In our past missives we have focused on the impact of unorthodox monetary policies currently being experienced by savers and investors.
Without a doubt, things are very different. If fact, we would wager to say that we have already hurtled into a new and unique epoch. Anyone holding to the conventions of a past era, will have great difficulty understanding current global financial machinations. This certainly also applies to economists and portfolio managers and anyone else trying to divine the "movements of human expectations." As Isaac Newton was to have said: "I can calculate the motion of heavenly bodies, but not the madness of people."
In any case, economics has always been about "political economics." This has never changed though it has become the norm to drop off the word "political" from its examination. As such, one can be led to forget about this side of affairs that most always facilitates every major trend and development.
Financial markets are facing the shifts and challenges that we see today because it was allowed by the accepted "political economics" of the past ... and the present. But, who determines the course of political economics? This is a loaded question; and we won't allow ourselves to be pulled into any conspiracy theories. The only conspiracies that we have ever discerned were all caused by the same human proclivities that are shared by all.
There are today 7 billion people in the world, that given the opportunity, would all (with the possible exception of a very small number who have taken a vow of poverty) choose to increase their "relative" wealth. You can be sure that the very best minds on earth have been recruited or attracted to scheme clever and devious ways to accrue and stockpile wealth. It goes without saying that this primordial impetus makes for a very competitive financial arena. Therefore, those who ignore this underlying predatory nature affecting the distribution of wealth are liable to be the casualties.
Just who are the likely casualties? Stay with us and all will be revealed.
Let's at least conclude for now that the course of political economics does not usually work to the favour of the "little" ... "average" ... nor even the "middle class" investor. And if that is indeed true, a most urgent conclusion should be deduced. Any massive wealth shift will tend to be underwritten by this mass group of the "little," "average," and "middle class." If that were not so, the majority would be rich.
Major wealth shifts do occur, but through different mechanisms. Some are loud; some surreptitiously silent. For example, we have often commented "Financial crises are the poor man's capital tax." Crises always seem to arrive unexpectedly for most investors, though they occur with some regularity. Their capital destruction is very visible ... especially after the fact. These types of crises provide crashes and bangs that everybody notices. But there are other wealth-destroyers in the gauntlet that investors run, that are not so visible nor loud, catching most completely unawares. These we will call SBDs (Silent But Deadlies), and they can be just as destructive as are financial crises.
In reality, of course, all investors whether big or small are vulnerable to the great "wealth transfers" that occur from time to time or at varying rates of change. These have happened since time immemorial, and are currently happening. How so? The reason most observers do not see the potential "wealth sapping" SBDs that are currently underway, is because they are being blinded by convention, dogma and lack of attention.
There are at least five wealth-destroying SBDs to watch. We will introduce them next.
1. Deceptively Low Inflation
One could be mistaken to think that overall inflation currently is very low. After all, the average consumer price inflation (CPI) in the U.S. over the last five years has just plumbed to a 45-year low. The fact is that very few people (including economists) really understand inflation. Moreover, they have been trained to identify inflation in a very misleading way.
The reason for this is that there is only one type (source) of inflation; but many different manifestations. People usually confuse manifestations for the cause; and secondly, are overly preoccupied with only one type of manifestation -- that of consumer price inflation (C.P.I.). As we said, it is one type of many manifestations, and in this case, only measures the purchase prices (of a defined, arbitrary, basket of goods ) of current GDP. There are other things that can be inflated that aren't in that "basket of goods." For example, historical assets (such as existing real estate) or future income streams (i.e. retirement income). We will explain. The point is not to be blind-sided by inflation. It is a crafty chameleon.
2. Inflated Cost of Future Flows
We have often pointed out that the biggest purchase that a middle-class household will make over its lifetime is retirement income (not a house, as most would think). It requires significant capital to generate enough future income to support a reasonably comfortable life-style. But just how much capital?
Readers will understand that as investment returns decline (as they must overall, as interest rates have fallen to post-WWII lows) it requires more capital to generate the same retirement lifestyle. Assuming one was to buy the same retirement income in 2012 with a 10-year U.S. treasury bond (average yield for that year was 1.8%) versus what income was on offer just 7 years ago in 2006 (average 10-year yield of 4.8% that year), buying that income would have become much more expensive. As this simple illustration would show, the cost of the same income has risen by 2.6 times. Is this not a form of inflation? Future retirees can easily answer this question without the help of a professional economist.
3. Don't Forget That Wealth is Relative
Why is inflation such a nasty thing? Among numerous reasons, it stealthily destroys wealth and purchasing power. But here again, people understand this to be the case in the conventional terms of high C.P.I. inflation. But, it is also possible that your purchasing power (and wealth, viewed in relative terms) can be sapped when C.P.I. inflation is very low ... or even negative.
Consider this question: If interest rates become negative in real terms (adjusted for C.P.I. inflation, such as is the case today in a number of O.E.C.D. countries) is this destructive? What can happen in this case is the very same result as with inflation -- destruction of relative wealth. To illustrate, if you were to sustain a negative real rate of return on your portfolio (and/or total wealth) of negative 5% per annum for 5 years (an exaggerated example, we admit), you will have lost 23% of your starting wealth at the end of that period.
In this case, the optics can suggest that there has been no inflation nor capital losses as nominal returns could be still flat or slightly positive. The net of it is that your relative purchasing power will have declined versus a borrower.
4. Following the Herd
What is the "investment" herd doing today? Understandably, it is chasing higher "yields" due to repressed yield levels. Equities (at least up until recently) are being shunned.
The popularity of different types of investments is not always driven by rational analysis. What may begin as a well-supported trend (i.e. residential real estate in the early 2000's ... or gold in the early 1980s), may eventually evolve into a manic price eruption that is supported on nothing more than irrational sentiment and momentum. The underlying causalities supporting value or real opportunity are either forgotten or ignored.
Why have most investors remained reluctant to direct assets to equities despite their strong recoveries from the lows of 2008-2009? Is it because they had experienced high stock market volatility and several swoons in value, generating potentially huge losses for portfolios in the decade between 1999 and 2009? If not that, is this attributable to a preference for the apparent safety of government bonds?
One of the reasons why stocks have outperformed bonds in recent years is that dividend yields on many equities are now higher than the average 10-year yield on a U.S. government bond. (The last time that this was the case was in the early 1950s.) In fact, the differential between the earnings yield of the S&P 500 and a 10 -year U.S. treasury yield is at a record high. But, after having risen so substantially, are investors again being attracted to equities? If so, the herd may again be at risk of switching horses at an inopportune time.
As the Great Gretsky supposedly said, "One needs to skate to where the puck is going to be, not where it is now." The bottom line, whether all assets go up or deflate in value, ultimately it is the relative gains and losses that will determine success.
5. Monetary Malfeasance Yet to Come
In a recent Global ETFlash we partially opened the curtains shrouding the mysterious alchemies that can be the domain of central banks. Quite a number of observers today are cheering them for the fine job that they are doing. But this kudos really depends upon the vantage point -- that of the investor or that of the macroeconomist and policymaker who is running out of thumbs to plug the leaking walls of post-Keynesianism.
Given the continuing structural issues challenging world economic growth, we expect much more unorthodox tactics by central banks in the future. How soon ... how unorthodox? Only time will tell. What is reasonably sure is that the average household will face a shrinkage in its share of overall wealth. How so?
Consider the popular Monopoly game for this simplistic illustration. Three players are playing a game. All the assets and rents on the board are already owned. A fourth player joins and is given infinite access to the bank at no cost. Let's assume that this player ends up then owning one half of the board. Whereas the original three players each owned 1/3 of total Monopoly wealth, now they own just one-eighth of real wealth and rents. And, it could very well be that the price levels of the properties may not have even risen in nominal terms. There are many more complexities of the real world that would need to be added to this example. But the main point stands. This issuance of fiat money (over and above the increase in savings) is bound to make most people poorer in relative terms.
How can one avoid being a casualty to all these SBDs? What to do?
Conclusions
These are unconventional times. Trust in financial markets and policymakers is low. Moreover, unprecedented conditions are being witnessed in financial markets ... certainly, very different than any professional under 80 years of age today would ever have experienced before. Interest rate levels are currently very low; and this at a most unfortunate time. In the Western world, there is a swell of retirees who are all looking for income from their pensions and savings.
This is a time to think "different" ... to think outside of the box ... to nervously look over one's shoulder. There are different types of inflationary manifestations that must be recognized. One needs to look through the structure ... see things in real terms and to not lose sight of the underlying wealth distribution and shifts. It remains a relative game even in a deflationary environment.
As for us, it is one of the most challenging times to be a portfolio manager. It is an era where massive institutionalized theft (yes, we did say that) is occurring and much more is expected. Sadly there is nothing that we can do about this set of "political economics."
We can only try to "strategize" and avoid the potential impacts of the SBDs. What we can do, is to try to protect our clients ... as best as we can ... through tactical investing, global diversification, and alternative investment types. ETFS are the ideal building block for such active, global, macro strategies. Given the treacherousness of the whole maelstrom of conditions that can affect this endeavor, our task will not be easy. There are 7 billion other competitors, in an increasingly predacious gaming environment. We must keep one step ahead in this relative game.
