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The New Momentum

As this story grew I had to cleave off the two biggest concept into articles of their own, so if you have not read Pop Goes the Commodity Bubble and Inflation? What Inflation? You might miss the point. In Pop Goes the Commodity Bubble I talked of the dark future for Australia, Russia and Brazil and to a lesser degree Canada. (Canada is spared because its economy somewhat more broadly benefits from US spending.) the effect is called Dutch Disease and you don't want to catch it.  Dutch disease is named after a downturn in the Netherlands' economy in the 1970s, when peaking natural gas prices were blamed for driving up inflation and driving down exports of manufactured goods. I also said these same factors would directly benefit the United States I call it the New Momentum -- let see how it works.

Oil is Big Business
America’s largest industry is Oil; America’s largest company by market cap is the behemoth oil company Exxon. The largest segment of the US trade deficit is oil.  The United States is by far the world’s largest consumer of oil.

According to The US government (EIA), Here is the Top 15 list of the world’s oil consumers in thousands of barrels a day
Saudi Arabia
Korea, South

Oil is Most of America's Trade Deficit
As recently as 2002, the U.S. trade deficit in crude oil and petroleum products was less than $100 billion. By 2008, with oil prices reaching all-time highs, the number was close to $400 billion, which represented 55 percent of the total U.S. trade deficit. As a result, the United States has run an aggregate deficit in petroleum of more than $1.5 trillion since 2007.

 (click any image to enlarge)

This chart explains the US trade Deficit in detail; notice the pivotal role oil plays in imports. Take oil out of the equation and most of what is left is some sweatshop t-shirts, running shoes plus a few cut price TV and cell phones from Asia. I call this the slave labour trade and you can read about it in Why I Believe In America.

Gas Prices Controls Consumer Spending
The price of gasoline is like a tax on every US consumer, low cost oil means more money for consumer spending. A $10 oil price decrease, sustained over four quarters, increases real GDP growth by 0.2 percentage point. The impact on consumption spending is twice as large: 0.4 percent. If WTIcrude were to drop from $110 to $50 per barrel, there would be 1.2% increase in American GDP. Many economists are making the assumption that US growth will remain stuck at 2%, and some account for sequester even place it lower. A 3.5% GDP growth rate would be a major gain changer in US employment and per capita income.

In Pop Goes the Commodity Bubble I explained how new drilling technology is releasing vast amount of oil here in North America and the United States is heading toward energy independence.  In Why I Believe In America, I explained the most of the world’s money is in western hands. In Pop Goes the Commodity Bubble I showed how most commodity price are simple speculation, not true demand. With the loss of oil revenue, most of the world’s resource based, developing world, the so-called emerging markets -- will be cut off from that revenue. The stakes are going to be very high for the persian gulf nations and for some parts of South America.  Look at this chart to see how oil world oil flows, then imagine the impact if the US stop importing oil.

Stuff is So Cheap
With the huge run up in oil prices this decade it is surprising that inflation stayed under 2%. But the truth is there is a large amount of deflation countering commodity prices. Asian sweatshops have completely driven labour and environmental protection cost out of consumer goods. It is amazing that you can get a forged tool like a pair of low end pliers for $1 world wide today. Automobiles are expensive but they also have some amazing features in safety, reduced maintenance and fuel economy that have lowered the overall cost of ownership.
Todays cars take so little maintenance that the corner service garage is becoming a thing of the past.   Housing has come back in to reach for most Americans with a some 23% drop in housing prices. Airfare have come down, with Southwest Airlines and Jetblue and Ryanair offering rock bottom prices.

In fact the only area that really looks to be heading the other way is Health Care costs. America does not have the most advanced health care in the world. Many nations have much higher estimated life spans, low birth death rates, lower postoperative infection rates and far less unnecessary screening with CATS scans and MRI machines.  However no one spends money on Healthcare like the USA. If you live outside the US travel medical insurance to the US is 5 times what it cost to visit Europe, Asia or anyplace else! 

The price war continues online as Amazon, eBay Netflicks and itunes destroy brick and mortar retailers. In their dust lie Blockbuster, HMV,  Best Buy and countless book stores. If that was not enough many frugal shoppers are buying recycled clothing from stores like goodwill. If you check the parking lot people are pulling up in a Lexus SUV to pickup some $5 Tommy Hilfiger play cloths for their yuppie puppies.  The donations are so large to these stores that they can turn over 60% of the clothing in to industrial rag and leave only quality merchandise for sale.  It is not just consumers, I built out a full DNA paternity testing lab with eBay surplus equipment for under $10,000.

Now with a global drop in commodity prices and fuel costs, expect even lower cost in everything from a cup of coffee to a chocolate bar. For someone who once paid 14% on a mortgage, it is amazing to live in a time of 2% loans little chance of inflation. 

But That is Also the Danger
If the only thing keeping inflation near a healthy 2% is oil prices, we run the risk of deflation. In 2002 as soon as Ben Bernanke took his new job as fed chairman he gave a speech about deflation entitled "Deflation: Making Sure It Doesn't Happen Here". The key take away line from that speech was:

"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress."

You have probably had to visit an elderly relative at some point in your life and
what might have struck you about their home was that  it had nothing new in it. Older Americans don't spend on entertainment cars or even as much food.  Aging Americans from the Baby boom are in those years now, and the more hip among them may have bought an iPad, but they certainly are not keeping their McMansion size homes or updating their decor. 

They are also working for cheap long past the time when they should have retired, but our healthier lifestyles are keeping us working, often just for something to do. This is not good for youth employment or economic stimulus.  

Another spending bottleneck around the world is the low interest in building small business. Over 80% of new jobs come from small firms. I had to face this issue myself, with todays tax structure, and the highly competitive global marketplace the wise move is a safe overpaid position in the civil service. I am one of three brothers, who were inspired in business from our father. Each of us has gone on to be CEO of our respective business. However our children entering school have been guided into Academia, Public Education, Public Transportation and Public Health Care. In most case these jobs are further backed up by strong unions. They may regret that one day if we to surcome to Greece style cuts, but for now it is the safe bet. It reminds me of a joke I heard once - An entrepreneur is someone who doesn't know any better.     

Japan has fought with deflation for a long time now, the so called lost decade is looking more like the lost 18 years. Japan’s real GDP growth rate from 1990–2011 was only 0.9% per year, noticeably less than the trend growth rates the country had experienced in the 1960s (9.6%), 1970s (4.2%) and 1980s (4.3%). While real GDP has risen very tepidly since the early 1990s, nominal GDP has been flat for nearly two decades in Japan due to the combination of slow real economic growth and deflation.

Now that you are worried about that, don't be. I would agree with the Brookings Institute:
 "A collapse of demand big enough to threaten a dangerous deflation is a truly remote possibility."

The Us Fed has been quick to respond to any slow down and with a quick response and many US firms are still reporting record earnings. There is even new life in the US housing market. These are not the signs of deflation anytime soon, even if commodity price do fall.

The New Stability
The BRIC countries have a poor outlook since they are basing their economies on rising commodities stemming from Chinese demand. However, China fails to offer the world much more than tyrannical slave labour camp that benefits a few well-placed party members. Europe is finally had to pay the piper for years of declining productivity and spiralling cost of government due to subsides, excessive tax and massive deficit spending.  There is also the Euro, this currency is fundamentally flawed because it has no real central bank while monetary policy is set ad-hoc by independent national governments. It is very hard to hold to together a monetary union without a fiscal union. Corrupt politics, war, disease, poor education and low levels of investment ravage Africa. While South America is overwhelmed by the battles of the drug cartels, with neither the resource nor the will to fight the highly organized and ruthless drug cartels, that in some cases have become the local governments. Even the tiny little Tax havens from Monaco to the British Virgin Islands know that, in a world of transparency, the game is up for offshore tax evasion What will they do to survive?

It all leaves just one world super power, just one haven of stability, the United States. It is very likely the United States will see a strong net inflow of investments in the months to come, if only because nothing else looks as good. 

Invest yes, but in what?
Not only is the world got little choice on what country to invest -- it also has little choice in what to invest in.
Money Markets – Oh Joy ½% return in a 2% inflation world.
Rare AssetsArt, Diamonds, Stamps even Wine. Fakes and abound and it may be difficult to unload when buyers are scarce
Commodities – Prices are falling, as the situation of China becomes to clear read Pop Goes the Commodity Bubble.
Gold – Perhaps the most dangerous trade of all – Read Afterthe Gold Rush
Real Estate – Perhaps, but only in the US, the rest of the world is still far over built. Even then with tight credit and once bitten twice-shy buyers it is not going to be easy. Also price may fall again if interest rates rise. 
Derivatives and Credit Swaps – Well if you did not learn anything from Orange County and Lehman Brothers, fill your boots.  

Of course the biggest investment market in the world is bonds. But the bond market is widely expected to underperform in the future. Both Warren Buffett and Dennis Gartman have called for now to be the end of the bond market.  That expectation for underperformance is directly related to the probability that benchmark interest rates will rise soon. When interest rates go up, bond prices move lower; the longer the bond’s term to maturity, the greater its price sensitivity to rate changes. This confounds people, but the idea is simple, if you have a locked in bond investment that pays 2% interest you bought in the past, it is hard to sell if new bonds are paying 3%. Of course if you hold it you get your return, but in real terms your investment has declined in value. For example if rates were to rise to 4.4% a 10-year bond would immediately lose about 25% of its value.  

That leaves only one choice, Equities. Especially large cap dividend plays. A 4% dividend in a rising equities market is a powerful call. According to Bloomberg news, for the first time in recent memory even risk shy central banks are buying equities. Look at the DVY dividend ETF performance in the last three years. That must be more tempting than a Bank CD.

And for those with more appetite for risk, who would not be tempted by tech superstar Goggle, rapidly getting the title as “the new Apple”.

Equities today are just a little below the classic PE value of 15.5 but don’t forget as the US economy gains strength the E side of the PE will increase. Also there are many new equity issues and add to that Mergers and IPOs that have been very subdued so far and we could easily see a much larger US equity Market. Ernst and Young reported that IPO are even now raising over 6 billion dollars each quarter and that is growing.  NYSE volume is half it historic highs, so there is lots of room for new growth.

Another source of potential growth in equities is the estimate $1.7 trillion cash US firms have in offshore subsidiaries. If the US changes tax policy this money may come rush back to the US, but that change is not essential. US firms can effectively repatriate that money by either using it to guarantee loans in the US or by having its stock bought overseas. In either case if the US economy grows, these firms will be quick to make use of this dead money -- further stimulating growth.

The Commerce Department reported Friday that America's jobless rate dropped to 7.5 per cent in March, the lowest level in more than four years as the U.S. economy added 165,000 new positions. This recent jobs report was better than expected and the market rallied on the good news but many overlooked the section on hours worked, it decreased. That means less overtime and more workers. That is a positive for the US economy since money spends faster if it is widely distributed. Certainly there appears to be no stopping the US consumer, look at the consumer discretionary ETF, XLY:

Confidence Returns
Of course the big fear up until now was that Ben Bernanke in 2008 fired a Trillion dollar bazooka called TARP and was it going to blow inflation through the roof. You can read Inflation? What Inflation? to see why this is not happening. 

There is also the fear of a strong dollar derailing the recovery, but the US had a strong dollar policy for years before 2007 and these were strong economic years. Time magazine  pointed out that a strong dollar is a sure sign of investing confidence. 

With the DOW hitting new record highs each week, and all the factors mentioned above, we are seeing a return of confidence to the economy. Look at the price of gold, or the value of the VIX index and what you see is the subsiding of fear in real time:

Banks Begin to Lend
The final holdback has been that even though interest rates are low, the banks have been hesitant to loan money these last five years. Lending conditions, particularly for businesses, are finally beginning to thaw after five years of financial lockdown, according to the April 2013 Fed Senior Loan Officer survey.

Banks are profitable now and they are flush with cash. The market has begun to demand a return on that cash and bank must put more money to work.

What Does it All Add Up To:
These are not trends for tomorrow or the day after, nothing here says we can not have a summer pullback,  in fact that could be positive too -- but, the long-term view, I expect the New Momentum to be the trend.
  • I expect Oil to flood the streets of the world, and to remain under $65 a barrel - freeing the US consumer. 
  • I expect Gold to drop below the 2009 level of $800 as the fear trade dies
  • I expect the Fed will skirt deflation, but just barely.
  • I expect the American equities market to be the only investment available.
  • I expect fear of Dutch Disease to spurn Canadians into manufacturing, design and technology and lower reliance on commodities. If interest rate rise I expect a very weak Real Estate market in Canada. I also expect some very dangerous escapades as overconfident big 5 Canadian banks bite off more than they can chew in global markets.  
  • I expect as all commodities including oil and gold price drop, a mini-depression in the Persian Gulf, Russia, Brazil and Australia. Kicked off by a massive drop in real estate pricing in those countries.  
  • I expect Asia (China and the 5 tigers) and some places in Africa like Madagascar to remain a slave labour market
  • I expect things to muddle along in Europe, but with sharper divisions between nations that stubbornly march towards either More Socialism and More Capitalism, neither working great. Because the Euro is like a round peg in a square hole.

In short, things are very good, as employment recovers, as wage increase, as America produce high value-added goods,  as the world invests in America, as commodity price fall and trade deficits shrink, I would expect a sustained rally perhaps for a very long time. Buy US equities, in US dollars. Don’t be on the sidelines too long – this is the new momentum