After crisis, it will be a brave new world

Your first step in preparing for a return to personal prosperity and future investment success is to recognize that the financial world awaiting us on the other side of this crisis will be far different from the one we’ve known in the past. As the old car commercial proclaimed, “This isn’t your father’s Oldsmobile.” The investment landscape will have an entirely new appearance, with new markets to explore, new power players with which to compete and new risks to confront.

It will be a far cry from the financial scenery of the past two centuries, during which the business, banking and investment activities of the world took place in the United States and the money centers of Europe (with Japan joining the ranks in the mid-1960s). As late as the 1980s, most of the developed world still wore financial blinders. When Americans wanted to purchase a bond, they’d limit their search to the offerings of the major East Coast or San Francisco investment bankers. When they wanted a stock, they’d call up their local brokerage office and place an order for a New York Stock Exchange or American Stock Exchange issue — or, if they were more aggressive, something traded on Nasdaq or over the counter. The truly adventurous might look overseas for a little added diversification, selecting something listed on the London Stock Exchange or putting a bit of cash in an international mutual fund.

Average investors were discouraged from trying anything beyond those choices — and the big-money pros weren’t much more “abroad-minded.” After all, most securities exchanges away from the United States, Europe and Japan were badly organized, with limited access, weak regulation and poor liquidity. The companies whose stocks and debt they traded lacked quality management and verifiable fundamentals, plus they did business in weak or developing economies with limited growth potential, often unstable governments and suspect currencies.

“Why even bother?” was the general attitude. “Why chase too little reward with too much risk?”

Today, the situation is reversed. The United States and most of the rest of the world’s developed nations are in financial disarray, beset by oppressive government and personal debt, dwindling business revenue and profits, mushrooming unemployment, declining currency values and concurrent inflation, particularly in prices for oil, commodities and other raw materials. What’s worse, the leaders of these nations are taking exactly the wrong steps to deal with the crisis — steps that will prolong our period of pain for much longer than any of the pundits have predicted.

By contrast, many of the world’s so-called emerging nations are enjoying growing — or at least comparatively stable — economies, driven by an expanding middle class, increasing domestic-consumer demand and steadily rising expenditures for infrastructure improvement. Because of revenue for past and continuing exports of both finished goods and raw materials, many also have low debt — or in the case of China and a few others, actual surpluses — and strengthening currencies. They are also building more-efficient markets and better business environments, thanks to shifts from repressive past regimes to more modern democracies or at least moderate government forms that have fewer arbitrary rules and better legal and regulatory systems.

What this means is simple: If, as an investor, you want to profit from the coming global recovery, you should look toward the developing nations and the emerging markets, not at the traditional financial venues of New York, Western Europe and Tokyo.

This time around, it will be Wall Street that offers too little reward with too much risk, too little promise with too much uncertainty. More dependable, more rapid and more dynamic returns will be found elsewhere — in the more lush, faster-growing and still-developing areas of the global financial landscape.

WESTERN OUTLOOK GRIM

Though we’ve seen a few bright spots recently, the outlook for the Western world is still grim — as bad as it has been since the Great Depression — and the problems aren’t going away anytime soon. Despite the bailouts and stimulus packages, America still faces four critical risks:

• An economic relapse that could throw us into an even deeper and longer recession.

• A further surge in inflation as a result of ill-conceived and ill-executed monetary policies.

• A resulting devaluation of the dollar to levels even worse than seen in 2008 and early 2009.

• A continuing credit crisis that would stifle each new push toward growth and recovery.

The chances of these risks’ being acknowledged and addressed by most individual investors are near zero. Hobbled by fear, yet still hopeful of an eventual recovery, they’ll sit on the sidelines, playing it safe — until it’s too late, at which time they’ll move back into the same old stocks, bonds and real estate investments they made before. While this approach is fatally flawed, it does compound the opportunities for those few investors who recognize the truth.

A big part of that truth is that the U.S. stock market won’t rescue us from this mess or restore our lost wealth — at least not in the near term. Most investors think the markets in the United States topped out in late 2007 and, after trending lower (with the exception of a few bounces) ever since, should be ready for a new surge higher. That may be true in absolute terms — but when you take inflation into account, the U.S. stock market is actually still mired in a secular bear market that’s been going on for almost a decade.

Including the one that ran from 1906 to 1921, the United States has experienced three similar secular bear markets over the past 100 years. Each eventually turned into a major bull market, with the United States leading the world to new levels of prosperity and creating more wealth than ever before. I firmly believe that this will eventually happen again — but with one major variation.

This time, it won’t be the United States that leads the recovery. This time, it will be the developing nations — with China at the front of the team — that pull the world’s economy and its investment markets out of the mire. Emily Brandon, writing in a recent issue of U.S. News & World Report, summarizes why:

“No question about it. Ten years ago, we had the Asia financial crisis. Today, we have the American financial crisis. Then, those countries had to be bailed out. Today, emerging markets sit on 75% of the world’s foreign-exchange reserves. [Then,] they were dependent on the West for money, for management, for everything. Today, we would not be able to function without oil from the Middle East. Our interest rates would be higher without the Chinese to buy our Treasury bills.”

Ms. Brandon went on to confirm my theme in much of this book — that the world really has changed and is tipping in favor of emerging markets. What we’re seeing, she said, is a large group of what used to be very poor countries’ becoming middle class. America overconsumes, and it underinvests. They underconsume and overinvest. They help the United States make up the difference between what Americans save, which is not enough, and what Americans invest, which is also not enough. The emerging countries help us maintain our standard of living.

So while it’s tempting for U.S. investors to stay home, betting on a repeat of past U.S. market recoveries, they will be leaving a tremendous amount of money on the table if they do, because the developing world will recover much, much faster. In fact, many of the world’s secondary markets are already far outperforming U.S. stocks — and did so even before the 2007-08 collapse.

WEALTH IS SHIFTING

The superior performance of foreign stock markets in recent years has been one factor in a steadily growing transfer of wealth and power from industrialized to developing regions of the world. It’s evident in the individual ranks — not just on Main Street and High Street, but also among the world’s wealthiest folks. According to the Merrill Lynch/Capgemini World Wealth Report released in July 2009:

• Globally, the number of high-net-worth individuals — those with at least $1 million in investible assets — declined by nearly 15% in 2008. The ultrahigh-net-worth individuals — those with at least $30 million in assets — did even worse, with their ranks plummeting by almost 25%.

• In the United States, the high-net-worth population declined by 18.5%.

• Despite the declines, the United States, Japan and Germany remained the three countries with the largest number of high-net-worth individuals. However, China vaulted to No. 4 — foreshadowing a continuing shift in wealth that, according to the study’s authors, will see the Asia-Pacific region surpass North America in the number of wealthy individuals by 2013.

That last statistic is incredibly important because it verifies the strategy investors must take in the years ahead if they want to keep up. If the number of wealthy individuals in the West is declining, while the number of wealthy individuals in China is soaring, you should obviously be investing not in America, but in the same things and the same places on which the wealthiest Asians are focusing. The profits made from those investments can be reinvested in America once fundamental economic reform takes place here.

If that doesn’t make sense in the abstract, think of it this way. Today, people hang on every word Warren Buffett says, but tomorrow’s investment icons may have Chinese names — names most Westerners haven’t heard of, such as Zhang Jindong, Yang Huiyan and Zhang Xin, all of whom are under age 50 and, according to Forbes, already billionaires. (Huiyan is only 27 and worth $2.3 billion.)

A STRATEGY FOR ALL

Be aware as well that this advice is not limited to more aggressive investors — those out for fast gains from increasing share prices. Even conservative investors more interested in a steady flow of income from stable, dividend-paying stocks than in quick capital gains can safely look at the overseas markets — and definitely should.

Given these market statistics — as well as the trends in the overall world economy — one thing becomes patently obvious:

The traditional asset allocation models we were taught to follow to produce maximum rewards with minimum risks no longer apply.

It’s no longer enough to keep some of your assets in stocks, some in bonds and some in cash, with a few gold coins in the safety deposit box. Stocks and bonds need to be split not just across various industries but across various borders and interest rate environments as well. Cash needs to be not just in U.S. dollars but also in stronger foreign currencies. And you need to recognize that gold isn’t the only — or even the best — hedge against inflation.

Virtually every investor in the United States today is dramatically underweighted when it comes to international holdings. Some recent surveys indicate average U.S. investors have just 10% to 15% of assets in international holdings; other studies suggest it’s a mere 6%. Whichever is correct, they’re severely underexposed. My view, given all we’ve discussed, is that 40% to 60% may be more appropriate. Here’s why:

In 1985, the United States accounted for 34.2% of the global economy; in 2030, that will fall to just 17.1%. The U.S. share of world market capitalization is declining even faster. In 2004, U.S. stocks accounted for 44% of the value of global equities. By the end of 2008, their share had fallen to 28%,

The value of international diversification is evident not just in stock portfolios but in corporate performance as well. It has been acknowledged for several decades now that during up markets, companies with an international business base produce higher returns on investment than strictly domestic firms — but that’s now been proven the case in down markets as well.

According to the Bespoke Investment Group, a market research firm, U.S. companies with the highest international revenue outperformed companies with no international revenue during the collapse of 2008 by 7.37 percentage points. That kind of edge in incremental return adds up to a tremendous increase in wealth over time — allowing an investor to double his or her money in less than 10 years. Put it on top of an average S&P 500 return of 9.7 % (since 1926) and the same investor could double his or her money in just over four years.

With all of these statistics to support it, there should be little doubt that every American investor needs a global strategy if he or she hopes to traverse the world’s changing financial landscape.

And if that’s not 100% true right now, it will be shortly. Why? Because despite the current economic hard times, my research suggests that worldwide investments will double to more than $300 trillion within the next five to 10 years, with 60% of that coming from new global markets — twice the amount that will come from mature markets such as the United States and Japan. That means if you don’t invest overseas, you risk forgoing large returns and leaving a potentially huge amount of money on the table — money that could spell the difference between a golden retirement and working under the golden arches in your latter years.

Perhaps even more compelling is the prediction by Antoine W. van Agtmael that within the next 10 years, there will be 1 billion more consumers in emerging-market nations than there are today — and in 25 years, the output of the economies of the emerging nations will surpass the combined economies of today’s developed countries.

Keith Fitz-Gerald the chief investment strategist for Money Morning, an online investment research site. This article was excerpted from his book, “Fiscal Hangover: How to Profit from the New Global Economy” (John Wiley & Sons Inc., 2010).

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