Edition 8

As I write, this will be the 8th Ein Harod Family Office BLOG since the pandemic. This is not an attempt to forecast future events which are unknowable nor is it a recommendation to purchase a security or make an investment.

‘Where there is no vision the people cast off restraint’

Book of Proverbs

The economic headlines and data are troubling and may be for many months ahead. However the equity market seems oblivious to this and the US and Europe, the world’s two largest trading blocs, seem to have priced in a return to pre pandemic activity by year end. Given that the market is forward looking, in our view it is looking through rose tinted glasses.

As the four main central banks keep pumping money into the economy it finds its way to Wall Street, the City and Tokyo, not main street where small businesses need it. Once again as in the last 11 years of ‘Quantitative Easing’, driving up asset prices.The stock market has decoupled from the economic reality facing most people.

It is still too early to forecast with any degree of certainty how long and what shape an economic recovery will take. Heath issues remain unsolved with uncertainty hanging over the autumn as colder weather returns to Europe and the US. No one knows what the outcome will be and much will depend on discovering an effective vaccine and being able to manufacture and distribute it in sufficient quantities. Until this happens opinions remain subjective and speculative.

The question confronting economists and investors is, whether when restrictions are lifted, pent up demand and central bank liquidity will produce above average consumer spending which could produce inflationary pressures? Or whether an already weak supply chain further disrupted by trade tensions and tariffs, a lack of consumer confidence, lack of jobs and increasing bankruptcies will stifle demand and lead to deflationary pressures? Stagflation, low growth, rising unemployment with rising inflation is also possible in the immediate term? In the absence of data from the second quarter of this year the market does seem to have got way ahead of itself and has priced in an optimistic outcome by the end of the year. The bond and options market is giving another signal.

The Powel ‘PUT’ and Modern Monetary Theory

We are learning by doing.

Ben Bernanke
Ex Chairman Federal Reserve Bank of America.

(see my article Learning by Doing)

I am often asked ‘why the Federal Reserve and other Central Banks can’t just keep printing and pumping money into the economy indefinitely?

Well in theory it can. The term money printing has been used euphemistically to describe a process but neither the Federal Reserve Bank of America nor any other developed central bank has the authority to print money. This is done by the Treasury which as a department of the Government’s administration is authorised to produce currency which it cedes to the central bank. The mandate of the central bank is to be independent of government but since 2008 the four main central banks are now politicised. If a nation has a Treasury, a Central Bank and its own currency it can keep producing money and feeding liquidity into the economy. However this is eventually inflationary as the sheer weight of currency chasing fewer goods and services weakens the purchasing power of the currency (see graph below). Paper currency is a claim on the issuing central bank that promises to make good its obligations.

Central banks have a balance sheet and hold assets and liabilities. The more risky the assets held the weaker the balance sheet. Traditionally the Fed only allowed very low risk securities onto its books such as Treasury Bonds with negligible risk of default. However as of last month the Fed began for the first time in its history accepting junk bonds with a high risk of default onto its balance sheet in exchange for issuing currency. Thus providing for the additional liquidity the government believes is required to support a struggling economy. As economic growth picks up the Fed needs to de-risk the balance sheet and sell back the risky assets to the market to reduce balance sheet risk thereby increasing confidence in their ability to pay creditors and not default.

It is interesting to note when considering how long it may take for the global economy to recover that this is the only time in history that developed and emerging economies have been literally ‘shut down’ by a political decision. It did not happen during the Black Plague, two world wars or the Spanish Flu.

Preserving Capital

I am more concerned about the return of my money than the return on my money.

Mark Twain

Preserving capital is really a question of preserving the purchasing power of capital over the long term. It is easier to make money than to keep it!

What we do know about the months and years ahead is that in economic terms we can expect deflation, stagflation and inflation. We do not know in what order this will occur or whether we will experience a combination of several pressures at once. But we can be sure that this will occur. Our all weather strategy seeks to preserve capital by holding assets that should provide protection during the economic cycles of deflation, inflation and stagflation whilst owning equity in businesses which will benefit in the long term when economic growth returns. As long term shareholders in a business we cannot know whether we have bought well or that the business will survive until at some point in the future. Dividend income allows us to be paid while we wait. At a time when European Bonds have negative yields and the US 10 year ( the global proxy for credit risk ) is yielding 0.70% pa some businesses with strong balance sheets are paying dividends of around 5% pa. In the main we do not hold individual stocks in our all weather strategy but hold a globally diversified strategy of very low cost broad based index funds.

The investment case for owning physical gold in the context of the possible economic outcomes is very strong. Gold is an insurance against geo political risk, central banks monetary policy; depreciation of FIAT currency and a weakening US Dollar, stagflation and inflation. Although it may appear counterintuitive Gold can be an effective hedge against deflation. In fact Gold’s purchasing power as a proven store of value is more likely to increase in deflationary periods than inflationary.

As investors we should be calculating the value of our assets against Gold net of tax and not against FIAT currency which depreciates dramatically against Gold. Since 2000 the Dollar has lost over 27% of its purchasing power while Gold gained 530%. In our All Weather Investment Strategy we hold a position in physical Gold.

Inflation Protected Treasury Bonds ( TIPSs ) provide protection against rising inflation and some protection against deflation.The price of these securities is now relatively low so insurance can be bought cheaply. For investors prepared to pay an opportunity cost of the carry should inflation begin to rise sharply nominal capital will be protected. Our All Weather Strategy has a position in TIPs.

With all good wishes for a restful weekend!

Jeremy Blatch TEP
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