For the past fifteen years I have written annually about a person I have come to call “The Smartest Man in Europe.” For new readers, he is a finance person in his 80’s who has built his reputation by identifying important trend changes early and putting serious money behind his conclusions. Descended from a mercantile family that operated canteens selling food and weather protection along the Silk Route, he was educated in Europe, trained in New York and returned home to take advantage of the wealth-creating opportunities resulting from the post-war recovery. Listening to conversations around the dinner table, he was encouraged to focus on the major events early, and his success is a product of this skill. That success is reflected in his homes and other comforts he enjoys. His art collection spans centuries, from Canaletto to Koons, but what keeps him vibrant is ideas.
Notable among the past events he was early to observe are the rise and fall of Japan, the opportunities in China after the death of Mao, the end of the command economy in Russia and the unrealistic valuations of technology at the end of the last century. We get together a few times a year, but this year our conversation was by telephone.
“The whole world is suffering from too much debt. As a result, growth almost everywhere is going to be slow. I know you believe the problem is insufficient demand, but the major industrialized countries already have considerable debt and do not want to add any more to it to stimulate the consumer. Japan is an exception. They already have the highest debt to Gross Domestic Product (GDP) of any major country and they are willing to add more. China is an exception on the other side. They are in a position to take on more debt because their debt to GDP ratio is low. Without more fiscal stimulus, demand will be tepid and growth will be disappointing. This is the state of the world now, and it is likely to endure for some time. In the near term, I don’t see a calamity, just sluggish economies and many equity markets not doing much.
“It is not easy to make money these days. In the past, if you had the right asset allocation, you could do well for institutional investors. Now most asset classes are fully valued. The bond market is expensive, equities are not cheap anywhere, gold is dead; other commodities are in bear markets, the emerging markets are generally not attractive, China is dangerous, and Europe and Japan are reasonably fully priced. As I said last year, the only way to make serious money is by carefully investing in innovation. You can make a modest return in equities in the major markets – I agree with you that the U.S. market will end the year higher than it is now. But if you want to make real money investing, you will have to do it by picking stocks in technology and biotechnology, and I would emphasize the latter.
“Most people still don’t recognize the gigantic implications of this phenomenon. Major breakthroughs are going to be taking place in cancer, heart disease, Alzheimer’s, diabetes, multiple sclerosis and other diseases. Picking the right companies can produce impressive returns in a difficult overall market environment. Right now there are literally hundreds of small companies working on significant products. Many of them will fail, but a few will change the world the way Google and Facebook did. Most are located in California and Boston, but there are also some in Europe and Asia. The United States is dominant, however. You should spend your time trying to understand what these companies are doing. The returns for picking the winners could be huge. What’s more, the pace of innovation is quickening. The rewards for proper asset allocation will be very modest. I like Facebook; Salesforce.com; biotech ETFs; an industrial company, CF Industries; Visa; Apple, of course; Alibaba; and Palo Alto Networks. I am out of Google.
“Think of all the tasks your smartphone can do for you. There is almost no question that comes to mind that cannot be answered with a Google search, from politics to sports to business to entertainment. I am convinced technology has made the world more productive, but it is hard to measure. The recent figures on productivity are negative, meaning there is less output per worker hour, but the benefits of information technology may be difficult to determine in traditional ways.
“There is also a question of the impact technology is having on the middle class. Millions of jobs have been eliminated through robotics and other forms of technology. The technical skills required to get and hold a good job are increasing all the time. Service jobs are growing, but manufacturing jobs are rising more slowly, and service jobs generally are lower-paying. Many kids completing college cannot find jobs in their chosen field and are forced to work at something temporary to pay the bills and student loan debts. This is a problem that is likely to get worse as more technology breakthroughs take place, so the social implications of this phenomenon are enormous. Advances in biotechnology also have the social costs, as more people live longer.
“In addition there is the problem of wasting time. Playing video games rather than reading books, and communicating with followers on Twitter, can keep a young person busy. The typical Facebook user is said to be spending twenty hours a month on that site. According to recent studies, the average college student only spends one hour a night studying alone, perhaps because of other distractions. These numbers could signal problems for American competitiveness going forward, so there is a downside to what is happening in technology.
“Looking around the world, trouble is everywhere. That is why you have to narrow your investment focus. In Europe, the Greek situation seems intractable. The Syriza party was elected by making promises that are difficult to keep. The economy is doing poorly, so it is hard to create a budget surplus that will enable the country to pay back some of its debts, even if the creditors were to discount the obligations. The new government promised relief from austerity, but its creditors want work rule changes, increases in the value added tax, reform of the generous pension system and greater flexibility in terminating employees. The Greek people want to stay in the European Union and maintain the euro as the country’s currency, but they do not seem willing to endure the sacrifices to make that happen. From the point of view of creditors, Greece’s unwillingness to compromise is unnerving, but that stance will change. I still think a deal of some sort is likely. Europe is fearful of the unintended consequences of a default and exit from the Union. Angela Merkel worries that the euro might appreciate if Greece leaves, making German exports less competitive. The situation looks dim now, but I think some temporary solution will be found. In the long term, however, I am not optimistic about Greece staying in the Union.
“The situation in the Middle East seems hopeless. No matter how many trips your Secretary of State takes, Israel and Palestine will never come to a two-state solution. The sides are too far apart. ISIS is a formidable factor in the region. They are ideologically driven, well-financed, skillfully trained, and encouraged by their recent victories. Only the Kurds seem to be effective against them. The Iraqi Army seems to have insufficient motivation, weak leadership and poor preparation: a deadly combination. Unless the United States is going to send combat troops, which is unlikely, ISIS will continue to make gains in Syria and Iraq, and the Taliban will be in control in Afghanistan. Sending a few hundred advisors to help the Iraqi forces is too little help coming too late. Even if you sent an army, the situation would return to chaos when they left. This condition will persist until Saudi Arabia is threatened. Then other countries may have to get seriously involved with military force.
“I think there will be a deal with Iran. It will not be satisfactory to many in the West, but it will slow down the Iranian nuclear development effort. If there were no deal, Iran could have a bomb within two years, destabilizing the region further, so I guess I’m on the side of thinking an imperfect deal is better than no deal at all. While the religious hierarchy in Iran may continue to pursue a hard line, the political leaders and the people want a lifting of the sanctions, which would create more opportunity in a struggling economy. There is a similarity here with Greece. Major compromises will have to be made to get anything done. Neither side will be satisfied, but the consequences of not working out a reasonable agreement in each case are sufficiently negative to force all sides to find a basis for an understanding. If there were a deal with Iran, there would be a flood of investment into the country, and that should prove to be very profitable.
“When you take a look at other problems around the world, it is clear that World War III has begun. Whether it’s Ukraine, Libya, Syria, Iraq, Afghanistan or Iran, there is no way the United States can use its power and influence to create a peaceful solution. The U.S. can provide arms for the locals, but you should not send troops to fight another country’s battles. You have no appetite for that anyway, and it won’t work. These problems have to be resolved by the people themselves. The Kurds are proving that. It is true that if you don’t stop the fighting, there is risk of terrorism rising, but that is something we will have to face. You should have learned by now that getting involved, unless you are prepared to do it in a big way, will be ineffective.
“Japan is all right for now, as a result of monetary and fiscal stimulus, but I don’t see any signs that it can grow without a continuation of these policies. As a result, it runs the risk of slipping back into a deflationary recession. Regarding those commodity-based emerging markets that I know something about, I expect continued slow growth. In the U.K. the debt burden will diminish the possibility of more than modest economic improvement. I expect growth in France to pick up next year because of the election. Last year I was worried about the political balance in Europe shifting to the far right, but I am less concerned about that now. I was pleased with the Turkish election and Erdogan’s resultant loss of power. He was beginning to show Putin’s tendencies. Right now he is respecting the results of the election. If that continues, it is very positive for Turkey.
“Looking at other financial markets around the globe, Modi is making constructive progress in India, but it is slow because of the bureaucracy there. China is working hard to rebalance the economy in favor of the consumer and away from infrastructure and investment in state-owned enterprises, but it is a long and difficult process. They will probably reach their target of 6½% to 7% growth, but they will have to increase their debt to reach that objective. Happily, their balance sheet is in a position to permit that. Real growth without the fiscal stimulus is much slower than that rate, which is why I am concerned about the Chinese equity market. I wouldn’t worry too much about China’s territorial expansion. That may be a problem in the longer term, but right now the leadership is focusing on reducing corruption and maintaining growth.
“I think we have seen the low point for the price of oil. I know inventories are huge and shale producers are back on stream, but I think $55–$65 is the bottom for Brent. The battle is between the Saudis and the shale drillers. The Saudis are shipping a million barrels a day above their stated quota in order to keep the shale producers in check, but demand is increasing slowly and prices will continue to rise modestly.
“Looking at other non-financial assets, I think residential real estate prices will hold up in places where finance and technology are doing well, like New York, London, Boston and San Francisco. You also see an enormous amount of capital migrating from Asia to areas they believe are safe refuges for foreign wealth. That is likely to continue, but the anti-corruption campaign going on in China may slow that process down. In commercial real estate, the real opportunities are in the distressed areas like Spain and Italy.
“The art market is heavily influenced by the new billionaires seeking recognition. You can buy a trophy painting and suddenly be an important person in the cultural world. You don’t have to read a book; you can hire someone to keep you from making mistakes. Art has proven to be a good store of value, particularly 20th century art and sculpture by well-known people. Based on the mark-ups at recent auctions, there are ready buyers for major paintings. Younger people hope to buy a promising artist early, but that is more risky.
“Regarding some other issues, I believe the Federal Reserve will tighten in September, but the increase will be small and they won’t raise rates at every meeting. I expect longer-term rates to rise but stay low by historical standards. The euro should remain in the 1.05–1.08 range against the dollar. European exports are doing well at that level. I do not see a break below par. Everyone is looking for a big correction in the U.S. equity market, but while it looks somewhat expensive to me, so much money in the world wants to have a position in American stocks that I don’t think the indexes will decline much. The vigorous merger and acquisition activity will continue, and I think that will help the markets.
“I sense a very nervous American psychology because of uncertainty about the economy. The public is skeptical about Hillary Clinton, but she can still win if she comes up with a credible plan to improve the outlook. Obama’s weakness as President gives the Republicans a great opportunity, but they will have to convince the middle class that the economy will do better if they are in power. A lot depends on how well U.S. business is doing as we approach the election.”
There have been times in the past when The Smartest Man has seen abundant opportunities everywhere. Right now he has concentrated his interest on technology and biotechnology. Across the world he sees economic growth restrained by debt, and he doesn’t believe much can be done about that. He expects Middle East turbulence to continue, and he believes the countries should settle their own problems without European or American intervention because he thinks that our noble efforts won’t work. He believes that the same applies to the Russia/Ukraine situation. He views terrorism as a disruptive force that could cause turbulence in the current investment environment and thinks we should do everything we can to protect ourselves against it. While there may be more risks than opportunities out there, he believes you can always find ways to increase your net worth.
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