Insight

Lockhart Capital – Q4 2019

En passant – debt, risks, and unintended consequences

We will circulate a shorter-term piece on markets, valuations and opportunities, early in 2020.

Here, however, we look to assess structural risks, the morphing of one debt problem to another, and the reality of unintended consequences. We will also touch upon the changing political landscape (extremism and property rights) – which could have hugely significant implications for asset prices – inflation, and our approach to Real Assets.

For now, the investment context is dominated by the UK General Election/Brexit/referendums, the US Presidential election of 2020, and the progress of US/China trade talks – markets are anticipating that the latter will be resolved relatively positively.

These are just the leading and open-ended issues that investors must contend with. They are all uncertainties, and resolutions to which could materially impact financial markets in due course, though for the time being even the uncertainty itself is weighing upon economies (see Fig. 1.);

Fig. 1.

The current political trajectory remains towards big(ger) government and loose fiscal policies – we have mentioned our expectations on this in the past – with some quite dramatic possibilities on the ballot paper on both sides of the Atlantic. Most political parties have bought into this, along with electorates (tired of “austerity” and failed policies).

Our sense is that central banks and governments will continue down the policy paths that they are on, with the assumption that what hasn’t worked yet is simply because it hasn’t been tried forcefully enough. That is, a doubling down on existing, and extraordinary, monetary policies. Voters can possibly buy this argument (for a bit), particularly if “Financial QE” morphs into “Social QE”.

Our associate Gerard Minack of Minack Advisors calls this “the intrusion of politics into investing” and warns that “market forecasts will increasingly be subject to political risk” adding that “2020 looks a particularly fraught year”.

Debt

US Federal Reserve Chairman Jay Powell, whose own organisation pays over $2bn in salaries each year, was recently bemoaning the undisputed fact that debt is growing faster than GDP.

The US has $22trn of public debt, but we also consider unfunded liabilities when assessing the implications for interest rates, inflation and the purchasing power of money. The UK, for instance, is reckoned to have some £11trn of unfunded pension liabilities, but worse are more usually to be found in the US. Here there are additional debt issues at State and municipal level, and pension contributions have been rising for some years, although to little effect, and still with unrealistic returns assumptions around their investments (See Fig. 2.);

Fig. 2.

President Obama added more debt to the total than all previous Presidents combined, President Trump has added a couple of trillion himself, and is now running a trillion-dollar deficit, at a time of falling tax revenues and increased Federal spending.

A critical element to the debt problem is of debt that has not been used productively. We find public debt that is not invested for a return (even in the broadest of senses), and private and corporate debt routinely used to buy (or leverage) existing assets, rather than being invested in infrastructure, R&D, business expansion, new hires, and so on.

Hence, consumption and growth are borrowed from the future, but no seeds are sown to allow any chance of replacing that growth, over time, and so also impacting the sustainability of that debt. There is an increased chance that this market cycle ends in wealth destruction, or rather confirmation that said “wealth” never really existed in the first place.

“Panics do not destroy capital—they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works.”

– John Stuart Mill

This is partially a consequence of a world of low interest rates, where yield is scarce, and, where it does still exist, is quickly levered and/or securitised. The demand for assets with a stable (or even growing) yield has been insatiable, leading to significant valuation premiums. This is a case of investors over-optimising for a current and very specific set of circumstances, but which won’t last for ever.

The cost of debt seems extraordinarily low, however that is mainly for people who don’t need it, while it remains pricey for those that do. Furthermore, productivity and the return on capital are both so low that even optically “cheap” debt can have a hard time paying for itself, and in real terms is arguably, and on the contrary, expensive. This is one reason why there is so little demand for the money printed during quantitative easing, in the real economy, and why most of it has ended up as bank reserves or has just been used to goose asset prices higher.

In 2007/8 the problem with debt originated at the consumer level (see orange arrow on Fig. 3.) and drove the real estate bubble of the time. Borrowers, lenders, regulators and politicians all thought that low quality credit should not be a barrier to taking on larger long-term mortgages.

Fig. 3.

Source: Strategas

For those that remember our monthly market comments in the mid noughties, skip ahead, if not – and apologies for the slightly breathless reporting – you can observe our growing alarm at that time:

April 2005: “the housing boom might be of more concern…there may be an accident waiting to happen here”,

November 2005: “it is the sheer scale of the debt that is concerning…the US simply cannot afford a “hard landing” in the housing market”,

October 2005: “we may now see a consumer recession at some point in the next 18 months, if only because consumers are overleveraged to property …if there was a recession it would likely be a nasty one, and so it is worth making sure that portfolios have some measure of protection against this eventuality.”

February 2007: “house prices would seem to indicate that purchasers are extremely confident of a) further large gains in the future, and b) the reliability of their own income. Perhaps there is an assumption too far in there somewhere.”

July/August 2007: “the full effects of the sub-prime housing debacle in the US are arguably yet to play out…could lead to a widening problem involving loans, leverage per se, and speculative investments bought on margin…is it really sensible to leverage yourself to the equity tranche of a sub-prime mortgage CDO?!”

October 2007: “recession looms large for the US, and it is inconceivable that the impact of such an event will not reverberate around the financial world.”

The Great Financial Crisis was just around the corner, as it turned out, and fortunately we went into it with a record exposure to defensive assets. We are just as concerned about protecting the real value of wealth now, although the danger is less likely to be wrapped in such a dramatic and near-term event. In fact, in this case we have been maintaining exposure to risk assets, given the ever-looser nature of monetary and fiscal policies.

The current cycle sees defensive assets as already over-bid, and debt as more of a corporate issue. Initially we weren’t overly concerned that businesses were being prudent with their expansion plans, and instead buying back their own stock, especially when it provided a de facto 5%+ yield (dividends plus buybacks) on the US market (see Fig. 4.), and which was so attractive versus the yield on fixed interest investments (red line):

Fig. 4.

Source: Strategas

In a world of over-capacity, and reasonable market valuations, this made some sense. However, corporates increasingly borrowed to continue to buy back equity (and at ever sharper valuations). The cost of borrowing was usually still lower than the cost of retiring the equity, but overly levered balance sheets can be dangerous, and, in many cases, businesses were then effectively reissuing the stock via options to Management. Shareholders have done well over the last ten years, but not nearly as well as management shareholders (something of which regulators and politicians are taking notice).

You can have too much of a good thing with public debt too. Again, issuing bonds to hungry investors initially worked well, as the world has been desperate for (any) yield and safety (perceived). However, the capital raised was rarely invested wisely, and arguably was misallocated on day to day spending. Furthermore, some central banks have gone on, as we know, to then print vast amounts of money to buy back their own Treasury’s debt (see Fig. 5.);

Fig. 5. Global Central Bank Balance Sheet Assets

Source: the bubbashow.org

American social commentator and humourist Will Rogers liked to say that Alexander Hamilton started the US Treasury with nothing, and “that was the closest our country has ever been to being even”.

This all has an “Emperor’s New Clothes” feel to it, in that there will be a tipping point when bond investors no longer wish to fund a heavily indebted country at the previous prevailing rate and while suffering their currency (of increasing supply) fluctuations to do so. Said country will then need to pay higher yields to attract borrowers, and this will be especially painful when it comes to rolling over existing debt (it only ever seems to get rolled over, rarely paid back!) at now higher levels. Many will find that they simply cannot afford to do so.

As and when this issue arises it will come at the US particularly fast, as so much Treasury debt is short dated. Some countries were in this position at the start of the 1970s re the US dollar (and wanted to exchange said dollars for gold). Most sensible investors don’t want their interest payment to be in a vulnerable or declining currency, and the eventual payment of principal to have diluted value.

So, US total public debt is running at over 100% of GDP, but Corporate debt to GDP is also now above previous cycle peaks (see Fig. 6.), but, crucially without the comfort of access to its own “printing press”.

Fig. 6.

Source: Money Week

GDP is a key metric in calculating debt sustainability and is possibly much weaker than it appears, as inflation could be much higher than is stated. For example, asset price inflation is not included at all in CPI calculations, while it is a fact that the dollar in your pocket buys five times less Microsoft shares than it did ten years ago, while a Mars Bar costs 62% more…and is 20% smaller!

Since 2009 it has required (an exhausting) 2.5 dollars of additional debt to generate each single dollar of nominal GDP. So, with rising debt versus falling nominal GDP, interest rates will have to be kept as low as possible, and ultimately – we think – the money printing presses ramped up further. Debt will be abundant, and so far has not been productively invested and hence can’t pay for itself, so the notional value of that debt should fall, in due course, even if expressed simply as a deterioration in the underlying currency.

Fig. 7.

Source: Strategas

The way this relates to the aforementioned housing crash is in terms of the occasionally ephemeral nature of value and prices. The mid noughties were superficially a reasonable period, economically-speaking, but it was a mirage sustained by surging house values (and mortgage equity withdrawal); wealth that was destroyed (or never really there).

One never knows when key psychological tipping points will be reached. In 1998, for Russia, it turned out to be when that country reached 12% of debt to GDP. Most of the developed world is on many multiples of that level now and seem likely to keep testing their creditors. Argentina (already by then the largest sovereign defaulter in history) managed to issue 100-year debt (!) in 2017, causing us to fall (metaphorically) off our chairs, although who could have guessed that it would be less than a year later that Argentina would be back in the arms of the IMF, requiring bail out loans?!

The bottom line is that too much debt increases vulnerability in a financial system, although is not necessarily an issue, until it becomes an issue, and usually when a psychological tipping point is reached.

Our view remains that debt will have to be inflated away (the path of least resistance), as large-scale formal defaults, including at public level, would be too catastrophic to bear. Therefore, it is inflation and the real value of wealth that is mission critical for independent savers and investors.

Energy

The new energy revolution has garnered much attention, and well it might. Wind and Solar is 90% cheaper now than in the 1980s, while Shale productivity has doubled even since just 2015. Technology being the catalyst in common, of course.

The link to debt is in the borrowing that has been rife in the Shale space, where loans may yet prove to have been less than prudent, as we have seen 33 bankruptcies this year just by the end of September, according to law firm Haynes and Boone, and S&P has been downgrading multiple companies’ debt. Money has been cheap and plentiful (including from Private Equity operators), and technological progress impressive, but most wells are not long of duration, energy prices are hardly robust, and these businesses burn through cash like there’s no tomorrow.

So, this is another, if specific, area that will feel considerable pain at the next economic and financial market downturn, and give appropriate feedback to financial institutions. The bond market seems to be figuring this out, and the Energy sector is the one part of the credit markets under pressure right now (i.e. spreads are widening). The following chart in Fig. 8. shows the recent performance of the High Yield Distressed Bond index (which is full of energy sector bonds), currently in a 28% drawdown.

Fig. 8. S&P US High Yield Distressed Bond Index

This is despite industry expectations for a massive increase in demand for gas, which is relatively clean burning and cheap, and seems the most likely middle step while renewables evolve beyond their various remaining kinks. The likes of Total, BP and Shell are pivoting to gas, while Exxon and Chevron are making moves into the Shale complex (both oil and gas).

However, there is significant “dis-investment” from these companies, as some investors take a dim view of their carbon pasts and present, and either avoid, underweight, or select only “best of breed” (while there are also potential drilling bans from government lands/offshore, as well as possible tax increases). This is not necessarily an incorrect approach to take, and some of our portfolios do just that, but if these businesses were to become starved of capital, and before alternative sources of energy are ready to take the strain, then the unintended consequence might be that the price of energy could surge (and bizarrely these businesses might suddenly become very profitable again), which almost no one wants (bar parts of OPEC). Expensive energy might even then encourage electorates to demand a cheaper source such as coal, which most would see as a backward step.

For the moment the demand for oil from commercial transportation and the chemicals industry is likely to remain firm. Even coal, while getting steadily phased out by more efficient gas-fired electricity generation, is still expected to be meeting 20% of global energy demand in 2040, even though its share is in decline, and consumption is concentrated in Asia. Scientists at RMIT University in Australia are testing turning CO2 back into carbon, which, somewhat ironically, can be used (very efficiently) in those shale fields, via unconventional techniques.

Fig. 9.

Source: BP Statistical Review of World Energy

The other issue with black-balling some energy companies, is that they are significantly involved in various areas of renewable energy and providing essential capital and R&D spend. For example, Shell (amongst others) is involved in the development of Kite technology, which is something potentially much cheaper than using wind turbines and is an area that encompasses, in its broadest sense, everything from tethered kites to offshore drones.

Equally, Exxon and Chevron are investing heavily in carbon capture technology (and MIT is actually making fascinating progress here too). So, one doesn’t necessarily want to be entirely cutting off all sources of finance from these businesses, a) because they are providing capital in essential areas (growth of R&D in renewables is critical), and b) at a time when debt levels are so high on the exploration side. Unintended consequences indeed.

Taxation

The tax burden in the UK is said to be at its highest in 50 years, and yet many people suspect that rates of Income Tax and CGT are still more likely to go up than down. More than half of UK income tax is paid by (just) 5% of people. The main risk to public finances, it would appear to us, is that i) the tax base becomes too narrow, especially as that 5% is arguably reasonably mobile, and ii) the state fails to become more efficient with its spending, and there is little scope to increase marginal rates further, without causing an unintended economic slowdown or some form of tax payer “strike”.

The issue is similar in the US, which, in theory at least, has quite a progressive tax system. There the top 5% of taxpayers receive 37% of the overall income, and then pay 60% of all income taxes. In fact, the Wall Street Journal states that more than 80% of taxes are paid by the top 20% of payers, while a majority of households are net recipients from the state. Politicians and the electorate in both nations seems to be at a fork in the road, as to which way to go on this front and will need to better define what they might mean by “fair share”, as well as creating a standard for the taxation of internet retailers. There is also an unattractive disconnect between the tax rates paid by most big businesses, and those incurred by their mid and small sized counterparts, who additionally are less able to leverage technology and have greater issues with access to and cost of labour.

One can joke about the critiquing of “capitalism” on Facebook and Twitter, via i-Phones using Starbucks’ Wi-Fi, but it is interesting that younger voters are polled as being far from averse to voting for neo-Marxist policies. One survey showed that 70% of millennials are likely to vote socialist. Perhaps surprisingly, only 57% believe the Declaration of Independence “better guarantees freedom and equality” over “The Communist Manifesto”, although this wouldn’t be the first slightly bizarre survey in the US.

In any event a continuation of the long-term trend towards a more statist technocratic approach to government (for better or for worse) seems most likely, in the Western world, despite the blips of 2016 (relentlessly “campaigned” against since). Political analyst Jonah Goldberg (to his disappointment) states that Rousseau (“General Will”) is beating Locke (“individual liberty”).

Marx (Groucho, not Karl) was on to something when he said: “Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies.” Unintended consequences are the norm, and this is what we should look out for from well-meaning but overly active administrations, of any stripe.

Innovation, voluntary exchange, specialisation, and competition have proven crucial to a successful economy, but can’t exist without (permitted) aspiration. Capital formation and growth relies on entrepreneurs risking their time and investment, and with the expectation that they can reap the rewards of ownership as well as suffering the full risks and consequences of (likely) failure.

There is therefore a difficult balance to be struck, especially when government picks winners and losers. Well-meaning regulation can actually preserve large incumbents and hamper dynamic new entrants – hardly free and liberal markets. Innovation that could improve (or save) lives then won’t happen, or at least can be delayed unnecessarily.

The pirate Ragnar Danneskjold in “Atlas Shrugged” worried about “the idea that need, not achievement, is the source of rights, that we don’t have to produce, only to want, that the earned does not belong to us, but the unearned does.” We are not there yet of course but in some senses the discussion is moving in that philosophical direction, which would in that eventuality likely have implications for invested capital.

Now, this is particularly relevant on the anniversary of the fall of the Berlin Wall and given the policy platforms of some political candidates. Rainer Zitelmann in “The Power of Capitalism”, recalls that, in 1989, about 99% of West German households had a phone. It turned out that only 16% of their East German counterparts had the same. If one is serious about, in effect, taxing competence and achievement, then this puts at risk the engine of the economy, standards of living, and indeed the progress of the last 200 years. Incidentally there is not a country today whose life expectancy is lower than that with the highest life expectancy in 1800.

Limited government isn’t on any ballot paper these days – there seems to be a very reduced constituency for this – and neither is much fiscal responsibility or economic freedom. So, and helpfully (from our point of view), it is only the extent of fiscal largesse that is in question, and how it is deployed. Portfolios therefore should be set up accordingly.

We still expect “Financial QE” to become “Social QE”, via some form of Modern Monetary Theory, although equally one can argue that this is what we already have, with those trillion dollar deficits in the US, and the Bank of Japan’s balance sheet through 200% of GDP (and remember that Japan has more people over the age of 80 than under the age of 10…).

Boris Johnson and Jeremy Corbyn would both spend, as will the winner of the US Presidential election next November (might both elections actually be good ones not to win?!). The add-on in the US is that economic protectionism is quite popular on both sides of the aisle now (and Elizabeth Warren also fancies “actively managing the dollar”). This is despite the fact that many studies show that open economies and free trade are negatively corelated with genocide and war, which would seem to be a plus point. It is worth recalling the final thoughts on Americans, of the imprisoned Russian diplomat in Solzhenisyn’s novel “In the First Circle”: – “Prosperity breeds idiots”.

Property rights

So, at some stage a government may be elected in the UK or US with a clear redistributive mandate, including, potentially, the introduction of wealth taxes. This would, arguably, suggest that government and the modern administrative state de facto owns all property to seize and distribute as it pleases (as a reductio ad absurdum), and that can be retained only at its pleasure. So much so, that in the US this move may actually prove to be unconstitutional.

Frederic Bastiat once said “everyone wants to live at the expense of the state. They forget that the state lives at the expense of everyone.” It is relatively easy to fleece the parts of society that are out of favour with the majority, at any one time, and seen as fair game. However, though it is likely that the deficit between ambition and tax revenue will be filled by excess borrowing; it is probable that this will now include or at least evolve to, actually printing (more) money and monetizing deficits. Is this a difference without much of a distinction? We will see.

Wealth is not a zero-sum game, but this is what can sometimes escape even the most genuine of politicians. The oft-used rebuttal is that the weak and the poor have done better under capitalism than in any other system, albeit by that we mean liberal economies and free markets rather than the crony-capitalist rust that has clung to the system in the last couple of decades.

What we obtain too cheap, we esteem too lightly – Thomas Paine

One may not place a high chance on such eventualities, but even low probability outcomes need to be fully assessed if they come with large enough potential impacts, such as in Pascal’s Wager! The biggest risk can be in assuming that the status quo will continue, or that something “couldn’t possibly happen here.”

The Argentinean central bank recently cut the amount of dollars that individuals can buy from $10,000 a month to just $200. Or how about the City of Berlin banning rent increases (over inflation), as it has recently done, for 5 years! (though, again, this may prove to be illegal). In the UK John McDonnell has talked about allowing tenants to buy the properties they rent at “reasonable” prices set by the government, and renationalising listed Utilities, at, again, below market prices. As an aside, according to Australian political scientist David Goodman, 90% of China’s millionaires are the offspring of high-ranking officials, which sounds incredible, but then look at Hunter Biden…

The easy prediction then would be volatility, at least in certain sectors, and likely a raft of those unintended consequences. Few things are for certain, and it is so easy for wealth to get trapped or diluted. The point of that “wealth”, in the abstract, at least for most of our clients’ purposes, is simply in what it allows them to do, or what Henry David Thoreau meant when he said, “Wealth is the ability to fully experience life”. This we seek to preserve and grow.

Of unsocial media and moral certitude…

One in three people in the world, and 90% of young people in the developed world, are on social media. The internet accelerates groupthink (and extremism) for well-understood reasons and has facilitated politics becoming a form of tribal entertainment. It appears to have incubated the growing trend whereby people often define themselves by what they are against, are no longer content to agree to disagree, and willingly assist in creating a huge pressure to conform (in a desire for uniformity rather than harmony).

Barack Obama spoke out, recently, on this topic (of social media, intolerance and imagined moral superiority). He said “The world is messy, there are ambiguities. People who do really good stuff have flaws. People who you are fighting may love their kids. And you know, share certain things with you…. If all you’re doing is casting stones, you’re probably not going to get very far. That’s easy to do.”

Fig. 10.

Source: The Rise of Social media, Esteban Ortiz-Ospina

For this he was pilloried, by his own side’s activists, for whom he is now too moderate and something of a disappointment. Even the Washington Post now calls him a “conservative” – time moves fast in the culture wars! He responded by reminding that “voters aren’t aligned with the ambitions of certain left-leaning Twitter feeds or the activist wing of our party”. This remains the risk for progressives, that they fail to take the public with them or try to go too far, too fast. Social media mavens are not the same as the general public at large.

“The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” – Bertrand Russell

Inflation

So, monetary and fiscal policy seem set to become ever more “enthusiastic”, with the risk that currencies become debased. A loss of confidence in a currency tends to be a non-linear event, and inflation is created as a by-product. This feeds on itself as consumers rush out to spend their cash while it still has some purchasing power – too much cash chasing too few goods = further inflation.

Fiat (paper) money has been a truly terrible store of value, over reasonable time frames, and this is what keeps us busy – seeking to maintain the purchasing power of the pound in our clients’ pockets. Yet “money” is simply zero yielding government debt, and which, when placed in a bank, disappears elsewhere. This leaves you as a creditor of said bank (though with access to their cash as long as the bank is healthy, and within any government-mandated insurance schemes). Are we sufficiently compensated for these risks, and especially when fiscal policies seem set to doom (one way or the other) the real value of that “money”?

The utility of money is instead found in it being a medium of exchange – exchange while you can and for what you can (assuming there is something available and which is of value to you). This may seem unnecessarily dry, but remember that the UK is unique in that its central bank has existed for 325 years (the pound has been around since Anglo-Saxon times, but it was the Bank of England that issued the first paper notes). This may give false comfort, as, conversely, the average currency has lasted just 27 years, so the pound is very much an outlier.

Now, we have seen incredible money printing by the world’s central banks over the last decade, but this has not yet created traditional inflation, as it encouraged speculation but itself is largely sat in bank reserves. We, and others, have argued that it has created asset price inflation, so just inflation of a different sort. The Weimar Republic was famous for printing its way to hyper-inflation in the 1920s, but the key difference there was that the money was printed and then spent. That made the velocity of money increase, which creates generalised inflation (and would again).

In our opinion there is a strong psychological component to inflation, and traditionally consumers frame their views in the rear-view mirror, i.e. if there hasn’t been much inflation then they don’t expect much in the future. For now. Yet the “latent inflation” is always there, to a greater or lesser degree, and even via just a change in that psychological perception – remember how, in the 1970s, employees asked their bosses for a pay rise every few weeks (and got them)! This was because prices were rising and hence they expected them to continue to rise and which became a virtuous (or vicious) circle. This is a similar tipping point to that of the bond investor who loses faith in the integrity of the underlying currency, as in both cases they worry about the loss of purchasing power in their principle or pay-packet.

Bringing it all together

Little of the possible future that we have alluded to here is certain, and any or all our analysis could be to some degree incorrect in of itself. However, fortunately we don’t invest on a single-scenario basis. Essentially, we want the Lockhart portfolios to perform adequately in the widest variety of possible circumstances, given everything we know today (and then tomorrow…), and seek to mitigate the most impactful of risks.

Rather than risk managing the portfolios when events happen, the risk management happens, dispassionately, at the original portfolio construction level, and then gets tweaked as new information arrives and we seek to further mitigate potential risks (that may or may not come to pass), at the margin.

Ray Dalio (of Bridgewater), one of the most successful investors of our time, suggests that a key to success is knowing how to deal well with what you don’t know. In the markets, that which is unknown is much greater than that which can be known (and relative to what is already discounted in the markets). George Will, a famous American political commentator, and “Never Trump-er”, in his book “The Conservative Sensibility”, affirms this by reminding that one reason to read history “is to know how little has generally been known about what was coming next”. Therefore, we feel that the best risk management is done in advance, and that every strategy must have the ability to adapt.

Money/cash is easily appropriated or eaten away at by inflation, and hence we have always had a strong preference instead for financial and real assets. The former has been much the greater part of our portfolios for the last 20 years, and this has worked well, but we suspect that the baton will pass to the latter, going forward. That is not so say that portfolios should be knee-deep in commodities – they most definitely should not! – rather that it is appropriate for the balance to change, at the margin. We can then adapt further as events unfold.

There is an interesting conversation to be had around collectibles too. That is, anything from Art, to Wine, to Stamps, to Baseball Cards, and so on. One might think of these as frothy, in valuation terms (and we’d agree), and of course there are the not-inconsiderable insurance, storage, and trading costs. Nevertheless, any subsequent decline in value might still be more palatable than that of one’s base currency. That is, in the Weimar Republic during that hyperinflation of the 1920s, the market for Renaissance-era paintings would not have been strong, and you certainly couldn’t eat one, but it would still have held its value much better than paper money that was worth less than the barrow or suitcase it was carried in. Afterall, a dozen eggs cost four billion Reichsmarks in October 1923, from only half a Reichsmark in 1918.

That is not to say that we are predicting hyper-inflation, but scenario-analysis is a useful exercise. We don’t normally recommend “collectibles” either, as they are quite individual and for personal pleasure. However, they do have the added benefit that they are potentially less easy to attack via wealth taxes, including due to the issues with valuing such things.

So, our approach to the marginal risk in the world as we see it, has been to increase the Lockhart core portfolios’ exposure to “Real Assets”, which is now towards the top of its permitted range (0-20%). As probabilities change, we might even need to reconsider those limits. However, for now, for e.g. the odds of a Labour majority at the general election is 25-1. And that is before factoring in the chances of the more extreme policies then passing through Westminster unmolested, which might prove tricky in the scenario of a small majority or a coalition government. Nevertheless, the possibility is “non-zero”, so needs to be sensibly considered.

Our use of Real Assets serves three purposes. Diversification is the obvious long-term benefit, and feeds into the second benefit of being a hedge against poor performance from traditional financial assets. Thirdly, and crucially, there is potential inflation-protection in this area. Our strong preference would be for there not to be an inflation shock, as that would be extremely nasty for economies, markets and asset prices. However, inflation is the single biggest risk to investment portfolios and the real purchasing power of wealth, so a sensible insurance policy here is an opportunity-cost (if that is what it turns out to be) well spent, and a hedge against currency debasement.

Within the universe of real assets, commodity prices are sensitive to inflation pulses, and we see this especially in gold, which also can perform in deflationary and recessionary times. Government Index Linked bonds (a growing market – see Fig. 11.) have a direct link to inflation (the principal is essentially riskless, as it gets adjusted for inflation and the sovereign issuer is in theory a sound credit).

Fig. 11.

However, index-linked bonds can’t do the heavy lifting all on their own. They are expensive (as all bonds are) and have had a supply/demand imbalance tailwind. There is no sign of that changing anytime soon, but a repricing would naturally follow such an occurrence. Furthermore, if cynically, we can’t expect the official calculation of inflation statistics to offer us many favours versus the other side of the trade, i.e. government. The US has been quite crafty in (arguably) supressing official inflation statistics, and the UK will no doubt complete the move away from using RPI in favour of CPI at some point. Additionally, the UK, unusually for a developed market, does not have a deflation floor for the principal, which is an extra risk, although historically the UK has been an inflation-prone economy so perhaps it was thought that this would never be of need.

Infrastructure investments sometimes link revenues to realised inflation, and the same can be the case with their debt. Global Property Securities (or REITs) are infrastructure of a sort, and these days have increasingly diversified exposure to non-core assets, which include anything from cell-towers to data centres to self-storage facilities. Cloud-based infrastructure is being built-out and needs warehousing too, while apartment REITs benefit from a generational shift to renting rather than buying (the aforementioned city of Berlin is 80% rental). Property tends to perform better than many other asset classes at times of inflation, partially as rents will generally be linked to real prices.

Finally, Timber and Timberland can be a helpful component in this space. Timber prices should track inflation over the longer term, and land values will, more often than not, be solid in this respect. The growth of the timber itself is a unique diversifier and unconnected and uncorrelated to economies or interest rates.

It is also true to say that currencies can have real asset and inflation-linked characteristics. This might be the case if the country concerned is a big exporter of commodities, or if its finance minister and central bank are much more prudent than their peers! However, generally we don’t try and get too cute here, as we like to run portfolios that are in any event already well diversified by currency. Furthermore, currencies are volatile, and you must rather second guess what a central bank will do, which is a big ask, especially as they are prone to intervene unexpectedly.

We do anyway think of Gold as a de facto currency, and it has a well-accepted role as a store of value. For example, from the World Gold Council survey, 61% of retail investors trust gold more than currencies, and we think there is the possibility for this to rise substantially, and as the 38% of investors who have never invested in gold but “would consider doing so” catch on and even just realise how simple it is to buy.

That said, as with everything in investment, gold is no panacea. It didn’t help much during the Asian currency and Russian rouble crises of 1997 and 1998, and in many decades has underperformed other asset classes and indeed recorded inflation. Nevertheless, it has outperformed equities 80% of the time when they are falling, so it does have defensive qualities and can be viewed a hedge against central bank policy error.

So that was a quick canter through the issues that are currently exercising our minds and ones that we are and will be taking into account within the Lockhart portfolios going into 2020 and beyond. Portfolio returns have been strong this year and we will continue with our quest to maintain and grow our clients real purchasing power in as many potential future scenarios as possible. We thank you for being our valued clients and take this opportunity of wishing our readers a peaceful festive period and a prosperous New Year.

Andrew Wilson, Chief Investment Officer, November 2019

The content of this newsletter is for information only. It does not represent personal advice or a personal recommendation, and should not be interpreted as such. Please do not act upon any part of it without first having consulted an Independent Financial Adviser.