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And now for the G20’s next trick ...

What a magic act! Over the past year, despite the biggest economic crisis since the Great Depression, central banks around the world have managed to create an environment in which just about every type of financial asset - stocks, bonds, gold, has headed straight upward.

The result of this great levitation is an environment that makes absolutely no sense from the viewpoint of standard investing logic.

Two demonstrators protest during the G20 Finance Ministers meeting in St Andrews, Scotland this past weekend. David Moir/Reuters

A big run-up in the stock market, like the one we’ve seen over the past few months, would usually be seen as a bet on a strong recovery that will boost profits. A surge in bond prices, such as we’ve experienced over the past year, implies the opposite. It suggests buyers see a weak, faltering economy ahead and want the security of fixed payouts.

Things get even stranger. Bonds are supposed to be at their best during times of deflation, when prices fall and the purchasing power of a bond’s distributions goes up as a result. In contrast, gold is supposed to shine during periods of inflation, when prices climb and people want the security of owning a real asset that can keep pace with rising bills.

So, according to the market trends of the past year, investors expect both a strong recovery and a weak one, both inflation and deflation. You thought you were confused? It’s nothing compared to how Market feels.

Perhaps the market is baffled. Or, more likely, it’s responding to the unprecedented level of government intervention during this crisis.Some of the most notable interventions are low, low interest rates. Another is ‘quantitative easing’ in which central banks, such as the US Federal Reserve and the Bank of England, have created massive amounts of money out of thin air to buy risky assets. (Andrew Smithers, a British economist, estimates these purchases total a staggering 5 percent of US GDP and 8 percent of UK GDP.) Finally, of course, there is deficit spending on a galactic scale.

The US federal deficit is expected to hit 13 percent of GDP this year, its highest level since the Second World War. Canada and other members of the Group of 20 rich and developing nations are also spending heavily and most are maintaining their low interest rates. After a weekend meeting in St. Andrews, Scotland, the finance ministers of the G20 pledged to ‘continue to provide support for the economy until the recovery is assured’.

To investors, a statement like this is a Zen riddle, capable of multiple interpretations. On one level, the G20 seems to be saying that the situation is still dire and interest rates will remain low for a long time. That suggests buying bonds is the smartest idea.

On the other hand, the size of the stimulus spending suggests corporate profits will be buoyed by a tidal wave of Government spending. That amounts to a vote for stocks.

Yet another way to look at the situation is to wonder how countries will ever pay for the massive stimulus they’re doling out. Rather than raise taxes to pay for it, Governments may inflate away the debt they’re running up. That would suggest that gold is today’s asset of choice. All three interpretations have something to be said for them, but all of them can’t be right.

The eventual winner may be decided by yet another factor, the US dollar. Nouriel Roubini, a professor of economics at New York University, believes that low interest rates in the United States are fuelling what he calls ‘the mother of all carry trades’ in which investors borrow money in the United States and use it to buy risky assets around the globe.

Roubini, who has earned the nickname Dr. Doom because of his funereal (and accurate) pronouncements on the global economy, says this will all end in tears. At some point, the US dollar will stop falling, the carry trade will lose its attraction, traders will rush to sell assets and repay their carry-trade loans, and one of the forces propelling all assets upward will start to drag them down instead.

So is there any safe place to hide? Jeremy Grantham, chairman of money manager GMO in Boston, has been one of the most prescient investors of the past few years.

He is a big fan of what he calls high-quality US stocks such as Johnson & Johnson, Wal-Mart Stores Inc., Microsoft Corp. and Coca-Cola Co.

“Quality stocks, simply look cheap and have gotten painfully cheaper as the Fed beats investors into buying junk and other risky assets”, Gratham writes in his most recent letter. These companies don’t carry large amounts of debt so they’re not going to be sunk by deflation or a slow growth economy. They enjoy some pricing power so they can hike prices if inflation roars.

They also have large sales in foreign currencies so the relative strength or weakness of the US dollar is not a huge factor over extended periods.

Unlike just about everything else, they haven’t gone up much in recent months, and that may be the best recommendation of all.

Financial Post

 

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