Martin Spring's On Target: Marc Faber’s Views on Investing Now

Lifted from Martin Spring's latest On Target newsletter, Mr. Springs features an interview with marquee contrarian market savant Dr. Marc Faber...

Marc Faber’s Views on Investing Now

I took time off from holidaying in Northern Thailand for the privilege of a two-hour discussion with Marc Faber, the well-known commentator and editor of The Gloom, Boom & Doom Report, at his Chiang Mai home. Here’s how it went…

The Dollar

Spring: Do you expect the greenback to continue losing value?

Faber: Over the next three to six months there is likely to be a dollar rally, ahead of news of favourable events such as an improvement in the US current account. Although we could see the dollar go on to make a new low against the euro, it’s possible that the low of the current cycle has already occurred -- at the turn of the year.

Over the longer term, all paper money will lose purchasing power, but Asian currencies less so than the US dollar.

Inflation

Spring: Almost all commentators argue that central banks’ money supply creation must eventually produce renewed inflation, which is why they are consistently negative about bonds. Is that realistic?

Globally, the imbalance between supply and demand puts downward pressure on prices, and that seems set to continue, given the vast new low-cost manufacturing capacity being created in China. In real terms, interest rates remain low, suggesting that central banks aren’t worried about inflation. What is your view?

Faber: There is already plenty of inflation! You can see it in the prices of things like property, insurance, education, a lot of which doesn’t show up in the official consumer price indexes, where governments manipulate figures to keep them down.

Because of the highly leveraged financial markets, central banks will always accept inflation as the price of warding off any recession threat. The moment the banks see economic slowdown, they will stop their current tightening and revert to “printing” money.

You can be sure that in ten years’ time just about everything will cost more than it does now. The integration into the global economy of 3 billion people emerging from communism and socialism is producing demand pushing up the prices of many resources. Oil, for example, is four times more expensive than it was in 1998.

Although there will always be some pockets of falling prices, I don’t believe the world will see across-the-board deflation. Long bonds such as 30-year Treasuries may continue to rally for a while, but I don’t believe interest rates can stay this low, because they will have to react to higher visible inflation.

Within the next 20 years we could easily see annual inflation in the US rise as high as 10 per cent – accompanied, of course, by a depreciating dollar.

US interest rates

Spring: Currently the financial markets are positioned to assume that the Fed will continue pushing up interest rates till its lending rate reaches about 5 per cent. Is that realistic, given the dangerous leveraging involved in the carry trade, and the Fed’s history of reacting nervously to any perceived threat by flooding the system with credit?

Faber: The Fed isn’t particularly smart, as it showed by creating the asset bubble.

Because the Fed currently – and erroneously – believes the US economy is fundamentally sound, it will continue to push up rates. But not to 5 per cent. Perhaps to, say, 3½ per cent. That would be enough to cool down the economy considerably, without putting too much strain on the debt markets, particularly housing finance.

For the next few months bonds will continue to perform; but there are large downside risks in bonds. Rising short-term rates are good for bonds… and for the greenback. Dollar-denominated zero-coupon bonds are a buy. When policy changes, so will the dollar… and bonds.

There is a stronger case for owning euro-denominated long bonds. We’re not likely to see much inflation in Europe, and in some parts, even deflation.

The problem with investment markets now is that there is no compelling buy – not stocks, not bonds, not real estate. It’s very hard to find anything with an upside potential of 500 per cent and a downside risk no more than 20 per cent. There’s so much money slushing around and being used by hedge funds, the trading departments of banks and other big speculators to chase up the prices of momentum plays.

China

Spring: Will the Chinese economy slow down, as is generally expected? Longer-term, will it continue to deliver the extraordinary growth rates we’ve seen in recent decades?

Faber: We have already seen a sharp slowdown in sectors such as automobiles, electricity and real estate. I am leaning towards the view that we’re going to see a hard landing in China. The capital investment binge has produced such overcapacities – in steel, for example, capacity has doubled over the past three years.

If interest rates continue to rise in the US, that will dampen Chinese export growth. The effects will be transmitted directly into the Chinese economy because of the yuan’s fixed link to the dollar.

However, industrial production continues to expand strongly. Even if economic growth continues at say 4 per cent, that will feel like recession.

Longer-term, say over the next ten years, I expect annual growth to continue to average between 6 and 8 per cent.

China is at the heart of an Asian economic bloc that is already the world’s largest. Its industrial production is already 50 per cent higher than the US or Europe. There are already 330 million mobile phone subscribers in China! There are growing populations, and fast-growing middle classes.

Investing in Asia

Spring: How can international investors profit from the coming economic growth in Asia? Currently dividend yields look good, dividend growth has been good, operational cashflows are good, and balance sheets have been strengthened considerably, with deleveraging.

Faber. Unfortunately there is no correlation between economic growth and share prices. The environment for investors may not be all that good.

However, Asian currencies are no longer vulnerable as they were in 1997. Assets are undervalued relative to those of the US and Europe.

Even if there is a world recession, that won’t necessarily be bad for Asian manufacturers. A slump drives companies to look for cheaper sources of supply. It could lead to Asian exports increasing rather than decreasing.

Some argue that the recent strong rise in the Indian stock market has been overdone, but in dollar terms Indian equities are no higher than they were in 1994, and the political and economic environment is now much more attractive than it was then.

I am not keen on buying Indian shares now, but in five years’ time they will be higher. The market is currently trading on an earnings multiple of 13 times, which is OK.

In January we saw an interesting development in Asian stock markets, when they decoupled from the rest of the world’s. The reason is favourable macroeconomic conditions. Real estate and equity valuations are low to reasonable. Asia’s sensitivity to the risk of faltering export markets is probably over-estimated.

Look to the importance of improving domestic demand. In China we are seeing a deflationary boom as goods become more affordable, as happened in the US in the 19th century.

In the short run, a “hard landing” could see some sales of Asian stocks by international investors. There is some froth in Asia’s older stock markets.

There’s a downside risk of say 10 to 20 per cent in Thailand, for example. But there are always opportunities to be found. In Thailand, in companies oriented towards domestic markets, or food product exporters. A market earnings multiple of 12 times isn’t unreasonable in a world of inflated asset prices.

There is some potential in Singapore companies offering 5 per cent dividend yields. Malaysia offers a well-educated population, stability, and valuations that aren’t overstretched.

As you know, I argued in my book “Tomorrow’s Gold” that one of the best ways to invest in Asia’s growth is through commodities.

In the short run rising commodity prices could be painful, but as additional output is encouraged, we could see oil fall back to perhaps $35 a barrel, and industrial metals retrench perhaps 30 to 40 per cent. At this stage opportunities look best in the soft commodities such as corn, wheat and soya beans.

Political risks

Spring: Are investors ignoring the political risks, with China’s increasing economic power producing greater military power, rising tension with Japan, and intensifying international competition for natural resources?

Faber: Political tensions are not likely to lead to military confrontation.

The Chinese are being very smart with their “soft colonization” of the world through investment and building trade relationships – which will be followed by migration of Chinese businesses and people to other countries.

South America, and especially Africa, are a perfect economic fit with China. They are areas with huge resources, marked by poor government and corruption, uneducated populations, and no manufacturing bases outside South Africa that could compete with China. They are big potential sources of resources such as oil, and foodstuffs.

Japan

Spring: Japan seems condemned to low economic growth, with a structural savings surplus and an aging population. Yet it could be the major beneficiary of China’s growth because of its growing markets and investments there. What do you think?

Faber: Although Japan has had low growth for 13 years, don’t forget that the typical household has enjoyed appreciating wealth. Houses, other assets, consumer goods, are much cheaper. Only bonds are more expensive.

Even with economic growth of only 1 per cent, there is a very favourable environment for financial assets.

Companies have moved much of their manufacturing to China and other low-cost parts of Asia. In time, they will earn the bulk of their profits outside Japan.

Stocks are now relatively appealing. I would rather invest in a country with a good savings rate than in one making no savings at all!

The Japanese stock market capitalization has declined from 50 per cent of the world’s at its peak in 1989 to around 9 per cent now. That makes Japanese stocks attractive, and I expect them to outperform the US over the next five years.

Gold

Spring: The recovery in the gold price in recent years has largely been a dollar phenomenon – I have described the yellow metal, at this stage, as being little more than an anti-dollar play. Do you agree?

Faber: In a world of inflated assets, gold is cheap relative to oil, the S&P500 and other assets. And with interest rates so low, the opportunity cost of holding gold is low. We are at the beginning of a long-term bull market in gold – and silver.

Europe

Spring: Given its over-regulated, over-taxed environment, with public opposition to reforms and increasing political stresses within the European Union, how can Europe hope to compete with Asia and the US?

Faber: The incorporation of the Central and East European nations into the Union will discipline the Western Europeans and force them to change. They’ll either have to work more or work for less pay, or they’ll lose jobs to the new member-states.

The living standards of Europeans are going to decline relative to those of Asians. A worker in Europe won’t be able to continue earning 20 times as much as one in Asia; an engineer five times as much as one in India.

The multinationals like Nestlé will continue to do OK, but worldwide they will face intensifying competition from the emerging “national champions” of China and India, as they have done in the past from those of Japan.

We are likely to see increasing polarization in the world between the rich and the middle classes – the latter have been the prime beneficiaries of asset inflation, especially in real estate. A newly rich class in Asia and Russia will be buying their houses in Belgravia, so there will be pockets of wealth in Europe.

You will also see some movement of wealthier people from Europe to Asia. Here in Northern Thailand you can live for just 20 per cent of what it costs in Europe.