MorningStar's Lee: How to Profit in America's Long-Term Decline

Thursday, 16 Jan 2014 07:36 AM

By Michael Kling

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Although America is in a long-term decline, investors can profit from that long-term macro-economic shift, says Samuel Lee, a passive funds research strategist for MorningStar.

In an article for MorningStar.com, Lee cites the five-stage model describing the rise and fall of nations, put forth by Ray Dalio, founder of Bridgewater Associates, who anticipated macro-economic shifts like the financial crisis, the bull market in bonds and eurozone crisis.

According to Dalio's five-stage hypothesis, empires go through five stages. First they are early stage emerging countries, then emerging countries, early-state developed countries and late-stage developed countries, before entering a period of decline.

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In late-stage developed countries, debt increases, stimulating income and asset price growth, which in turn stimulates more debt in a self-reinforcing cycle. Budget and trade deficits increase and infrastructure falls into disrepair.

In the last stage, the self-reinforcing debt cycle reverses as private players default or pay down debts, prompting falling income and asset prices.

The United States was recently in the fourth stage, Lee argues, pointing to increasing deficits, low personal saving rates and the housing bubble.

We now face slow growth and massive debt levels that will take decades to pay off., he notes.

Although the United States won't become a banana republic, Dalio's model calls for a decades-long period of relative decline for the United States as it deleverages and China and other emerging markets move from stage three to four.

But the outlook, Lee writes, is not so bad.

The United Kingdom was massively indebted after World War II, with a total debt-income ratio over 400 percent, but it gracefully deleveraged by devaluing its currency, suppressing real interest rates and allowing some inflation.

The United States could do the same, Lee predicts.

"Intriguingly, it turns out that a deleveraging country's stocks can do quite well," he writes, noting that British equities returned 13.3 percent annualized from 1947 to 1959.

Bonds also can perform well even with low yields, he adds..

"If you can leverage up bonds to match the volatility of stocks, you would have received mid-teens returns in both ugly and beautiful deleveragings because of capital gains from rolling down the yield curve and deflationary surprises."

Gold also does well against a deleveraging country's currency, Lee states.

Pimco CEO Mohamed El-Erian coined the term "new normal" to describe a long period of deleveraging, slow growth, and massive central bank interventions, but recently wrote the phase may be drawing to a close.

"Time is running short for the strategy of simply riding the wave of central banks committed to disconnecting market pricing from fundamentals," he writes in an article for IndexUniverse

"A much-less-certain investment outlook is ahead, and one that requires change not only in what investors do, but also in how they think about their overall investment positioning.

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