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The New Normal
New York: February 15, 2010
By John Stephenson

Recently, the stock market has been moving in fits and starts as it tries to assess where the risks and opportunities lie. A few months ago, commodities were on fire as the U.S. dollar was weak and investors fretted about a pile-up of U.S. debt and millions of Americans had negative equity in their homes. Today, the U.S. seems like an investment panacea in comparison to the PIGS—a Goldman Sachs acronym describing Portugal , Italy , Greece and Spain—the poster children for Europe 's fiscal mess.

Governments around the world have poured trillions of dollars into stabilizing their national economies in the hope of stimulating economic growth. On Wall Street, an army of risk management specialists is trying to uncover the next most-likely financial catastrophe. But trying to handicap which crisis will be front and center in the world of investing is no easy task.

Corporations are in much better shape than in the recent past, largely because of all the government check writing. Unfortunately, their customers aren't. Most consumers are deeply in hock and remain fully levered with little hope of escaping economic rehab as long as unemployment levels remain in the 10-20 percent range worldwide. Adding to consumers' misery are credit cards which are maxed out, a lack of income growth and with 25 percent of U.S. homeowners underwater.

Most of the West enters this new decade, surrounded by a sea of red ink at both the government and the household level. Lawmakers and concerned citizens are banding together in an attempt to more aggressively regulate various aspects of the financial system, suggesting that years of regulation and deleveraging of government and individual balance sheets will be the new normal.

A recent study by the McKinsey Global Institute examined the debt and deleveraging after the global credit bubble burst and drew upon 32 historical examples of deleveraging in the aftermath of a financial crisis. What the researchers discovered, was that in about half the cases they examined, sovereign defaults and inflation were the likely outcomes from a financial crisis, while, in the remaining cases, a prolonged period of belt-tightening was the norm. They also discovered that the ability of a country to respond to a financial crisis was related to the level of total national debt (government, corporate and personal) before the crisis. Not surprising, countries going into a financial crisis in good economic health were more likely to recover quickly than those with high levels of national debt.

According to the study, Japan with a staggering 471 percent total debt to GDP, was in the worst shape of any nation followed closely by the United Kingdom at 466 percent. While much has been made of the problems confronting America , U.S. total debt to GDP at 300 percent looks relatively healthy. The countries in the best shape were the developing countries led by India with a total debt to GDP of 129 percent, Brazil with a total debt to GDP of 142 and China at a ratio of 159 percent. Research from the International Monetary Fund (IMF) also forecasts similar trends with the so-called developing economies showing stable debt trends, while the developing economies are expected to see escalating government debts in the future.

The new normal for investors is a developing world, which is likely going to outpace the economic growth rate of the developed world for the foreseeable future. With years of painful deleveraging ahead of it, the West will likely muddle through with a slower-than-normal recovery trajectory.

For investors, this shifting world economic order has profound implications. Growth oriented assets such as currencies or stocks should be directed toward Asian countries where national debt levels are lower, reserves are high and the consumer sector is in its infancy. Countries such as China and India offer real potential to transition from a savings-oriented economy to a consumer-focused economy over time—a potential bonanza for investors.

While emerging market economies will likely offer the best fundamentals for bond investors, the smaller less developed nature of their financial markets will force fixed income investors into the securities of the “old” world for return. But a key consideration for fixed income investors, particularly those buying government bonds, is the level of national debt and potential for currency devaluation. The United Kingdom 's Gilts are a case in point and should be avoided at all costs since they rest on a quagmire of debts and potential currency debasement—presenting unnecessary risks for investors.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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