Alex Carrick: To understand the economy, keep an eye on five asset classes

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The recent turmoil in financial and bond markets, brought on by U.S. debt woes, acrimony between the Republicans and Democrats in Washington and Standard & Poor’s downgrade of U.S. Treasury Bills, has presented huge problems for those trying to understand the economy.

As an economist, I’m often asked for investment advice, which I’m reluctant to give since my expertise does not extend to accounting rules and corporate balance sheets.

However, I have noticed over the years there is one way to artificially order events that provides considerable insight into what is happening in various market niches.

It’s as simple (and as complicated) as taking into account the following. There are five asset classes and money shifts around between them depending on which is currently in favour.

The five asset classes are: stocks, bonds, currencies, commodities, and real estate.

In case you think I’ve left out some items, such as fine art and other collectibles, understand that those are easily classifiable as commodities. The proof is in the fact there are public auctions to sell such objects as paintings and a myriad of other goods, including antique cars.

Interest in one asset class is rarely mutually exclusive. Nevertheless, a turning away from one category is likely to lead to greater interest in another. After all, money has to “park” somewhere. And I’m talking big money, not the kind that sits under grandma’s mattress.

The most recent three years, encompassing the recession and Greek debt crisis, have provided a case study on the movement of money between the five asset classes.

There have been several examples of heightened uncertainty about the economic outlook. Such circumstances automatically entail more risk. Big professional investors in charge of hedge funds, private equity funds and pension plans are averse to risk.

The answer most often chosen by professional money managers, when confronted with doubt, is to move cash into government bonds. This is the “safe haven” argument. On several occasions over the past three years, investors have scurried for the protection of U.S. government debt.

That’s partly why the latest crisis, throwing in doubt the rock-solid nature of U.S. notes, has been so upsetting. There has been an unwarranted reaction regardless. More on that in a moment.

Certain commodities may also benefit as risk escalates. Gold has always been popular as a hedge against strong inflation expectations and worries about political and economic upheaval.

Hence the drawn-out upsurge in the price of gold, with new record highs being set regularly.

From October 2008 through early 2009, equities plunged in value. Demand for U.S. treasury bills rose and the value of the greenback climbed as investors everywhere sought safety. Once the worst of the recession was over, there was an acceptance of more risk again. Stock markets roared back, with the indices climbing 60 per cent to 80 per cent versus their trough levels in February 2009.

Then the sovereign debt problems of Greece, Ireland, and Portugal reared up, beginning in the spring of last year. Again there was a rush to move funds into U.S. dollars by way of treasury bills. This benefitted the U.S. by lowering interest rates. More demand for bills raises the price and lowers the rate. There is an inverse relationship between bond prices and interest rates.

The U.S. faces some unique challenges. When it comes to competing asset classes, personal property real estate has largely disappeared from the equation over the past nearly six years. Existing home prices in the U.S. are down 33 per cent nationwide versus their peak in early 2006.

By spring of this year, North American stock market indices recovered again, nearly doubling in value versus two years before. But early August saw a renewal of wild swings. The major catalyst has been the downgrade of U.S. debt, from AAA to AA+ by Standard & Poor’s. Other factors have also played roles, including evidence of a slowing world economy, partly brought on by worries about Chinese inflation and monetary tightening, and the debt problems in Europe.

Lack of success in providing jobs in the U.S. has hurt consumer confidence. Plus some large lending institutions have lingering financial problems as a result of faulty mortgage foreclosure practices. In Europe, there are major banks with scary exposure to sovereign debt.

The U.S. debt downgrade contains a certain “bogus” element. The U.S. government isn’t out of money, nor is it ever going to stop paying its bills. The crisis was politically engineered. It was about establishing electioneering platforms for the 2012 vote. S&P’s action was a virtual tongue-lashing telling the two parties on Capitol Hill to get their acts together. Compromise, which has worked so effectively in the past, has been sadly and at great expense abandoned.

The U.S. economy is still, by far, the world’s largest with tremendous potential to grow out of its financing problems, given a little luck and the correct policies. Furthermore, there is no other foreign currency held by investors to anything like the same degree as the U.S. dollar.

The sheer liquidity of the greenback and U.S. treasury notes means the greenback’s prominence continues to be assured for years to come. Recent events have provided the proof. After treasury bills were downgraded, demand actually picked up, lowering yields to their lowest levels on record. While this may go against pure theory, the logic is clear and relates back to what was said earlier. If there is more concern about the world economy, then money will flow into the world’s reserve currency and, for now and at least the next decade, that’s the U.S. dollar.

For some countries, several of the five asset classes may move in tandem. Canada and other predominantly resource-based nations, such as Australia and Brazil, fall into this category.

For Canada, the dynamic for asset appreciation has come mainly from commodity prices. Emerging nation demand for agricultural products, in short supply around the world, and metals and minerals to undertake infrastructure projects has driven up the prices of many of the raw materials this nation provides. Until recently, high commodity prices have been the driving force behind the appreciations of share prices on the TSX and the value of the Canadian dollar.

The recent retreat in world oil prices has lowered valuations in Canada’s resource sector. Doubts about the strength of our major trading partner have also exerted some drag, but a substantial drop in gasoline prices will help the 70 per cent of the U.S. economy that is driven by the consumer.

Alex Carrick is Chief Economist with CanaData, a division of Reed Construction Data (RCD). CanaData is the leading supplier of statistics and forecasting information for the Canadian construction industry. RCD is a division of the global publishing firm, Reed Elsevier. For more economic insight from RCD, please visit www.dailycommercialnews.com/features/economy. Mr. Carrick’s lifestyle blog is at www.alexcarrick.com and he would welcome a follow on Twitter (Alex_Carrick) or Facebook. 

www.alexcarrick.com

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