It’s time to shift your focus to the most unloved, abused securities.

Here’s why: As the global economy slips into an economic recession over the next several months, those unwanted securities will yield the fattest profits for your portfolio.

The last time the global economy suffered the tribulations of a major economic recession was back in 1990. We can thank the last U.S. real estate “bubble” (a.k.a. Savings & Loans Crisis), and the demise of the European Exchange Rate Mechanism (ERM) for that contraction of output. You may remember the European Exchange Rate Mechanism (ERM) as the euro’s predecessor - the European Currency Unit (ECU).

Asia, however, saw the biggest decline in economic output since WW II starting in 1997 when Thailand triggered the Asian economic crisis. That watershed event led to the massive destruction of credit, currencies, and stock-market values. As a result, regional economies plunged into the abyss until they finally bottomed in late 1998.

The last U.S. recession in 2001 was mild by historical standards. That’s because housing values continued to appreciate during that span while financial assets were decimated. Basically, money had somewhere to flow unlike this year. Until recently, commodities have been the only “game” in town for investors. And now, even commodities are pulling back.

The Worst Worldwide Recession in 20 Years

The economic slowdown now threatening the United States and other industrialized economies will probably lead to the worst recession in almost 20 years.

The world economy will continue to struggle with the heavy burdens of rising food and energy inflation. On top of that, industrialized nations are facing deflation in housing and bank credit. And all the while, consumption will continue to erode because consumers will save more and spend less to address balance-sheet erosion.

For the first time in the post-WWII era consumers are facing a bizarre mix of lethal food and energy price inflation and deflation (or declining prices) in real estate and financial assets (stocks and bonds).

Never in the post-war period have consumers and investors alike faced such a challenging environment. We’ve simply never had to deal with two powerful economic forces converging with lightening speed.

Deflation, not inflation, does far more destruction to consumers and the global economy. That’s because debt burdens become increasingly difficult if not impossible to finance.

That’s the lesson of the 1997-1998 Asian economic crisis, the Russian ruble collapse in 1998 and now, the credit and real estate deflation attacking the United States and Western Europe since August 2007.

Inflate or Die

In a typical deflation environment, credit “bubbles” deflate. This process or monetary phenomenon can take several years to control until finally the forces of inflation eventually win. At that point, global central banks usually try to print their way out of economic distress.

The only way to beat deflation or an environment of rapidly declining prices is to expand bank credit like there’s no tomorrow. That’s what Asian central banks did in 1998 and the United States started in 2001.

The last U.S. deflation, back in the 1930s, was eventually cured by the Second World War. The war led to renewed economic production as the United States converted from a sleepy, peaceful country to a wartime economic juggernaut.

But today, the sub-prime crisis has morphed into a diabolical monster as it spreads from one facet of credit to the next. In the process, debt deflation or credit destruction is now underway.

The entire gamut of credit deflation reads like a bad movie script - and it’s still unfolding.

Bank credit continues to tighten in the United States and Europe, particularly in the United Kingdom, Ireland and Spain. As a result, default rates are now rising for companies and consumers.

Credit card delinquencies are surging and even top-notch investment-grade companies are being denied credit. Corporate bond spreads trade at multi-year highs, banks’ capital ratios have plunged amid a blizzard of unprecedented losses, and mortgage markets are hemorrhaging.

The Debt Deflation Strategy

According to data from Morgan Stanley, only U.S. Treasury bonds posted gains during the last deflation or Great Depression of the 1930s. Gold, however, might have gained in value had FDR not confiscated ownership in 1933.

In my view, gold along with the U.S. dollar would post significant gains versus most assets, including foreign currencies in a debt deflation.

Silver, however, might not appreciate as strongly as gold in a severe recession.

Silver remains mostly an industrial metal and I doubt it would appreciate in the same context as gold during price deflation. That’s because industrial demand for silver would collapse in a hard recession, unlike gold - viewed universally as a surrogate currency and a long-term store of value against fiat currencies.

Other commodities, including oil, are unlikely to rise in value if the current economic situation deteriorates further. There’s no historical case to be made for holding raw materials in a debt deflation. Not even China will save commodities from a major decline.

High quality Treasury bonds and non-financial A and AA-rated corporate bonds are also ideal hedges against credit destruction. As interest rates collapse amid an outright deflation or severe recession, long-term debt prices should rise markedly. Avoid junk bonds and any other category of bonds that aren’t of the highest quality.

The U.S. dollar is also poised to rise vis-à-vis most currencies as the recession unfolds. That’s because foreign economies lag behind the U.S. credit squeeze by about 12 months and will increasingly find debt deflation at their doorstep.

Foreign central banks will begin cutting interest rates in 2009 to offset rapidly deteriorating output. That makes the dollar more attractive on a relative basis because the Fed has already aggressively reduced lending rates to boost growth. That’s certainly not the case in Europe and Asia.

Get Out of Dodge While You Can

I would also consider opening a foreign bank account to hold some gold and U.S. dollars as a safe-haven strategy.

It is not unfathomable that some sort of foreign exchange control may arise over the next few years. If that happens, it will restrict your overseas transfers and stop individuals from opening a foreign account. The British government imposed such controls in the early 1970s during an economic crisis. It can happen again.

I have little faith, apart from the above short list of strategies, that other assets will protect investors. Debt deflation is the absolute worst nightmare for investors, central banks and the general populace.

The key is to protect what you have. At some point, as the crisis eventually subsides, great bargains will beckon in distressed debt, bankruptcy reorganization securities, common stocks and real estate.

For now, I’d brace for some difficult years ahead and start planning for a hard economic landing. In a worst case scenario, it’s better to be safe than sorry.

15 2008 - Australasian Investment Review – (AIR)

Suddenly the spectre of inflation no longer hangs over the world: it’s gone, banished by the reversal in sentiment in commodity and financial markets. Banished by fears of recession, which were confirmed overnight with Europe contracting in the second quarter, with Germany and France following Italy into a slump. Oil, copper and gold down, and wheat, corn and soybeans as well it’s been a sea change in sentiment in the past month. Slowing Europe and Japan suddenly mean the US is not alone, so it’s off into the greenback because you’ll be more protected there. Europe moved into a real slowdown in the June quarter,with growth contracting by 0.2%, Germany’s economy contracted by 0.5%. France slowed as well, with the economy falling a surprising 0.3% in the quarter. Growth is still up for the first half after the March quarter saw growth of 0.7%, but the size and speed of the slump was surprising, and emphasised why commodity prices are weakening, along with the euro. Inflation is supposed to have peaked, or is close to peaking; growth is slowing, and so will price pressures as recession bites. That’s why the surge in consumer inflation last month in the US came as a complete shock to the markets. Despite the slump in oil and petrol prices from mid-month onwards, and the rise in the value of the US dollar, the CPI surged by a rather large 5.6%, the highest rate since January, 1991 when the first Gulf War was raging. That compares to an annual 5.1% in the year to June. The CPI rose 0.8% in July, compared to June when it jumped 1.1%, so there was a small slowing. But the surprising news had no impact on interest rates, shares or sentiment. Oil was still easier, gold fell sharply, losing the gains of the day before and copper was lower. Higher food, petrol and energy costs were responsible, despite the drop in oil and petrol prices. Those falls are continuing, that’s why economists believe the CPI will drop sharply this month. Now the older and wiser of those in the market wonder if there’s something more dangerous approaching, along with the slumping global economy: deflation. More of that shortly. All year long, the debate has raged over whether the world faces a greater risk from resurgent inflation or from a deflation, caused by the credit crunch, to match Japan in the 1990s. The fall in commodity prices has, for now, convinced the market that we need not worry about inflation. In the US, the market for government inflation protected bonds (called TIPS) now implies that inflation will average 2.16% over the next decade. That’s the lowest in five years, but is it just as much an overshoot as the upward drive in commodity prices when they peaked midway through last month? What is still clear is that inflation is still with us: from the United States, through Europe and Asia, prices are still rising. Wholesale price inflation is double digit in China (but consumer prices are easing); in the US, Europe and the UK wholesale and consumer price inflation are at levels not seen for more than a decade in some cases.  In Japan this week’s report of a 7.1% jump in wholesale inflation was the steepest rise in 27 years In the eurozone, the consumer inflation hit 4.0% in July; more than double the European Central Bank’s inflation target of 1%-2%. Inflation stands at 3.6% in France, at 4.4% in Britain (its highest level for 16 years) and at its highest level for 12 years in Italy at 4.1% and 11 years in Spain where its running at 5.3%. In Germany inflation hit 3.3%, the highest rate since 1993 and enough to get the old anti-inflationist Bundesbank rolling in its grave. Inflation hit 4.3% in Norway, Eastern Europe it’s 6.7%, while in India it’s running at nearly 12% and in Japan at 1.9%, the highest for more than a decade. In some countries such as Argentina there’s doubt about the declared rate (9.3% there) because of changes to the way the government accounts for and reports inflation. In Thailand it’s running at 27% and higher in Egypt This week China reported a slowing in consumer inflation to 6.3% from 7.1% in June. But core measures which discount food and energy have risen past 2%. Now the point of this international roll call is to make a point: normally it would be enough to see interest rates rising everywhere: in India, the central bank is tightening policy, but apart from the increase at the start of July by the European Central Bank, central banks are holding back, transfixed in the case of the Fed and with the Bank of England by fears of a downturn and fears about inflation. So why then are financial markets (even bond markets) suddenly more relaxed about price pressures and galloping into equities and out of oil and commodities? Relative growth differences between the US, Asia and Europe is the one reason already stated, but the Merrill Lynch’s August fund managers survey provides a second reason. Big international investors no longer fear inflation.They worry more about recession, which they believe will take care of cost pressures.So does that indeed signal a deflationary period of rapidly falling growth and prices?

Here’s what Merrill Lynch concluded this week:

Fund managers’ fears of inflation have all but evaporated to reach their lowest level since the downturn of late 2001, according to Merrill Lynch’s Survey of Fund Managers for August.

Merrills said a total of 193 fund managers participated in the global survey from 1 August to 7 August, managing a total of $US611 billion. A total of 161 managers participated in the regional surveys, managing $US432 billion.

The survey captures an extraordinary reversal in investors’ attitude towards inflation. A net 18% of the 193 respondents expect global core inflation to fall in the coming 12 months.

In June’s survey, a net 33% thought inflation would rise.

A falling oil price and growing evidence of recession have prompted this rethink.

More investors believe that the global economy has already entered recession - 24% of the panel take that view this month compared with 20% in July and 16% in June. During the credit boom, investors urged companies to borrow more, but with the credit crunch biting, they are now concerned about leverage.

The net percentage of investors who believe corporates are under leveraged has tumbled to 9%, down from nearly 40% at the end of 2007.

“The message from investors to corporates is that if we are headed for a recession, they should clean up their balance sheets and prepare a financial buffer,” said Karen Olney, chief European equities strategist at Merrill Lynch.

“As banks de-lever, non-financial corporates will have to wake up to far less flexible world of credit.”

Merrill Lynch found that US assets are indeed back in favour (as it seemed in the Mat survey).

“With the economic downturn spreading to the eurozone and certain emerging markets, investors are starting to view U.S. assets as attractive.

“The net balance of asset allocators overweight U.S. equities stands at 12 percent, its highest level in more than six years.

“Supporting this view is the widely-held belief that the U.S. dollar is undervalued.

“A record net 58 percent say this month that the dollar is undervalued, while a net 71 percent say the euro is overvalued. Investors believe that the U.S. has a better corporate profit outlook and higher quality earnings than the eurozone.”

In Europe, investors are moving from oil to consumer stocks.

“European investors have responded to the fall in the oil price by selling oil producers and buying into discretionary consumer stocks.

“The percentage of European investors overweight oil & gas stocks collapsed to 11 percent in August from 52 percent in July.

“Investors have also significantly scaled back large underweight positions in travel & leisure, personal & household goods and retail companies.

“Technology and media sectors, both with significant exposure to consumer demand, also swung back in favour.

“At the same time, inflation fears among the European panel have fallen to levels even lower than in the Global Survey.

“A net 45 percent of European fund managers expect the region’s core inflation to fall over the next 12 months. In June, 32 percent of the European panel were predicting rising inflation.

“The market appears to have overreacted to a fall in the oil price, and investors have turned a blind eye to second round effects of inflation, such as rising wages,” said Karen Olney. “It will take several months of slowing global growth to be sure that the inflationary dragon has been slain.”

But the Merrill Lynch survey contains a cautionary note.

“One consequence of the recent fall in the oil price has been a rapid unwinding of what the survey has highlighted as a highly-crowded trade: Investors have reduced ‘long’ or overweight positions in energy and started closing underweight positions in financials.

“But have they lost sight of the fundamentals in unwinding this position?”

Merrill Lynch says it believes that the energy sector will continue to be supported by a strong oil price.

The firm forecasts oil at $US119 in the fourth quarter, underpinned by low, real global interest rates.

Francisco Blanch, Merrill’s head of global commodities research, said in a statement with the survey results: 

“While we have started to see some demand for oil curtailed in OECD economies, the economic fundamentals in China and other emerging markets support oil at more than $US$100 a barrel into 2009.”

“Investors have moved to close underweight positions in European financials after second quarter results suggested banks are on the road to improvement.”

But, according to ML’s Stuart Graham, head of European bank equity research, toxic write-downs are coming to an end and banks have completed more than half of their capital raising.

However, although earnings downgrades for banks are well under way, doubts remain about the sector’s ability to bounce back quickly.

“Banks are highly unlikely to see a V-shaped recovery in their share price given the uncertainties in the market,” said Stuart Graham. “Apart from the economic outlook, a key question is how stringent regulators will be in setting new rules to govern banks’ capital ratios. No one yet knows what the appropriate capital structure of the future is.”

After a longer than normal delay, commodity prices have entered a significant correction on the back of slumping global growth and a stronger $US.

Notwithstanding, occasional bounces (such as that seen in the last 24 hours) the downwards correction in commodity prices has further to go over the next six months or so.

The AMP’s Dr Shane Oliver says this is good news for the global growth outlook and for shares generally as it takes pressure off inflation and hence clears the way for lower interest rates.

But it is bad news for resource shares and the $A, as we have seen with its 12 cent fall in a month against the US dollar.

While the correction in commodity prices has further to go, their long-term trend is likely to remain up, he says.

From recent highs oil, gold and copper prices have fallen around 20% and wheat and corn prices are down around 30%.

Of course this has occurred from very high levels, as evident below.

What is driving the slump in commodity prices?

What are the implications?

Is this the end of the commodity bull market or just a correction?

Commodity prices and the global growth cycle

In a normal global economic downturn commodity prices fall in response to slowing economic activity.

This takes pressure off costs and inflation, allowing interest rates to fall which sets the scene for an economic rebound.

This time around has been a bit different. Until a month or so ago commodity prices remained very strong being propelled by still strong growth in the emerging world (notably China), investor demand for commodities as a hedge against a falling $US, and speculative demand made possible by the growth of commodity funds and partly fuelled by investor scepticism with financial assets.

The problem was that the surge in commodity prices, notably for oil, was not only cutting into profit margins and consumer spending power but that it was directly adding to global inflation; this was keeping global central banks far more hawkish than they should have been.

So while the credit crunch meant interest rates should have been falling, in the US and UK and being increased in others (e.g., in Europe and Australia).

The end result has been more global economic pain than would normally be the case.

Back to normal

The past month has started to see commodity prices return to something like their normal relationship with the global growth cycle with sharp falls now becoming evident.

There are several reasons for this.

Firstly, recent data has shown that Japan and Europe are flagging just as badly if not worse than the US. In fact the recent flow of economic indicators suggests that both regions may now be in recession.

This is bad news for the emerging world including China because they will find it harder to divert their exports away from the already weak US.

Secondly, it has become increasingly clear that China, India and other emerging countries are also slowing.

Chinese economic growth looks like being 9 to 10% this year compared to last year’s near 12%.

As a result, Chinese authorities are now starting to back pedal on some of last year’s tightening.

Indian growth is likely to slow back to 7% from 9% last year with aggressive monetary tightening starting to bite.

Growth in Brazil is also likely to slow on rising interest rates.

Thirdly, the slump in share markets as oil went through $US120 a barrel in May and increasing evidence of falling oil demand indicated that the surge in the oil price was starting to “choke off” growth and hence oil demand.

Rising base metal inventories are also starting to become evident. See the chart below.

Fourthly, the realisation that growth outside the US is now slowing faster than that in the US has seen the $US break higher.

This in turn has suddenly removed investor demand for commodities, such as oil and gold, as a safe haven against a falling $US.

The combination of all of these fundamental developments has seen commodity speculators squeezed.

The favourite trade recently was long oil/short banks, but in the last few weeks it has suddenly reversed.

This has forced investors to close their positions, which has only added to the severity of the moves.

A pause, not the end, in the commodity super cycle

China may be slowing but is not about to collapse and the long term demand potential in emerging countries is huge.

China’s copper usage per person is less than half US levels and its oil usage per person is around 10% that of developed countries.

Rising income levels and the increased use of agricultural products for fuel will also see ongoing upwards pressure on agricultural demand.

Just as we have seen in the last six years, supply will struggle to keep up with commodity demand over the long term.

As such, the long term trend in commodity prices is likely to remain up. See the chart below.

In this context the recent pull back in commodity prices should be seen as a correction, but it likely has further to go.

Commodity prices remain well above their rising trend (as evident in the previous chart) and speculative positioning and sentiment regarding commodities is yet to fall back to levels associated with a durable rebound.

More fundamentally the economic news over the next six months is more likely to get worse before it gets better.

The next chart shows the relationship between a leading indicator of world growth (based on the OECD’s leading indicators for OECD countries plus Brazil, Russia, India and China) and commodity prices.

Normally there is a close relationship, but it broke down last year and into mid this year as the leading indicator fell but commodity prices surged.

But a more normal relationship seems to be getting reestablished. As can be seen below, the leading indicator suggests more weakness in commodity prices ahead.

Against this backdrop speculative positions in commodities are likely to be wound back further particularly as the $US now seems to be on a firmer footing relative to other currencies.

In the very short term commodities have become oversold and due for a bounce, but the trend over the next six months or so is likely to remain down.

Implications – the good and the bad

The cyclical down turn in commodity prices now underway has a number of implications

Firstly, the correction in commodity prices is good news for the global economic outlook and share markets generally.

Softer commodity prices will remove much of the pressure on inflation.

This in turn will help global central banks move towards lower interest rates and provide greater flexibility to deal with the ongoing credit crunch.

We expect lower interest rates in Europe, the UK, Japan and Australia over the next six months.

Secondly lower commodity prices will also help reduce corporate cost pressures and provide increased spending power for consumers.

To the extent lower commodity prices make it easier for a healing of the global economy it should be positive for global shares generally.

Thirdly, falling commodity prices are of course bad news for resources shares.

As such, there is potential for a further reversal of their relative out performance versus financial shares over the last year.

See the chart below in relation to Australian resources and financial shares

Given the relative importance of resources in the Australian share market, it is also likely to mean that Australian shares may under perform global share markets for a while yet as the commodity correction continues to run its course.

Asian shares are likely to be key beneficiaries of the correction in commodity prices given Asia’s high reliance on commodity imports.

Fourthly the commodity price downswing means the $A has entered a cyclical correction greater than any of the pullbacks seen in recent years.

While the $A is oversold having fallen 13% in four weeks, and so may have a short term bounce, more downside is likely in the months ahead, possibly to $US0.80.

Parity against the $US has been postponed probably till late 2009 after the commodity cycle turns up again.

And lastly a downturn in traded commodity prices will also dampen the terms of trade boost for the Australian economy, adding to the case for RBA interest rate cuts.

Conclusion

Commodity prices have entered a cyclical correction which looks like running a bit further.

While this is bad news for resources shares, the relative performance of Australian shares and the $A, it’s necessary to clear the way for lower interest rates to combat the credit crunch.

So overall it’s more good news than bad.

More broadly we think that the commodity super cycle remains alive and well, but a sustained resumption of the uptrend in commodity prices probably won’t get underway till some time next year.

What Happens to Shares When Central Bankers Change their Tune

Some people look at the RBA and see a puppet-master, pulling strings to keep the economy dancing a merry tune. We look at it and see an irrelevancy.

Our own opinions aside…if the RBA starts cutting rates, it should mean joy for the share market. All other things equal, of course.

The last cash rate tops haven’t necessarily coincided with a booming All Ordinaries, though. In December 1994, the rate topped out at 7.5%. The index went straight up. But it’s the only textbook example of rate tops meaning market bottoms. In the early 1990s we had a recession despite falling rates. And after the top in August 2000 the market traded sideways for month.

This time could be different, of course. And if history sets it apart from the other examples, it’ll probably be because of a continued drop in the oil price.

SINGAPORE : Finance Minister Tharman Shanmugaratnam on Sunday gave the assurance that Singapore is not heading for a recession.

Speaking at a community event, Mr Tharman said, “From all indications we have at this point, I don’t think we’re heading for a recession. But there will be discomfort on the ground. Unfortunately, the fuel price increase in Malaysia does mean that vegetable, poultry and some other prices will go up. We can’t avoid that. Fortunately, rice prices globally are coming down.

“But overall, we’re in a situation which isn’t temporary — this will be with us for a while. Commodity prices are much higher than what they used to be. But we’re tackling it, and we’re confident of tackling it — both through the government’s measures, the Growth Dividends, the GST Credits, as well as the way in which you see a lot of community initiatives on the ground.”

Mr Tharman was speaking to reporters at the Entrepreneur—in—You Carnival at Republic Polytechnic, where some 7,000 people turned up to pick up tips on starting their own business.

The carnival included forums, workshops and an exhibition to nurture business acumen.

There were also winning business presentations by tertiary institutions, and a presentation of the 2008 Youth Enterprise Awards.

The People’s Association organised the event to encourage Singaporeans to be entrepreneurial. — CNA/ms