Friday, August 1, 2008

Investment strategies in this time of transition (I)

In my post of July 29, 2008, “Understanding the Economy” I discussed two possible interpretations of the current economic situation. One interpretation concentrated upon demand side changes in the economy whereas the other interpretation concentrated upon supply side changes. I argued that it was important to get the correct interpretation because the policy prescriptions would be different in each case and would produce substantially different results.

I gave two reasons for focusing upon the latter explanation as the cause of the business cycle and stated that it was important to create policies that provided supply side stimulus rather than policies that just attempted to stimulate demand. If the United States focuses on demand side stimulation, the argument is that this will just exacerbate inflationary pressures with little or no response in terms of increased output. Any governmental efforts need to be aimed at stimulating supply so that output can increase without undue pressure on prices.

A similar proposal has been presented by Kenneth Rogoff of Harvard University on Wednesday July 30 in the Financial Times, “The world cannot grow its way out of this slowdown.” (See,Authorised=false.html?

Rogoff argues that “if all regions attempt to maintain high growth through macroeconomic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.” He goes on to say, “In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up.”

Furthermore, Rogoff states, “Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.”

In other words, pumping up aggregate demand at this time is not going to get a supply response and hence almost all of the increase in aggregate demand will go into prices increases. Not a very pretty view of the future.

My description of this scenario was presented in the earlier post. In this post I want to examine investment strategies for the two different scenarios. Since we started on the demand side responses and believe that policies aimed at spurring on aggregate demand have the highest probability of occurring, let’s begin here.

Demand side programs, according to the scenario presented by Rogoff (and myself), will have more impact on increasing inflation than they will on increasing output. As a consequence, investor focus should be on protecting oneself from rising prices. (Sounds like the seventies doesn’t it!)

What to look for? More tax rebates (already being discussed); support for housing (already being discussed); keeping interest rates low (already being discussed); and other programs and policies being presented by presidential candidates and Congress.

Investment strategy? Where are your inflation hedges? Gold…commodities…housing seems to be out this time (it was a great hedge in the 1970s)…inventories…paintings…rare coins…

Obviously, these types of investment do not do a great deal to contribute to increasing output or stimulating productivity. This is what happened in the 1970s as the focus changed and people pulled back from investing in innovations and capital that resulted in increases in productivity and which also created positive externalities that spurred on the economy.

Demand side strategies at a time like this divert attention away from productive investment and toward investments that hedge against inflation and contribute little to resolving the underlying economic problems that plague the United States (and the world). But, demand side strategies are very popular with politicians because they can allow the candidate to talk about help to the ‘disadvantaged’ and the ‘little guy’ and beating up the ‘bad guys’. And, they promise faster results. Furthermore, when investors hedge against the inflation that is created, these same politicians can blast the ‘wealthy speculators’ for driving up prices which additionally harm the less well off. And, this is what happened during the years of the Carter administration.

Rogoff concludes his analysis with this warning: “In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater ad more protracted downturn.”

What about supply side policies? Not as easy to do and certainly not as easy to sell! First off, the fiscal authorities must take pressure off the monetary authorities by exerting discipline over the government’s budget. The irresponsible behavior of the current administration must be overcome by bringing the deficit under control. Doing this will help strengthen the value of the dollar, something that will help the performance of the United States economy in the longer run.

The attention of the monetary authorities must be focused on keeping inflation at a low level. What finally got the United States out of the malaise of the 1970s? Some tough policy actions on the part of Paul Volcker and the Federal Reserve that broke the back of inflation (even though this is not what Jimmy Carter really wanted). Inflation is counter-productive to economic growth, productivity, and innovation. We cannot get a supply side response as long as businesses and investors focus on inflation. Keeping inflation at a low level will also contribute to the strength of the dollar. (See Fred Mishkin’s last lecture before leaving the Fed:; and

Other supply side policies are still needed to spur on a recovery, but these will not result in programs that generate a short term payoff, something, of course, that politicians do not like. But, it must be remembered…it took us a long time to get where we are now and it will take a long time for us to get back ‘on track’. People must remind the politicians that they turned their heads aside for a long time allowing this economic dilemma to arise…and they are not going to be able to get us out of this mess with a wave of a magic wand!

It seems to me that there are at least two aspects to creating the platform for the next period of expansion. First, we must go through the economic transition to get our financial legs back under us, both in our financial institutions, but also in non-financial areas as well. Second, we must go through the technological transition that will result from the advent of new sources of energy. And, this transition will impact almost every sector of the economy. The important thing here is that the government must introduce policies and programs that will support the PROCESS of transition and which will not impede that process by shooting for specific OUTCOMES.

What to invest in given a supply side response by the government? Well, this is a time of transition and that means we must look into areas in which the transition is going to take place. One possible source for investment is in companies that are getting back to basics and bringing their focus back into the areas that they have or can establish sustainable competitive advantage. Here we can look for turnarounds, restructuring firms, and acquisitions to gain scale, customer captivity, or create barriers to entry. Second, we look toward those innovators that are working in the energy field to construct technologies or market structures that might create sustainable competitive advantage. This means that the scope of potential investments may be quite large, but the focus will be on future market structure. I will write more on these in the next two posts.

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