It seems that the pieces of the ‘New Normal’ jigsaw are starting to fall into place. But, as is to be expected given that this is a ‘New Normal’, the way these pieces fit together is currently far less stable and orderly than in the ‘Old Normal’. And what may seem today like a completed part of the jigsaw may, by tomorrow, once again prove to be a state of great uncertainty and chaos.
The key difference between this new era and the previous one is, of course, the size of the balance sheets of all the central banks in developed economies: the Fed, the BoE, the BoJ and, to a lesser extent so far, the ECB. The headlong rush that quantitative easing (QE) represents is driving up the market prices of virtually all assets and directly related markets. And this reality is as striking as it is fleeting, since the mass printing of money has as much influence on asset prices as it is unsustainable, given that the tap on QE will inevitably have to be turned off at some point in the not-too-distant future.
We will therefore, to a certain extent, have to dance to the tune set by the central banks. And the million-dollar question for investors is obvious: in which assets will it be profitable to invest over the coming months or years? Or, more importantly: in which assets will investors suffer permanent losses in the medium and long term?
To complicate matters further, the history of the Fed shows that its chairmen have never been able to turn off the tap of quantitative easing in time in the past. They have always preferred to flood the monetary system with excess liquidity rather than let it run dry, no doubt due to political pressures, as a spike in inflation is a far more forgivable sin at the ballot box than an economic recession.
The problem is that today we are starting from a situation of unprecedented liquidity. Over the last six years, money creation has reached dizzying levels, the inflationary potential and momentum of which are enormous. And we are not just talking about the Fed, but also the other central banks mentioned earlier. As you will know, inflation requires not only an increase in the money supply, but also an increase in the velocity of money (I recommend a an article from 5 years ago (in which we discussed this in the midst of the stock market crash). And today, whilst the size of central banks’ balance sheets is enormous, the velocity of circulation is close to zero, as commercial banks have their hands full simply trying to survive and avoid bankruptcy, let alone thinking about lending and taking on new credit risks that might add to the already critical level of non-performing loans.
But this lack of credit will come to an end as commercial banks’ balance sheets are gradually cleaned up. And at some point, that enormous money supply will slowly start to move. If, at that point, central banks are unable to reduce their balance sheets in a judicious, agile and expeditious manner (which has never happened), inflation will soar because the inertia of QE is immense. That is the most likely scenario, given that central banks are not going to take the risk of jeopardising the extremely fragile economic recovery by being too quick or too forceful in turning off the tap. If, historically, they have never been known for getting their timing right, why should they do so now, with balance sheets of a size and with a momentum never seen before?
We must therefore prepare ourselves for a few years of high inflation (though not in the ‘banana republic’ style, of course). These will be years of extremely high volatility, driven by the enormous repercussions of any move made by central banks in one direction or another. Times in which inflation will not only not be curbed, but will in fact be desired – albeit in a way that is hard to admit. Who else will be able to pay off their debts? Both governments and the population of the developed world in general need significant and sustained inflation to devalue their debt if they are to avoid a massive default.
In this inflationary scenario, it is obvious that if there is one asset class that is set to suffer particularly badly, it is fixed income in general, which is already trading at extremely high prices inflated by QE itself. This is because the vast majority of public and private debt worldwide uses the price of the risk-free asset (sic) as a benchmark, which has traditionally always been the US Treasury. If this collapses, the rest will follow suit to a greater or lesser extent. For all these reasons, we are unlikely to see positive returns in the coming years from fixed-income assets, which will also be hit by inflation. Woe betide the pockets that depend on large pools of money such as pension funds and other institutional investors, which will not be able to achieve the necessary returns in the coming years…
By contrast, one asset class that can weather this wave of inflation without suffering serious losses along the way is equities. But beware, because the enormous volatility that will be generated by the tapering Globally, this forces us to focus solely on shares that offer value, as a sudden withdrawal of quantitative easing (QE) would cause share prices to fall more sharply than we would like. And only by buying excellent businesses at a good price will we be able to recoup our losses in the short to medium term. However, we must rule out those businesses that cannot raise their prices swiftly in the face of inflationary pressures or rising raw material costs, and prioritise shares in companies that can do so with ease.
These may also be good times for investment strategies that aim to achieve absolute returns by reducing volatility and decoupling themselves entirely from the markets. Amidst the mediocrity, we can find gems of fund management. They do exist, but they are scarce, obscure treasures whose success is more fleeting than one might wish. It will therefore be difficult to invest profitably the portion of one’s wealth that cannot withstand high stock market volatility. And for those who regard gold and silver as safe-haven assets, they must bear in mind that their extremely high speculative element should rule them out as a place to invest the majority of non-equity wealth.
In short, we are facing a few years in which volatility will be enormous, inflation persistent, and fixed-income investments a poor bet. In short, tough times for the most conservative savers and investors, and a favourable scenario for debtors of all kinds. In fact, it is only by favouring debtors and penalising investors that the world will be able to avoid a chain of bankruptcies. In other words, once again rewarding those who have done badly, and penalising those who have done well…
Now more than ever, we need a strategy that can navigate the Age of Central Banks, which breaks with the traditional models of any investment advice based on the classic allocation between fixed income and equities. A word of warning.
P.S. For those who are unsure how the monetary system works between central banks and the real economy, I recommend taking a look at this interesting and informative video featuring Bridgewater’s Ray Dalio.