Published in the Bangkok Post, 30 October 2007
Imagine trying to build a house in a world where units of measurement were variable. If you managed to build it at all, it would almost certainly come crashing down within a short time. The same problem arises with paper currencies whose supply can be literally increased at the push of a button.
When a country increases the amount of its currency in circulation by more than the rate of growth in the economy, the result is a fall in the purchasing power of that currency. This is the reason why counterfeiting is such a serious crime but the result is the same, whoever is printing the money.
All hail the Dow
For the 12 months to October 24, 2007 the Dow Jones Industrial Average has risen by around 9.8% and during the same time, the US dollar index, which values the greenback against a basket of major currencies, has fallen by almost exactly the same amount.
This might imply that the average foreign investor in US stocks has just about managed to stay afloat but the devil is in the detail. The following dollar devaluations against individual currencies, puts many foreign investors underwater for the 12 months to date:
• Canadian Dollar: 16.8%
• Australian Dollar: 15%
• Thai Baht: 13.5%
• Euro: 12.7%
Investors of British Pounds can celebrate a modest net gain on their American investments because Sterling has only appreciating by 9% against the US dollar in the last 12 months!
American real estate returns will have fared little better in the hands of foreigners and depending on the property location, could be much worse.
The performance of the ‘Dow’ may not be seen entirely in its proper context by those living inside the US, particularly when US Government bodies are reporting ‘inflation’ rates of little more than 2% for ‘core’ inflation, that excludes rises in food and energy prices. For anyone who still needs to eat, drives a vehicle and who needs to heat and light their home, this is perhaps a puzzling way to monitor cost of living increases with the price of oil in US dollars climbing almost 30% in the year to October 2007.
Foreigners buying oil are somewhat cushioned from this sharp increase, with their appreciating currencies acting as a discounting mechanism to the US dollar price of oil. Here in Thailand the price of petrol has certainly not risen by 30% in the past year.
In December 2005 the Economist magazine reported that residential real estate was in a global bubble, bigger even than the ones that preceded the Wall Street Crash of 1929 and the dot.com crash in March 2000. The report focused on rental returns relative to property prices with returns at around half of their long term historic yields. Two years on these yields are even more skewed.
Although most major currencies have strengthened against the US dollar, those currencies are also printed in excess of the real economic growth of their issuing country, resulting in an internal fall in purchasing power. When looked at in this context and the very real prospect of house price stagnation or worse, caution might be the order of the day for those considering investment in property.
Like property, commodities are ‘hard assets’ but whilst property is probably the asset class with which people are most familiar, knowledge of commodities is generally much more limited. With regular news reports that many commodities are trading at or near all time highs, it is important to look at this in its proper context.
Paper currencies that can be printed out of thin air are a rubber yardstick when it comes to acting as an objective measure of ‘value’ and so real commodity prices are much lower than they appear.
Oil and gold
According to the UK Chartered Insurance Institute, the British Pound has less than 10% of the purchasing power that it did in 1971.
This means that in 1971 prices, gold would currently cost around USD 76 per ounce with oil at USD 8.80 per barrel.
This represents a real gold price increase, from its long term fixed price of USD 35 in 1971, of just 117%, or less than 3% a year compounded; hardly bubble territory. In real terms gold today is actually trading at around a 30 year LOW. Some value investing experts might describe this as a buying opportunity.
Equally oil was trading at 3 dollars a barrel at the end of 1971, (prior to the quadrupling of prices by OPEC by the end of 1974), giving a much more respectable 193% return in 36 years. This represents a compound annual return of around 5% which today would probably be considered a target return for a cautious investment.
Flight to quality
It would be difficult to deny that property is an important asset class and it is a fact that over the long term, equities do outperform cash and bonds, but with equity multiples and entire indices in many emerging countries, over 50 and residential rental yields globally that are currently so clearly over extended, the fundamentals of commodities seem to be much stronger.
At the time or writing, at the end of October 2007, global equity markets seem to be making almost daily gains of between 1% and 3%. These are punctuated with pull backs like the 4.8% drop in Shanghai on October 25 and an almost 10% plunge earlier in the month in India before trading was halted.
It would be a brave man indeed who would try to second guess the top of the current global equity and real estate bull markets and the subsequent bursting of these bubbles, but in the words of ‘Hot Commodities’ author Jim Rogers, ‘The last leg of a bull market always ends in hysteria’.
Richard Colburn (Cert PFS) is a UK qualified financial adviser with Sterling Assets.
Questions to the author can be directed to 053 216 528 or email@example.com