Tuesday, June 28, 2011

Invest For Inflation

Economies tend to act in a cyclical fashion. Cycles caused by statistical randomness or due to human behavioural or other patterns. There are additional factors that influence stock markets and economies alike, such as psychology and evolution or the finite amounts, no matter how large, of world resources. For years we have hoped to profit from the rapid economic growth of the BRIC countries and today the expectation of continued growth is by most taken for granted. Despite the enormous growth of emerging economies, stock market returns over the last decade have been muted. This often caused by investor's tendency to pay too much for obvious growth. This was true for the high tech boom in early 2000 and it is true for investing in the current BRIC boom.

Today economic growth in China and other emerging countries is coming back to earth. China's competitive advantage - low labour costs - is disappearing. Commodity prices are rising, in spite of IEA intervention. Higher energy prices are here to stay but they are capped by the economy's ability to grow. Once the fog of high government indebtedness clears the world may have yet changed again in a dramatic fashion.

I see over the coming years that Canada will become the resource oasis for commodities; one of the few places where private investment, political stability and business friendly policies still reign. At the same time, China and its emerging brethren may revert to a centrally planned economy focussed inward on their domestic markets and aimed at satisfying their populations' demands for a social safety net, for better wages and for a better lifestyle. This has happened to many countries before - Japan being the quintessential example. Where in past decades cheap labour created astronomical 'productivity gains' felt throughout the world and that helped significantly reduce inflation worldwide, now the opposite is about to happen. Yes China's economy will likely keep on growing at 6 to 10% for some years to come resulting in an ever increasing commodity demand and in an increasingly more expensive labour force. These are factors that will feed worldwide inflation. Technological innovation will likely continue to improve productivity but not enough to offset these inflationary forces.

To combat increasing transportation costs, in the Western world local industries are likely to flourish and globalization may slow down or retreat. However, a retiring Baby Boom generation likely will result in labour shortages and higher wage demands in both Europe and North America. Add to this the high levels of government debts, the costs of a war in the Middle East (Libya, Syria?) plus a winding down war in Afghanistan and we see even more inflationary pressures.

Finally there is the Middle East. The Arab Spring is just the beginning of major social changes in that part of the world. The Arab population also wants to enjoy life's luxuries and it will consume an ever increasing share of its oil resources. Resources that already today can barely keep up with world demand and that start showing clear signs of depletion.

All of this will likely lead to higher inflation. Ironically, the U.S. and Canada in its tow may become the real winners. The U.S. is one of the world's most desirable immigration destinations. Thanks to its numerous illegal immigrants the U.S. is demographically one of the world's younger countries. So is Western Canada. The U.S. with its entrepreneurial spirit combined with a young population and relative low government intervention is optimal for innovation and for improving productivity just like Canada - in particular the West. In the meantime, China is increasingly returning to a planned economy. Governed by a few who are trying to control the population, China faces a continuous rise in the cost of living. The stifling of innovation inherent to central planning and the increasing cost of living will handicap China severely and it will reduce its competitive edge visa vie the U.S. further. The short term nimbleness of central planners due to a shorter line of command hides the long term inability to adopt because central planning stifles the multitude of opinions and initiatives that exists in China's population.

On the other side, the U.S. and Canada have what only few in the world have - natural gas and oil in relative abundance, water, large reserves of resources such as potash and numerous other commodities and the freedom to follow our dreams. We are having affordable energy, fertilizer and water plus a young population filled with new ideas and endeavours. No wonder, that Warren Buffett expresses his bullishness on North America. So count on high inflation, the return of manufacturing, innovation and plentiful resources that will ensure the resurgence of North America and that will power the North American stock market in the years to come.

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