PORTFOLIO POINT: Resource depletion, the decline of GDP as a key economic metric, and changing financial norms are just three of the trends which will define markets in the years ahead.
Last week, I wrote about the industrial sectors I like and don't like, framed within an overview of where US equities are at the moment (see Pick a pocket of US stocks). Today I want to expand on that analysis, contextualising that sectoral outlook within a number of broader historic themes.
On Saturday, Alan Kohler beat me to the punch, however, with an appraisal of three big themes that will, to a great extent, shape the market and the economy in years to come: energy, the digital revolution and the contraction of government.
If you haven’t read it yet, you should. There are, however, three more to think about: resource depletion, the beginning of a post-growth age and the establishment of new financial rules and norms. Just like Alan’s themes, all three are deserving of a lengthy book, but I’ll try to provide a snapshot of each as they provide an insight into what is shaping my thinking.
1) Resource depletion
Segueing from Alan's point, while I agree that energy is a defining theme in the present era, I disagree that we’re seeing a peak in prices. While we might be at temporary highs if Iran and Israel make amends and as new production comes on stream, I don’t see abundant shale oil as being the answer to what is otherwise a most certain decline in cheap conventional oil supplies globally.
And similarly, I disagree strongly (albeit reluctantly) with technology utopians like the Rocky Mountain Institute's Amory Lovins, who believe renewables are at a stage where energy returned on energy invested (the all-important EROEI) matches that of oil or coal. Natural gas, meanwhile, has always been abundant, but as most car drivers know, that doesn’t mean everyone will suddenly shift their fuel use. Indeed, this is why on Friday I wrote about a small-cap company called Cue Energy & Resources (see Under the Radar).
Therefore, rather than the five-year oil futures’ discount to spot signalling a bubble in current prices, I think there’s a good chance that we’ll see a run-up in long-term prices going forward.
Resource depletion is the overarching reason for this and it is something that investors, and society, will have to get used to. Technology has and always will lead to productivity gains that mean energy or resource use as a unit of GDP growth will decline as individuals and nations move up the economic ladder, but this cornucopian joyride of efficiency nevertheless splats into the Malthusian wall of finite resources and a global population of seven billion human beings. That is, unless a giant asteroid made of light sweet crude crashes into the Pacific Ocean or we discover a reliable way to scale up the production of fusion energy. Both, however, are fairly unlikely.
As Tim Treadgold wrote on US investment strategist Jeremy Grantham in May last year (see Peak Everything), the extraordinary rise in commodity prices since 2002 either illustrates a bubble or a true paradigm-shift. While I believe that prices of iron ore and coking coal are in a medium-term bubble thanks to a misguided and ultimately futile attempt by China to turbo-charge an industrial revolution via Soviet-style fixed capital over-investment (remember, China tried it once before through the Great Leap Forward), over a 20 to 50-year period, I think what we’re seeing may only be a taste of things to come.
When asked what the most powerful force in the universe was, Albert Einstein supposedly said compound interest. Like much of what Einstein said, this may be apocryphal, but a statement that isn't comes from another famous physicist named Albert – Albert Bartlett: "The greatest shortcoming of the human race is our inability to understand the exponential function."
In what's known as "Bartlett's Law", it's a mathematical certainty that as populations increase exponentially and arable land (or energy supply, or mineral production) increases only arithmetically, crisis will ensue. Efficiency and productivity gains have helped so far, but there are limits to these as well, as the very counter-intuitive decline in the rate of innovation and advancement in the physical sciences demonstrates.
All this is discussed at some length in a fascinating research note recently written by Tim Morgan from Tullett Prebon, a wholesale money market broker. Commencing with a combination of Professor Bartlett’s favourite charts, Morgan goes on to refute the arguments of all those who deride the so-called doom and gloomers: you can’t just keep growing beyond your capacity for growth without either eating down your balance sheet (i.e. wrecking the environment) or borrowing beyond your means (i.e. the explosion of global debt and fiat money in the last 20 years).
A forest of exponentials
Source: Tullett Prebon. RPI = retail price index; M3 = bank reserves currency in circulation large and long-term deposits
Quoting Kenneth Boulding, another prominent scientist from the University of Colorado, where the now 89-year-old Bartlett is still based, “Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist”. Simply put, the global economy can only grow as fast as the factors of production can grow. And with the exception of population growth, the factors of production that remain are innovation and energy, both of which are presently in a relative decline.
Just as the second half of the twentieth century was characterised by the Cold War, the first half of the twenty-first century may thus come to be characterised by “warm wars”, as the complicating factor of global warming, a side-effect of the exponential rise in the consumption of fossil fuels since the 1800s, overlaps the scarcity of resource supply. The financial crisis of 2007-09 will be seen as a geopolitical turning point long into the future, but historians may well mark the Rio Summit of 1992 as marking the beginning of the new age.
As much as the present conflicts in the Middle East may be seen through the lens of Islamist extremism, the fact that these areas of conflict overlap areas of intense resource concentration is surely no mere coincidence. If present trends continue, let alone if sea levels rise or if rising powers like India and China compete for supply, expect more of the same. Indeed, some may say globalisation renders geopolitics obsolete, yet in an age of resource constraints, climate change and agro-ecological crisis, geopolitics will mark its violent resurgence and, as it did in antiquity, landscape will determine the fate of nations.
2) The beginnings of a post-growth age
In response to the phenomenon of real and urgent resource constraints, the no-growth mantra of what many regard as fringe-dwelling greenies will go mainstream. In fact, Barack Obama's World Bank nominee Jim Yong Kim is already leading the way.
The current president of Dartmouth College, and a former director of the World Health Organisation's HIV/AIDS program, wrote Dying for Growth: Global Inequality and the Health of the Poor in 2000. And while he’s not anti-growth per se, he recognises its limits as an economic imperative.
But that’s not all bad news for individuals or a society reared on growth. While China’s blistering rate of GDP growth has hallmarked Asia’s economic story in the last 10 years, a far more benign development has been happening in no-growth Japan, where per-capita GDP has increased the most per annum among developed economies.
While this, no doubt, has come at the expense of sovereign debt, Japan's net international investment position grew during its “lost decades” from ¥42.543 trillion ($US554 billion) in 1989 to ¥251.495 trillion ($US3.3 trillion) in 2010. Over the same period, Japan's life expectancy has increased from 78.8 to 83 and the yen has risen almost 90% against the US dollar. Furthermore, as former FT editor Eamonn Fingleton writes, the country's national infrastructure (road, rail and internet) continues to lead the globe and Japan still produces world-beating exporters.
Not that any of this should be that strange. After all, even gross domestic product, which is fetishised today, was once a fringe phenomenon. Developed in 1934 for a Congressional report (its author, Simon Kuznets, warned that it was not useful as a measure for welfare), it was later used in wartime planning, but John Maynard Keynes, who came up with the formula C I G X – M = Y (Consumption Investment Government Spending Exports â Imports = GDP), thought it would fall into disuse soon after. And while some alternative measures like “gross national happiness” are specious at best, in France, GDP is already on the way out. Even in the US, there is a growing move by economists to measure gross domestic income, an alternative statistic that more accurately describes a nation's wealth and welfare.
3) The establishment of new financial rules and norms
Along with the long and protracted death of GDP, a true, mainstream post-Keynesian economics can be expected to rise in the ashes of the old. While most of the Australian media obsesses over his house price predictions, Professor Steven Keen from the University of Western Sydney is one of the pioneering thought leaders in this and related fields.
Among the other shibboleths we can expect to be cut down as a new consensus emerges are the highly problematic LIBOR, which forms the basis of most money-market transactions, the increasingly reflexive VIX measure of volatility (which these days is as much a reflection of what people expect it to be, than a usable indicator of what risk is being priced as), and the ever-questionable notion of the risk-free rate.
For investors, this slow but seismic shift in the rules of capitalism has led many investors into gold in the absence of better investing ideas, but as George Soros seems to argue – having developed the theory of reflexivity, which can account for much of what is happening in the VIX, among other things – the tail is, in effect, wagging the dog.
With gold’s surging price more a function of investor supposition – especially with the explosion of exchange traded fund holdings in gold – than an indicator of the death of fiat money (see Make-believe money), I still believe it’s a bubble. As the dust settles on the shift to a post-Keynesian world, useful things like oil, fertiliser, machinery and farmland will be valued higher than gold, which as Warren Buffett likes to say, gets dug out of the ground only to be put back in.
And of course, while continual technological advancement throughout all of this will make things like iPads and e-books cheaper, more physical goods like tonnes of potash, rods of graphite and motor vehicles will get more expensive. Building on an oft-cited analogy, the excellent MacroBusiness blog this weekend wrote that if advances in the car industry had been as great as in computing, "you could now buy a Rolls Royce for a couple of bucks."
As the global economy moves from a focus on aggregate growth to a focus on consolidating gains made thus far, and as resource depletion increasingly challenges the viability of economic and business models, investors will need to construct new strategies to cope with a changing world. The strategy ideas I’ve covered in my column have been an attempt to cope with this view of the world, and after the Easter break I’ll present a few more ideas on this.