Risky Business

After 30 years of a mummified political existence, the Egyptian political scene exploded into protests and unrest last week, threatening to destabilize the Arab world’s largest country.

Although the Egyptian financial markets barely register from a global perspective, the unrest reminded investors that the world remains a risky place. The US dollar rose, gold perked up and oil, which is not a big Egyptian export, was back on the rise.

If you read Stratfor.com’s excellent coverage of the crisis, you will note that the most likely outcome for this crisis is a fresh face from the military who will rapidly move to:

1. close down the Muslim Brotherhood,
2. shore up the US alliance, and
3. quietly assure Israel that the 1977 Peace Deal is still in effect.

But the fireworks along the Northern bit of Africa are not the only worry in the world.

US Growth

In a detailed letter this week, John Mauldin takes apart the latest US GDP numbers and finds that there were more statistics than recovery in the numbers. It makes for interesting reading, especially when one considers how the inventory numbers change because of the change in oil prices over the quarter. The issue of US growth is tremendously important because much of the world’s monetary policy (in particular, the fast growing developing markets like China) are tied to the FED through fixed or nearly fixed exchange rates. Weak growth means that the FED will continue to err on the side of accommodation, which means that US interest rates will remain low until the bond market rebels and/or inflation becomes too obvious to hide.

The US economy is starting to pick up but at a growth rate well below that of previous post recession recoveries.

Inflation

Related to the sluggish US growth rates and resultant accommodative monetary policy, it looks like we will see commodities surge ahead once again. In this week’s rankings, Silver (SLV) and Food (DBA) score highly with Base Metals (DBB) and Oil (OIL) putting in lower but respectable scores. Commodity Related ETFs like Russia (RSX), Global Energy (IXC), and Fidelity Funds like Select Energy (FSENX) and Natural Resources (FNARX) are also near the top of our various portfolio lists.

The strength is due to the solid demand for these commodities which is driven in no small part by the massive supply of dollars floating around the globe. The desire to turn the seemingly unlimited supply of dollars into more supply restrained commodities looks set to remain a theme for the foreseeable future. Higher prices will eventually entice more suppliers onto the market but the lag should be prolonged enough to make some money from the next leg of the commodities rally.

Sovereign Debt Crisis: Japan

Another story that should have caused more concern than it did was the downgrade of Japan’s long term debt by S&P. The rating drop from AA to AA- doesn’t seem momentous compared with some of the sovereign crises we have experienced over the past couple of years. However, two things bear watching. The first is that ratings agencies historically have been behind the curve in downgrading sovereign debt. If S&P is downgrading now, this may be the start of a more serious cycle. The second question to ask is: “Who will buy Japanese debt?” In the past, this was not a terribly interesting question because the bulk of JGBs (around 94%) were absorbed domestically. With the aging of Japan, it is not unreasonable to expect that the robust savings rate, which allowed Japan to self fund its government debt, will shift into reverse. Last year the Japan Post Bank (the biggest owner of JGBs at more than 20% of the total) announced that it would no longer be a net buyer from 2011. According to the Economist, gross debt to GDP is an eye watering 190% and rising (although other sources already quote figures in the 200% plus range) so having a major buyer like the world’s largest bank (by deposits) pull out of the market is not a small issue. The pricing mechanism for JGBs looks set to change as foreign investors are asked to bid for bigger slices of Japanese debt. On the negative side, it will not take much of an interest rate hike to overwhelm Japan’s fiscal budget with interest expenses. On the positive side, the pressure from the bond market could be enough to spur Japan to enact much needed but unpopular reforms that could set the stage for an escape from two lost decades. However, any good news will only come after a period of painful adjustment.

So what should an investor do?

We think the best approach is not to run away from risk but to manage it. The recovery from the Global Financial Crisis has been rocky and looking around at some of the overheating in China, the rolling sovereign debt crises along the rim of the EU and now the turbulence in the Arab world, it is obvious that some of these trends will lead to trouble down the line. We think the solution lies in identifying and monitoring a fairly broad universe of asset classes and recognizing that the institutional money in the market will be draw towards and scared away from different asset classes at different times. By deploying one’s investment funds in the asset classes that are benefitting from the rising tide and avoiding those where sentiment is draining away, we think one can achieve a solid return on one’s portfolio despite the generally directionless but highly volatile overall direction of the financial markets.

CIVETS anyone?

We have received a number of questions about the CIVETS market (Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and how they compare to the previous emerging markets grouping, the BRICs (Brazil, Russia, India and China). We decided to see how far along in the cycle we might be by using the System to pick when and where to invest in each grouping.

So, if you were wondering if it was too late to jump on the bandwagon, this chart suggests that there is still some money to be made in CIVETS.

Read more at Fund-King.com