staunton.

The title refers to the long term. Over the very long run, and certainly over the course of the 20th century, the extent to which equity markets beat other assets – notably bonds and cash – came as a surprise to the sceptics.

Triumph of the Optimists includes stock market returns from 1900 to 2000 for 16 developed countries. The data shows that over long periods of time and expressed in real terms, stock market returns and growth in GDP per head are actually negatively correlated.

In other words, the faster an economy is growing, the worse the stock market returns. This isn’t just a fluke result. The data was updated through to 2002 by Professor Jay Ritter in a paper, Economic Growth and Equity Returns, which found similar results.

So although it seems rational to expect emerging markets to grow more quickly than the slow growth, debt-ridden economies of the West (and also to expect those markets to become richer), that is not the same thing as saying that their stock market returns will necessarily be higher.

What does this mean for investors?

Well, it seems that the most sensible way to profit from and preserve your money in a world where the West is stagnant and the emerging economies are growing rapidly, is to own shares in businesses who are based in the West, but who do a lot of business in the East. In other words, companies which transact a significant and ideally growing amount of business in the faster-growing developing world.

Just in case you’re thinking I’m biased here, the rationale for owning Western and UK-based business is not merely home market prejudice on my part. It’s also a recognition of the fact that corporate governance and accounting standards are objectively higher here than they are in emerging markets (think China or Russia, for example).

So you get the best of both worlds: the security of investing in a developed market, along with the growth prospects of emerging markets. I attended a MoneyWeek roundtable recently where we discussed this topic – and some tips to take advantage of it – in more detail.

• Tim also writes The Price Report newsletter. 

Category: Market updates

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