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The seeds that delivered that crop – the global financial crisis – there's more of those seeds than ever. They're bigger than ever.

~ Rob Arnott

I've got a really interesting video link for you in today's Friday Food for Thought. I found it via Preet Banerjee at Where Does All My Money Go. It's an 8 minute clip of Rob Arnott of Research Affiliates in which he discusses his outlook for the economy and the markets. If you've been reading Balance Junkie for a while, you will likely recognize some of these themes as I've written about many of them quite often.

Mr. Arnott does not believe the financial crisis is over, but that the problems that caused it are still there and have only grown larger. I put a similar idea forward back in early February of this year when I wrote about 10 Reasons to Be Cautious Right Now. At the time, the market rebound was in full swing, but the mounds of debt were still piling up. The first wave of market trouble as a result of that debt hit in May of this year, punctuated by the alarming flash crash of May 6th.

The 3D Financial Hurricane

I've used the hurricane analogy a few times in discussing the current economic climate. Cloudy with a Chance of Hurricanes is my general economic forecast for the next decade or so. I happen to be in the camp that thinks we may be in the eye of the hurricane at the moment. Things were relatively calm, if not outright sunny after the first part of the storm passed early in 2009. But the second part has yet to make landfall.

Rob Arnott thinks we're in for a 3D hurricane. He thinks deficits, debt, and demographics will conflate to cause some pretty big problems in the near future. Here's how he sees each of the 3 D's affecting us:

1. Deficits: Many estimates put the U.S. deficit at about 10% of GDP. Mr. Arnott points out that this doesn't include liabilities that are kept off balance sheet. Nor does it include the U.S. government obligations with respect to Fannie Mae and Freddie Mac. If the term “off balance sheet” sounds familiar, you're probably experiencing an Enron flashback. In fact, Mr. Arnott directly compares these questionable accounting practices to those employed at Enron, observing that any corporate executive who tried the same thing would likely be in prison. These off balance sheet liabilities put the deficit in excess of 18% of GDP. Incidentally, the U.S. will not pass a budget resolution for this year because the deficit numbers are not pretty. A.A. Latimer said that a budget “is a mathematical confirmation of your suspicions”. Enough said.

2. Debt: The U.S. government originally agreed to a limited backstop of Fannie and Freddie when the housing market began to unravel. When things turned really ugly, they lifted those caps and now have an unlimited liability with regard to those two toxic waste dumps government sponsored entities. They continue to hemorrhage capital as unabatedly as the Deepwater Horizon is spewing oil. This liability is not counted in the U.S. national debt, which some measures put at 90% of GDP.

Mr. Arnott finds those measures specious at best. If state and local debt plus the GSEs (Fannie and Freddie) were included in the U.S. debt tally, it would top 140% of GDP. To put that in context, Greece has encountered its recently well-publicized difficulties with a debt to GDP ratio of about 120%. If you go on to include the unfunded liabilities mentioned earlier, the numbers inflate to multiples of that very quickly. Now that's ugly.

3. Demographics: The population in the U.S. (and in many other countries) is aging as the Baby Boomers age. That means there will be fewer young people to pay for a larger number of pensioners and a growing mountain of debt. This is pretty simple math. It basically reverses the trend of the past few decades where the Boomers supported the economy by buying lots of stuff and putting money into mutual funds for the future. If they aren't buying as much and actually begin to draw down those investments, it's pretty easy to see how that might adversely affect the economy and the stock market. Japan has faced a similar demographic trend over the past few decades and it hasn't been kind to their markets or economy.

Mr. Arnott sums up the current environment very concisely: “We have a government and a society addicted to debt-financed consumption.” That can't continue for very much longer.

Where Do You Put Your Money in a Hurricane?

So these concepts are not pleasant to contemplate. But if he's right, how does Mr. Arnott think you should prepare? He thinks “there's always something interesting to invest in”. In How to Manage Your Money in Challenging Times, I compared 3 different approaches to financial hurricane preparation. Rob Arnott gets a little more specific.

Given that he believes that double-digit inflation is coming down the pipe at some point, Mr. Arnott recommends buying TIPS (Treasury Inflation Protected Securities). In Canada, Real Return Bonds are similar as they rise in value as inflation rises. You can buy them individually, or via an ETF like the iShares DEX Real Return Bond Index Fund (symbol XRB).

Commodities also tend to perform well during inflationary times, so Arnott likes those as well. But he cautions that he sees another recession coming before the inflationary phase, so he would wait to buy commodities on a pullback related to the coming economic slowdown. If you follow the Baltic Dry Index as an indicator of economic health, you will have noticed that it's been dropping for a while now. Further, the U.S. reported the Worst Home Sales Numbers Ever on Wednesday. So much for the government-induced housing recovery. This is also bearish for the economy, so commodities could take a hit near term.

There are lots of different ways to gain commodity exposure. Just being invested in the Canadian market gives you quite a bit of it (along with a hefty dose of financials). You can also invest in commodities via various ETFs that give you exposure to commodities (oil, precious metals, base metals, agricultural materials, etc.). individually or in groups. Make your list and check it twice. If the markets turn stormy again, we could get a kind of commodity Christmas with nice companies selling at low low prices and naughty ones going out of business.

Do you think we are likely to see a financial hurricane as a result of deficits, debt and demographics? How are you positioning  your finances?

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