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Shifting Sands of Growth

The last 100 years have been good to the United States. So good, in fact, we can hardly imagine a world without the U.S. as the global growth engine. While most would acknowledge the U.S. is in an economic rough patch, the consensus seems to be that our continued economic dominance is unassailable. I would argue otherwise, if for no other reason than things change. That's not to say that we know where growth will come from or that the U.S. cannot maintain its economic dominance, but it does seem reasonable to abandon a U.S. centric approach to investing and view the global market as your opportunity set. To expect dramatic shifts in global growth patterns is not a revolutionary statement. In 1850, most would not have expected the U.S. to become the economic superpower and source of prosperity that it ultimately became. In fact, at that time, Great Britain, India and China where the established economies while the U.S. was a place for speculation. In fact, as the graph below attests, the U.S. accounted for only 10% of the global economy while China was the powerhouse, contributing 35%! Fast forward 100 years and those numbers were reversed.

The next chart, graphs global growth by region/country from the First Century, A.D. (courtesy of the website Zero Hedge). Talk about shifting sands! The chart clearly shows that the winners in the race for growth change over time.

Certainly a lot transpired on both sides of the Pacific from 1850 to today to account for these changes. This shift can in part be attributed to some favorable initial conditions that clearly inured to the benefit of U.S. domiciled investments over time. Among these favorable initial conditions can be counted the following: a) We were once a nation of savers. Savings are a form of capital that can be put to work to build businesses. b) The U.S. filled the gap left by the collapse of the British and then Soviet empires. The collapse of the British and Soviet empires created a geopolitical vacuum for the U.S. to fill, which ultimately favored American enterprise. c) The U.S. enjoyed rapid population growth until relatively recently, first from immigration and then the baby boom. Applying capital and high productivity to a growing or underutilized population is a powerful formula for economic growth. d) Two world wars transpired elsewhere. Following the devastation to much of the productive world from WWII, the U.S. had the infrastructure, capital and population in place to produce, sell and lend to the rest of the world. e) The global currency system evolved in favor of the U.S. dollar. The rise of the U.S. dollar as the global reserve currency provided incredible benefits, including flexibility in monetary and fiscal policy without the repercussions felt by other countries. These conditions and the resulting impact on market performance have cemented high expectations in the minds of American investors. The next graph charts the growth of a dollar invested in various domestic stock and bond indexes in 1925. Given the extent to

which this performance has helped to shape investors collective experience, it's no wonder expectations of 10% return on stocks is so hard to shake.

Unfortunately, having the reserve currency has turned us into a nation of borrowers, rather than savers over time. In order to maintain reserve currency status, we have had to run continuous trade deficits for decades with the rest of the world. The dynamic that resulted can be summed up as follows: the Middle East and Asia, respectively, manufactured oil and consumer goods. We borrowed money from these same economies to buy the oil and consumer goods by selling them Treasury bonds (selling bonds is the same as borrowing money). And where are the pools of capital/savings now? The Middle East and Asia.1 Ultimately, this dynamic created massive global trade and savings imbalances. The imbalance took years to create and will take years to unwind. One way to view that imbalance is to say that the U.S. borrowed a higher standard of living and now must pay it back. How it gets paid back and who pays for it is what austerity, the "Fiscal Cliff", the debt ceiling, Fed money printing, inflation versus deflation, etc. is all about. And while we certainly don't have the space to unpack all of these topics, this narrative at least provides perspective on where the U.S. economy is and how it got here; which brings us to current conditions.

Indeed, much of those savings are tied up in Treasury bonds and, as the saying goes, if someone owes you some money, it's their problem but if they owe you a lot of money, it's your problem.

Where you go has a lot to do with where you start. Initial conditions matter, and as we look around the global landscape estimating where the burden of economic growth will go, we can look to aspects of those regions as initial conditions that will serve as either tailwinds or headwinds to growth. For instance, many economies in South-East Asia are characterized by large, underutilized populations with a surplus of savings and capital. Governments in this region have strong balance sheets so the citizenry is not burdened with financing large debts relative to GDP. The financial systems of these economies have piggybacked on those of the western world; the benefit being that financial transactions have become more efficient and transparent over the course of the last two decades and those transactions have better legal protections. This has enabled greater and cheaper access to outside capital. Applying excess capital, whether internally or externally sourced, and high productivity to underutilized populations has given rise to an emerging middle class. This has lead to increased individual earnings on average. By coupling this trend with abundant natural resources, we conclude that living standards will continue to rise markedly. Though in different proportions, these initial conditions are also in place for countries in other regions, such as the Middle East and Latin America. In contrast, the U.S., as well as the developed countries of Europe and Japan, are faced with the dual head winds of high debt and low to no population growth. As investors, we must consider the full range of opportunities. The conditions that created an environment favorable to 10% returns for U.S. stocks have either ran their course or are unlikely to repeat. That's not to say other favorable conditions are not in place, like abundant energy supplies from shale formations, but it's no stretch to suggest that performance largely dependent upon a different set of conditions is unlikely to repeat in their absence. We don't know how the future will play out, but we want to position ourselves so that the future doesn't have to repeat itself in order for your investment strategy to succeed.

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