How does the theory of inverse stagflation translate into meaningful judgments concerning asset allocation?
Taking inverse stagflation as an investment theme, we distinguish three main threads that guide our thinking. We anticipate a structural rise in the pricing of real assets, which should outperform other asset classes through the next decade and beyond. We expect to see a marked overall decline in global equity indices as the value of stocks at the major exchanges falls, and we think that fixed-income markets, which consist of various-duration government bonds and investment-grade corporate bonds, will be trapped in a narrow trading range with low to very low yields.
A key part of understanding what is driving this new dynamic hinges on grasping the fact that global growth is no longer being driven solely by consumption patterns in developed nations. The entry on to the stage of emerging market consumers is absolutely key. As emerging economies consume—rather than export—their way to growth, an inevitable corollary of this is that their diet changes.
The average emerging economy diet starts to be more protein-rich. As people eat more meat, the need for grain rises sharply. For example, the Cornell University Journal of Environmental Development and Sustainability points out that it takes eight grain calories to produce one calorie of protein. So when a country starts to eat more meat, that drives an accompanying escalation in demand for grain, which can be expected to create upward pricing pressure on global grain stocks.
So if we look at how this will play out, today if you chart the S&P 500 against the price of corn and the price of gold, taking 1980 prices as your base of 100, you have a very significant pricing gap between paper and real assets. Gold and corn overlap each other, but the S&P is way higher at 1,000, as against approaching 200 for gold and corn. We expect this to potentially reverse some time between 2013 and 2014, with the S&P falling to around 300 and corn going through 400, with gold not far behind. It is hard to overemphasize what a major structural shift this projection envisages.
A second important point, to set alongside the impact of diet changes in emerging economies, is water scarcity. At present this is hardly priced into soft assets at all, but it is going to be a major driver of price. The UN Food and Agriculture Organization points out that it takes between 10,000 and 13,000 liters of water to produce 1 kilogram of beef, while a kilogram of wheat or rice takes just 1–4 liters. One effect of this is that global water consumption is doubling every 20 years.
Then there is the impact of biofuel production to be considered. The US Department of Agriculture estimated that demand for corn for ethanol would approach 4.5 billion bushels in the 2010 growing season, compared to 1.2 billion bushels seven years ago. In 2011 some 30% of the entire US corn crop will be used for ethanol, according to the US Energy Information Administration. Demand on this scale drives pricing.