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New world order: three central economic theses

According to Johannes Müller, Chief Economist of DWS Investments, the next ten to twenty years will bring 3 major changes: higher rates of inflation, weaker importance of the U.S Dollar and an increase in market volatility.

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- We will have to get used to higher rates of inflation

Increasing rates of inflation, as we can already observe, now demonstrate only the very start of a long-term trend. Over many years, prices in Germany and other industrialized nations increased only moderately. Companies exploited all the globalization opportunities that increased particularly with the demise of communism, to relocate production facilities to low-wage economies. China became the West’s satellite workbench. Corporations had their products manufactured cheaply and exported goods at bargain prices to the West.

Consumers did not in fact pay less for products from China. Cheap competition increased price pressure on all companies to tighten their own competitiveness, to slash costs and increase productivity. In many cases retrenching and meager wage increases were the real prices to be paid.

The dampening effect globalization had on price inflation cannot be accurately calculated. One indication is the consumer basket used to calculate the US inflation rate. While, for example, foodstuffs and services have become much more expensive since 1995, the price of consumer durables, such as motor vehicles or electronics actually fell by 20 per cent.

This trend is coming to an end. China in particular is no longer just a cheap producer. The country has developed. Its people are no longer content with low wages and companies can no longer manufacture so cheaply. Higher wages increase their costs. In turn, this also makes exports more expensive. Though some companies have again relocated to other low-wage economies, this effect cannot be completely compensated for. At the same time, the increasing prosperity of its population is transforming China from a producer into a consumer. The Chinese people can afford more and are also willing to spend money. Demand is pushing global market prices upwards.

Industrialized countries can therefore expect high inflationary pressures over the next ten to twenty years. In Germany, for example, an inflation rate of three to four percent is possible. That will not happen suddenly. It will be gradual.

And what does this mean for the private investor? Inflation will depress the value of his savings. As well as this, he must be cautious about long-term investment in fixed-income securities. Inflation could cut the interest coupon. One means of avoiding this is to invest in bonds carrying inflation protection. Another – probably better idea – is to invest in cash short-term and in real assets.

- The days of the Dollar standard are numbered

Since the Bretton Woods agreement over 60 years ago, the Dollar has been the world’s dominant currency. Oil and many other commodities are priced in Dollars. Over 60 per cent of the world’s currency reserves are held in Dollars. The reason for this is the USA’s supremacy in political, military and economic terms since World War II.

This dominance is disappearing. The world is becoming multi-polar. The USA has been living beyond its means for many years. The country is severely in debt and the trade deficit is large. At the same time, the power of emerging markets is on the increase, most especially China. The People’s Republic has now become the second largest economy in the world. The global superpowers are jostling for position to the benefit of Emerging Markets. In many countries, a process of recovery began after the end of communism.

It is a positive for the global economy when there are multiple growth centers. Europe benefits especially with production of machinery, luxury goods and other products which emerging markets need. The USA will struggle more by contrast.

So it is simply a logical consequence that a world in which there is no longer a single superpower should have a number of reserve currencies. The Chinese Renminbi, the Euro and other currencies will gain in importance while the Dollar will lose importance. For all countries except the USA, it is a good thing when there are alternatives. For the United States that means that business must play by the general rules.

If the Renminbi is to become a genuine reserve currency, the government must abandon exchange rate restrictions. Until now the currency has been held artificially low, to give Chinese companies competitive advantage. Appreciation of the Renminbi would also be in keeping with the government’s objective of promoting consumption. Imported goods would be more affordable, inflation would fall and purchasing power would rise.

And what does this mean for the private investor? If the value of the Chinese Renminbi rises, that should have a similar impact on the value of currencies in neighboring countries such as the South Korean Won. So far, governments have not permitted that to happen, simply because companies would lose an element of their own competitiveness versus China. If the People’s Republic allows their currency to appreciate, the other countries could follow suit. In addition, investors can count on further growth in Emerging Markets. Apart from the BRIC countries of Brazil, Russia, India and China, there are opportunities in Indonesia, Thailand and Malaysia. There also remains great potential in Africa.

- Market volatility will increase

The financial crisis brought an illusion to an abrupt end: economic cycles cannot be perfectly controlled with monetary and fiscal policy. For years, economists and investors were convinced that it could be and the global economy let them think they were right for a period. Downward trends were short-lived and upswings ever longer.

But we have paid a high price for the stability and growth of recent decades. We lived through a cycle of super debt. Money was cheap, companies and private households borrowed with abandon and spent it just as quickly. Those days are history. In future there will be more serious blips in the economy, both up and down. The financial crisis and its consequences will be with us for a long time to come. Admittedly, growth prospects in the USA have improved, but the risk of a setback is just as real. The real estate market has still not recovered from the collapse that sparked the crisis. If prices fall further, that will threaten US growth as well as retail consumption. And this would have repercussions for the global economy. China has of course caught up, but the USA remains the world’s largest economy.

The relaxed monetary policy practiced by States and central banks alike to tackle the financial crisis harbor further risks. For example, the price of commodities has risen radically because investors have a surplus of money. Expensive copper, zinc or iron ore are a risk to the economy and drive up inflation. Higher commodities prices are also a threat to the financial markets. A whole group of market observers suspect that a bubble has built up. If it bursts, it will rock the equity markets.

Economic programs, and other measures that governments have taken to tackle the financial crisis, have brought about a situation where many States now have high levels of debt. This causes disquiet on the government bond market. And the truly necessary cost cutting programs threaten an upturn in growth.

At the same time, the economy is more susceptible to shocks as everything is interlinked. Disorder in Libya has an impact on the global economy via the oil price. The Japanese earthquake has not only impacted companies in that region. Supply chains transported production stoppages at Japanese companies right around the world.

In the final analysis, market participants have become more cautious as a result. Many old rules no longer apply. Trust has been shaken to its core. Many people react more sensitively to news. Market volatility will increase as a result.

And what does this mean for the private investor? It is no longer possible to simply sit on titles, but they will need to manage their portfolios more actively and even withdraw profits. For those who previously focused mainly on equities, this is familiar territory. This approach now applies to government bonds. State debt problems are depressing the market. Some countries are on the brink. Their followers analyze every piece of economic or political news. Reactions could be severe simply because the situation is so precarious. Investors must therefore keep the situation under constant review. Bonds cannot just be left alone till their maturity date.

Johannes Müller , May 2011

Article also available in : English EN | français FR

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