I am thinking about the general problem of retirement portfolio allocation, given the current economic conditions. This is a classical allocation problem, where putting money in one set of aset classes has a certain risk/reward profile. But it is also a mirror of the current economic and political trends facing America today.
- Peak oil: despite the polyanna-ish voices to the contrary (it is astounding to me that anyone actually questions this assumption), there is a limit to which we can pump the gooey stuff to make the explosive stuff. Peak oil may - probably- not produce, in my opinion, exactly a "clusterfuck nation," but it will certainly impose a constraint on which economies grow and how fast in the short term, and in the long term should - I think, if handled wisely, certainly not the way Bush is doing it with crony capitalism- actually produce sustained long term benefits for the US economy...but...we still have...
- Inflation: and what I suspect is the relative inability of the Fed to control it. This, I think is a huge threat to the economy; yeah, there's this huge corporate, government, and personal debt, and an epidemic of over-consumption of Americans on all levels. But the paradoxical thing, is that much of the shit people need is expensive: a roof over their heads, an education for their kids, and medical care are already obscenely priced. "Cheaper" needs such as food, clothing, also cost money, and the latter two will be subject to inevitable commodity inflation. Discretionary spending will likely be cut, but after a while, people will be paying for the "necessities," as well as their own debt service.
- The end of the US "ownership" of "creative destruction" of the American economy. If, as I believe, Europe and Japan embrace "creative destruction," with a human face, there will be very little reason for investment in the US; we'll be like Argentina, in the near term.
- The rise of emerging markets: still very risky, this is a new source of both demand and cheaper labor/goods. Emerging markets will basically help produce cheaper goods until they don't.
- Bird flu. This scenario (to have been another chicken-little-was-right thingy) actually goes against the prevailing economic trends, but not in a pretty way: if 5% or 10% of all people who get this die, this will have a notable impact on demand in the short term, sending it substantially lower world wide. In the long term, it might actually, uh, makes the survivors richer; at least that's what happened on a mass scale after the black plague.
Putting it all together here's my short and mid and longer term prognostications; your mileage may vary:
1. There is no reason for US markets to perform any better than European or Japanese markets in the near, mid or long term..
2. There is no reason to be anything other than a dollar bear in the mid-to long term; the end of "peak oil" means the end of dollar supremacy.
3. Emerging markets will likely get their act together because they can. Brazil is self-sufficent in fossil fuels, and has told the world it won't pay royalties on AIDS drug patents. Argentina gave the IMF the finger. In the last couple of years, those countries' equity markets have skyrocketed. Of course, the rub is all emerging markets are not alike.
4. The US with its high rates of consumption of everything, and its high rates of importing everything, is most susceptible to commodity inflation. If the US uses the Fed to "control" inflation with higher interest rates, it risks playing a global game of chicken that goes in 2 directions: one way (interest rates too low) discourages investors in American debt, the other way (interest rates too high) brings on a global recession(we are, after all the consumers of last resort). Everybody- everybody wants a "soft landing," but because the central banks always work with a limited amount of information, sooner or later they will fail to achieve it and there will likely be a global recession or, if you like, a "restructuring."
5. Demographics and the bird flu favor pharmaceutical companies; the US at some point will have to get tough with them, though.
Given all the above, it is clear that an underweighting of US equities, an overweighting of Europe/Japan equities, and an overweighting of emerging market equities (carefully chosen) is in order. In addition, some protection in hard currency/commodities is needed too (if only because the "gold standard" nuts on the right might push events in that directon). Note that I'm speaking of "weighting" within the context of some assumed portfolio allocation; I should at some point set up the "general" problem, which will be a nice exercise in the math at least for me.
Because of this math I haven't sketched out yet, bonds are tricky; there is some optimum overall allocation of bonds by country, risk, and maturity; suffice it to say that putting your nest egg into long term bonds denominated entirely in US dollars isn't a good idea in my opinion.
Update: on energy, I think this is pretty good middle of the road advice:
For policymakers, the oil market presents a classic case of decision under uncertainty. There are two axes to consider. First, either the optimists are right or wrong. Second, either the world invests in technology/exploration, or it does not. So there are four combinations. (1) Optimists right/Few investments: Civilization is safe, with little waste. (2) Optimists right/Big investments: Civilization is safe, but has wasted some resources. (3) Optimists wrong/Few investments: Civilization is NOT safe. (4) Optimists wrong/Big investments: Civilization safe, but not as rich as if oil were unlimited. For a policymaker, it is better to spur the investments, because the worst possible outcome is a bit of waste. This waste can likely be absorbed by economic growth.
For individual investors, the problem is different, because investment portfolios are necessarily small and concentrated. From this viewpoint, a more effective mechanism for pooling global energy risks seems advisable. Clearly, individual investments in energy development, technology, and conservation will be a growing part of portfolios over the years to come.
Moreover, a key point is that the disagreement between optimists and pessimists is about prospects in the long term, not short term. Hence, immediate investment implications are not very different. There will likely be more attraciveness in investments in energy technology, exploration, and conservation.
Not to mention environmental technologies spurred by alternative investments in energy...