Investment Outlook 2nd Half 2010 - 2011

I have this uneasiness about our long-term future. We are addicted to hydrocarbons, warming up the earth at an exponential rate. Northern countries like Russia are experiencing record high temperatures this summer. We are probably past the peak of oil reserves. No more easy oil. We are drilling deeper into the ocean, resorting to more difficult to process oil sands.Yet the demand is accelerating because China, India and the rest of the emerging world are still at their early stages of economic development, with the same living standards that the Europeans were back in the 1950s. But the population of the emerging world is far larger, at 5 billion vs less than 500 million Europeans and Americans in the 1950s. The world will surely either run out of cheap oil or boil to death in the next 20 - 30 years. Yes, it will happen in most of our lifetime.

Food demand is rising faster than our productivity gains can cope. Forests, which absorb carbon dioxide and produce oxygen, are being stripped to grow crops. Carbon intensive animal farming is increased to meet the demand for more protein.

Wars will be fought over fresh water. If the glaciers disappear, perhaps 30 - 50% of the world's water supply will dry up.

That's all very depressing. Now back to the relatively more cheerful near term!

The Economy

We are not likely to hit a double-dip in 2011. We may have a recession in end 2011 or 2012, which is more than a year away. But not now. Look at the chart above. Our 10-yr US Treasury is around 3% while the 3mth US Treasury is around 0.5%. When short term yields are so low, the economy is unlikely to fall into a recession in the next 12 months.

When will our short term yields start to rise? It all depends on inflation. In the US, inflation is between 1.5 - 2.5%. With economic growth anaemic for 2H 2010, I don't expect inflation to rise until 1H 2011 when the world's economies stop its decline and start to rise. Inflation will quickly hit 2.5 - 3.5% by middle of 2011, forcing the US and EU into a series of hikes that will bring the Fed Funds to 2.5%, which is the considered the "mid point" by most economists. The hikes will continue until the end of 2011, when it may reach 3.5 to 4%. However, since the 10 year UST hovers around 3 to 3.5%, inversion of yield curve may occur as early as 3Q 2011. Then the clock starts ticking. By 3Q2012, we are likely to have another recession.

All this while, the US and EU will not enjoy the kind of GDP growth seen between 2004 - 2007. Those years were fuelled by drunken leverage. NObody needed to save or put downpayments to buy houses. This time round, households in the developed world are deleveraging. Wages will rise very slowly while unemployment will fall very slowly. Economic growth will range between 2 - 3% in the US and 1 - 2% in the EU. The rest of the world will spend more but will fail to fill the gap left by the developed world.

Inflation will run riot before growth in the US and EU can hit anywhere near 3 - 4%. Why? Back in 2005, oil prices were still benign at between USD20 - 50 bbl. It took 2 years for high oil prices to filter into higher inflation. Oil price hit USD70bbl in 2009; 2 years later, we will face spiralling inflation.

In Asia and the rest of Emerging Markets, we will see 5 - 8% GDP growth but inflation between 3 - 6% in most countries. Rate hikes, which already began early 2010, will continue into 2011.

Welcome to the age of STAGFLATION! The vocab most governments want to shun.

Equity Outlook

So if we are not facing a double dip in 2011, but we will face a recession in 3Q 2012, what will happen to equity markets? Equities are likely to rise after 6 months of consolidation. The consolidation in most markets started in April 2010 and I don't expect it to last beyond Oct 2010. Investors, who are doubtful of stock markets and parked most of their money into bonds, will be surprised at the strength of the rally at the end of the year. They will also see their bond returns destroyed by inflation and belatedly shift their funds back into equities. Such is the POWER OF ZERO. When rates are this low, it is impossible to remain in cash for long. It has to go somewhere.

The rally may last until end 2011 or early 2012 (before 1Q2012). We will probably Emerging stock markets hitting new highs. Markets like Mongolia will be headline news for their staggering rallies.

Look at the LIBOR-OIS spread above. It is finally thawing. Banks are less nervous and will lend more henceforth. Get ready for another rally. Stay in Asia ex Japan and Emerging Markets. I like stocks in Brazil, Russia and India. For regions, I like the Middle East, Eastern Europe, resource rich regions like Latin America and Africa. I would avoid developed markets at all costs. High correlation of stock markets worldwide mean there is little diversification benefit in the first place. So why buy US?

Caveat: We may see stock markets falling another 10 - 20%, triggering a mini-bear market, shaking out all the investors with no holding power before rallying. In the mean time, stay neutral (60% equities max).

Bonds

We are entering an age of high inflation. Yields will never be this low again. Inflation will destroy the value of investment grade bonds. Avoid investment grade bonds like AAA, AA or A. I would focus on emerging market government and corporate debt. Yields can still come down, though not by much. If stocks were to crash, bonds usually rise. But this time, I am doubtful that bonds can provide the shelter because interest rates in developed countries are already at record low. Only in Emerging Markets and in commodity rich countries like Canada, Australia and Brazil have started to hike rates and have monetary room to ease.

Be very careful therefore. Go for fixed income of Asian coutnries and corporates where fundamentals are better.

Commodities

A super cycle that is likely to rise higher in 2011. The world must rid itself of oil addiction. Otherwise, we might never enjoy another period of high growh, low inflation again. Technology must resolve the world's resource constraints otherwise the future is bleak. For these reasons, commodities are the way to go.

The frequent question I get asked is whether to buy a commodity futures fund or commodity company. My answer is it depends on whether your portfolio has too many stocks. Look at the 2 best funds from each categories. DB Platinum Commodity is a futures fund. BlackRock World Mining fund is a top equity fund that focuses on mining stocks. During the rally from 2009, DB Plat rose by less than 50% from the trough in Apr 2009 whereas BlackRock World Mining troughed in Nov 2009 and rose by 250%. It is obvious that equity mining funds perform better than futures funds. This is because mining stocks have fixed costs and experience exponential rise in profits when commodity prices rise. Commodity futures are purely a function of demand-supply.

But another sinister effect called the negative roll-yield eats away returns of futures funds. Most commodities are in contango; the longer term futures prices are higher than the near term. For example, a barrel of oil costs USD100 in 2011 and only USD76 in Aug 2010. This means that everytime a futures contract expires, it rolls over at a higher price, thereby eating away your returns.

Go for mining funds like BlackRock World Mining and BlackRock World Gold.

Alternative Class (Property, Hedge Funds)

The Amundi World Volatility and Amundi Euro Volatility Funds are one of the best funds to get into for all weather. In a bear market, both funds will perform around 20% per year. In a bull market, they will achieve 5 - 7%. In a hovering market like this year, around 12%. Why? Because they short the VIX when it is above 30 and long when below 25. Here's the proof:

Above is the S&P 500 Index. Notice the crash between Nov 2007 - Mar 2009 and the subsequent recovery.

This is the VIX. Notice it rose to almost 80 points at the height of the crash in 2008. Recently, it rose again to around 40, coinciding with the major correction from Apr 2010 to now.

This is the Amundi Volatility World. Notice the 30% spike in the fund's NAV during the bear market between Nov 07 to Mar 09. Since then, it rose a further 10% in the bull.

Other than shorting stocks, the Amundi Volatility World (USD) and Euro Volatility (EUR) are the best funds to get into when the market crashes or to diversify the portfolio.

Asset Allocation

I would put 50% of my money into funds in Asia ex Japan (Templeton Asian Growth), Latin America (Amundi Latin America fund), Emerging Europe (Schroder Emerging Europe), BRIC (HSBC BRIC), Middle East (Schroder Middle East), Emerging Europe, MIddle East & Africa (Fidelity EMEA), Emerging Markets (Schroder Global Emerging Market Opportunities), the Mining Sector (BlackRock World Gold and BlackRock World Mining). I would also hold stocks that were severely battered like Citigroup, BP, and good growth stocks like CSE Global, Ho Bee, Jardine C&C and Belle.

I would put another 30% into the Amundi World Volatility. Only 20% of my money will be in high yield bond funds like Fidelity Asian High Yield and Templeton Global Total Return.

This the asset allocation for my risk profile, which is currently moderate aggressive.