“A remarkable thing happened in Silicon Valley during the past decade. Venture capitalists and entrepreneurs set their sights on clean energy as the Next Big Thing. They audaciously hoped to reinvent energy by harnessing the incredible innovation that had transformed information technology and biotechnology. 

The truth is that jobs are migrating from one area to another, as they have done for 150 years. Ever since the Industrial Revolution, factories have located where critical resources are available, and later moved when other resources replace them or become more important. The factories of the mid-19th century drew manufacturing from backyard workshops to central locations that offered water power. When steam and electricity eliminated the millstream’s advantage, plants were relocated closer to raw material supplies, labor pools, or markets. That trend continues.

Yes, low-level, labor-intensive work moved to China because labor is a lot less expensive there. But U.S. industrial output has continued to grow through continuously improving productivity and a migration to more sophisticated, higher-margin, less labor-intensive products.

China isn’t immune to this cycle. A growing middle class with its demands for higher wages and better working conditions is seeing jobs leave China for less-developed areas with the low wage rates that China can no longer offer. Chinese factories are now moving up to more sophisticated products and higher productivity in a continuation of the cycle.

In truth, China has seen job losses due to increasing productivity similar to those in the Western world. According to a 2004 report[1] by China’s Department of Industry and Transport Statistics, part of the National Bureau of Statistics: “The relative magnitudes of job loss in manufacturing in the developed world and China are similar, with both experiencing 15% declines between 1995 and 2002…For example, textiles was one of the worst hit industries in the U.S., with 415,000 jobs lost, but the losses in China were much greater, at 1.8 million jobs.”

Innovation is the key to the continued growth of Western manufacturing. And, yes, “continued growth” is the right description. Even though there are fewer manufacturing jobs here in the West, industrial output is still increasing year-to-year due to higher productivity. And that increasing middle class in the East will demand more Western products as their income and lifestyle improves. The weak dollar helps make our exports more attractive and imports relatively more costly, so demand for domestic products should increase here as well.

China is not the enemy. It is just another part of the manufacturing cycle, similar to what the U.S. was to Europe in the 19th century, Japan was to the U.S. in the 20th century, and Malaysia, Vietnam, and other countries are to China today. And so it goes. European manufacturing did not collapse when the young U.S. developed its manufacturing base — and U.S. manufacturing is not going away either.

by Mark Symonds is President and CEO of Plex Systems, and a member of the Manufacturing Leadership Council.

DFA, is a global asset manager that oversees $206.5 billion in all and owns a mind-boggling 13,000 stocks, or about 70% of the world’s publicly listed equities. Because DFA’s investment process is purely quantitative, it doesn’t have the option of succumbing to fear in the face of adversity. It certainly helped that DFA focuses much of its attention on some of last year’s highest-performing equity areas – value, small-cap and emerging markets.

The privately held firm (Arnold Schwarzenegger is an investor) also is known for keeping a lid on costs that can rob shareholders of performance points, steering clear of some foreign markets where it doesn’t believe funds can get a fair shake on prices.

SensiblePortfolios’ Smart Strategy seeks to generate global market returns using mutual funds engineered by DFA.  We too  understand that controlling fees and expenses is important for long term success.

To learn more about our  Smart Strategy please visit www.sensibleportfolios.com.

Congratulation DFA and thanks Merriman Inc. for  the article.

I hope everyone enjoys the 4th of July weekend… Darrell

From The Economist:

‘Labor arbitrage – taking advantage of lower wages abroad, especially in poor countries—has never been the only force pushing multinationals to locate offshore, but it has certainly played a big part. Now, however, as emerging economies boom, wages there are rising. Pay for factory workers in China, for example, soared by 69% between 2005 and 2010. So the gains from labor arbitrage are starting to shrink, in some cases to the point of irrelevance, according to a new study by Boston Consulting Group (BCG).

‘Sometime around 2015, manufacturers will be indifferent between locating in America or China for production for consumption in America,’ says BCG’s Hal Sirkin. That calculation assumes that wage growth will continue at around 17% a year in China but remain relatively slow in America, and that productivity growth will continue on current trends in both countries. It also assumes a modest appreciation of the yuan against the dollar.

BCG lists several examples of companies that have already brought plants and jobs back to America.

1. Caterpillar, a maker of vehicles that dig, pull or plough, is shifting some of its excavator production from abroad to Texas.

2. Sauder, an American furniture-maker, is moving production back home from low-wage countries.

3. NCR has returned production of cash machines to Georgia (the American state, not the country that is occasionally invaded by Russia).

4. Wham-O last year restored half of its Frisbee and Hula Hoop production to America from China and Mexico.’

You’re a 19 year old kid. You’re critically wounded and dying in the jungle somewhere in the Central Highlands of Viet Nam. It’s November 11, 1967.

Your unit is outnumbered 8-1 and the enemy fire is so intense from 100 yards away that your CO (commanding officer) has ordered the MedEvac helicopters to stop coming in.

You’re lying there listening to the enemy machine guns and you know you’re not getting out. Your family is half way around the world; 12,000 miles away, and you’ll never see them again.

As the world starts to fade in and out you know this is the day. Then – over the machine gun noise – you faintly hear that sound of a helicopter. You look up to see a Huey coming in. But… It doesn’t seem real because no MedEvac markings are on it.

Captain Ed Freeman is coming in for you. He’s not MedEvac so it’s not his job, but he heard the radio call and decided he’s flying his Huey down into the machine gun fire anyway.

Even after the MedEvacs were ordered not to come. He’s coming anyway. And he drops it in and sits there in the machine gun fire as they load 3 of you at a time on board.

Then he flies you up and out through the gunfire to the doctors and nurses and safety.
And, he kept coming back!! 13 more times!! Until all the wounded were out. No one knew until the mission was over that the Captain had been hit 4 times in the legs and left arm.

He took 29 of you and your buddies out that day. Some would not have made it without the Captain and his Huey.

Medal of Honor Recipient, Captain Ed Freeman, United States Air Force died August 20, 2008 at the age of 70, in Boise, Idaho.

The chart below shows that the US monetary base has spiked since 2009. While inflation has fluctuated considerably, it has not tracked the changes in the monetary base. Although no one can reliably forecast inflation, we think markets do a pretty good job of sorting through all the macroeconomic data. At present (mid December), the markets do not appear to reflect expectations of runaway inflation in the near future.

US Monetary Policy since 2000

Source: Federal Reserve Board

Nevertheless, investors may be growing anxious in response to media coverage of the Fed’s continuing expansionary policy. For those who are certain QE2 will be inflationary, perhaps the recent example of Sweden’s monetary base run-up will offer some reassurance.

In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country’s monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. The graph below documents that even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit, and in fact, remained flat before falling in 1996.

Swedish Monetary Policy in the 1990s
Source: Sveriges Riksbank

Sweden’s monetary base expansion is one of several international examples of quantitative easing over the past two decades. These case studies, which include past expansionary periods in the UK, Switzerland, Japan, Australia, New Zealand, and Iceland, are discussed in a recent Federal Reserve Bank of St. Louis review.3 The researchers concluded that doubling or tripling a country’s monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.

Of course, many factors may come into play, and we cannot know whether the US will share the same fortune. But at least we know that quantitative easing has occurred without triggering high inflation.

As government spending hits record levels around the globe, some politicians, economists, and pundits are warning that rising indebtedness may drag down economies and financial markets. This issue has raised concern among investors who assume that a government’s fiscal policy is closely linked to the country’s economic growth and market returns.

The graph below shows the projected state of indebtedness around the world.¹ Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP levels above 70%—and the US, Canada, and the UK project debt levels exceeding 80% of their economic output.

Government efforts to stimulate these economies out of recession may partly explain this level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions, and rising health care obligations are compounding the fiscal challenges of these countries.

Global investors may be particularly concerned about the economics of government spending in countries around the world. So how does public debt affect economic growth and market returns? The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.

Let’s explore these issues by addressing a few popular questions about sovereign debt:

Do rising deficits drive up interest rates?

Yes. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. The public sector consumes savings and investment that may have otherwise fueled private sector growth—a displacement of resources known as the “crowding out effect” in economic theory. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.

Consistent with this theory, our analysis shows that current interest rates reflect expectations of future deficits² but that current government deficits and debt do not predict future interest rates or bond returns.³ So, long-term interest rates rise when the market expects future deficits to increase. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.

Do higher deficits hamper economic growth?

It depends on a country’s debt level. Using World Bank data from 1991 to 2008, we compared current deficits to future GDP growth in sixty-seven countries and found an increasing interactive effect between deficits, debt, and economic growth. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can create headwinds for economic expansion, but slower growth is not guaranteed.

So investors are justified in having some economic concern about higher government spending and borrowing. But the impact on investment returns is less clear. Let’s now consider the potential effect on equity markets.

Does low economic growth result in diminished equity returns?

No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. We conducted this analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.

The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.

Applying the same methodology to the MSCI emerging market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).

Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns.⁴ Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses, and private investments.

Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market.⁵ Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.

Do fiscal deficits lead to currency depreciation?

No. It is commonly believed that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources, and investors who are concerned about inflation and default risk flee the currency. Although recent developments in the US would seem to support this relationship, there is less convincing long-term evidence that deficits affect currency rates. During the 1970s and 1980s, the dollar strengthened while the government increased deficit spending.⁶ This observation is consistent with academic studies concluding that exchange rates appear to move randomly, and there are no models to date that can reliably forecast currency returns.⁷

Conclusions

 Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets, or anticipate short-term currency movements.

Investors should assume that stock and bond prices reflect all that is currently known and expected about government spending and debt, economic growth, risk, and other issues affecting performance.

2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year US deficit projections (as a percent of GDP) to yield spreads (five-year US Treasuries minus three-month US Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.

3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.

4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.

5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.

6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.

7. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).

This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

So I have decided to share with him and with you, three additional reasons why a middle-aged investor should consider using a simpler approach to investing. (As discussed in the ObliviousInvestor.com’s blog.)

Middle-aged Investors cannot afford to make investing mistakes.
A simple well-designed portfolio makes it easier to know how your money is invested. And the better you understand how your money is invested, the less likely you are to make mistakes.