One of the most influential things I have ever seen is a presentation on YouTube. Its formal title is Arithmetic, Population and Energybut it is described, for once, I think, without too much exaggeration, as The most important video you’ll ever see. You can judge for yourself and watch it here.
The presenter is the late Dr Albert Bartlett, an emeritus professor of physics at the University of Colorado at Boulder. He is believed to have given this presentation over 1,700 times during the course of his career. Without giving too much away, Dr Bartlett makes two key points. One of them is that, as humans, our biggest frailty is our inability to understand the power of the exponential function – that is, something growing at a steady rate over time. It is also known as the miracle of compounding, something that Einstein allegedly referred to as the eighth wonder of the world. The second point, related to the first, can be summarised in his quote: “For any entity beyond maturity, further growth is either obesity, or cancer”.
All very interesting, you might say; but what does this have to do with the financial markets?
Plenty. We live in a physical world constrained by finite limits. No matter how ingenious humanity gets, we cannot conjure up an infinite amount of food or energy (at least, not yet). But the world of finance seems to operate as if there were no constraints on anything. Our appetite for credit alone appears utterly boundless.
We can indeed make an argument that the world of finance now requires constant growth, simply in order to service the debt pile amassed by governments, households and corporations. Without constant economic growth, the bond market is reduced to a house of cards.
Perhaps the most shocking financial statistic was the one revealed by the consultants McKinsey back in early 2015. Contrary, perhaps, to the understanding of some, austerity never happened. In the years since the Global Financial Crisis that ignited in 2007, global debt levels did not contract. They grew. No major economy managed to reduce its debt-to-GDP ratio since 2007. Global debt, in fact, grew by some $57 trillion. Yes, that’s trillionwith a ‘t’.
Squaring the debt circle
We can plausibly argue that Quantitative Easing (QE) was all about tackling this monstrous debt pile. If you accept my thesis that Finance World is facing a possibly existential crisis over an unmanageable mountain of debt, you should probably accept my suggestion that there can only be three ways of resolving the problem.
One is for the major governments of the world to engineer enough economic growth to keep the debt serviced. The demographics of the eurozone alone suggest that such ‘permagrowth’ is unlikely there. The second is to default on the debt. If you prefer, you can sugar-coat the outcome with the words ‘debt jubilee’ or ‘restructuring,’ but it amounts to the same thing. A broad-based default would also instantaneously bankrupt the global banking and pension fund industries, as the largest holders of said debt. So, what’s in Box Number 3? What’s in Box Number 3 happens to be what all governments throughout history have resorted to when they get desperately out of their depth in debt: inflation.
The capacity of the Gilt market to deliver shocking returns for ‘investors’ today should not be underestimated.
So, it’s entirely plausible that QE was created to square the debt circle. Default on the debt in such a way that most people barely recognise what’s going on. Stealth default, if you like. It happens to be the crowning irony of monetary policy that QE never managed to deliver the inflation its governments wanted, to help them out of the debt quagmire. But it did manage to create inflation in the prices of financial assets, bonds, stocks, property and rich boys’ toys. So if you want to know who Public Enemy No.1 is in the context of the rising wealth inequality that we have experienced over the past decade(“For whosoever hath, to him shall be given, and he shall have more abundance: but whosoever hath not, from him shall be taken away even that he hath”) look no further than our central banks.
So now we face an intriguing challenge. The debt pile has simply got bigger – and it was already unsustainably high a decade ago. Monetary policy rates (short term interest rates) are now rising in the US and the UK. There is one iron law in finance, and it suggests that if interest rates go up, bond prices go down. This is because bonds’ coupon payments, being in most instances fixed, become comparatively less attractive when deposit rates rise, so the price of those bonds falls in order to compensate their investors.
Whether you can even call bondholders ‘investors’ at this point in time is something of a moot point. The great value investor Benjamin Graham offered a definition of investing in his seminal work Security Analysisof 1934, co-authored with David Dodd: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
10-year UK government bonds, or Gilts, at the time of writing offered a nominal yield of roughly 1.5%. Given that UK inflation currently stands at approximately 3% (put to one side whether that’s an accurate reflection of our real rate of inflation), and assuming that it doesn’t change over the next decade, that effectively means that Gilt ‘investors’ today are locking in a guaranteed 1.5% real terms loss. Safety of principal? Satisfactory return? That makes bonds today look somewhat speculative, in my view.
So, it is rather awkward that the financial regulator, and by extension most wealth managers, regard government bonds as the only thing approximating to riskless assets within a balanced portfolio. Riskless? A Gilt investor in 1973 subsequently incurred a real term loss of over 35% of his capital. He did not make any positive return from his Gilt portfolio until 1985. That’s a 12-year period of no real returns. Gilt yields today are far lower than they were in the 1970s. The capacity of the Gilt market to deliver shocking returns for ‘investors’ today should not be underestimated.
For all of these reasons we have pretty much eliminated bonds from our client portfolios. But given that both bond and stock markets are trading at levels that could fairly be described as elevated, there are clearly other risks to be faced.
The power of gold
When Ben Graham referred to “safety of principal” it’s not clear whether he was referring to the ‘store of value’ properties of money itself. Given that the pound sterling has lost roughly 98% of its purchasing power over the last century, it’s useful to consider ways in which we might try to protect our own purchasing power, as savers and investors, in the years to come. It’s for this reason that we see especial merit in having an allocation of personal capital to a form of money that can’t simply be printed on demand out of thin air. That form of money is, of course, precious metal: the likes of gold and silver.
Gold remains, in my view, one of the most misunderstood assets in the world. Like the topic of Brexit, it tends to provoke strong emotional responses and passionately polarised opinions. I particularly like this anecdote from Peter L. Bernstein’s book on the subject, The Power of Gold:
About one hundred years ago, John Ruskin told the story of a man who boarded a ship carrying his entire wealth in a large bag of gold coins. A terrible storm came up a few days into the voyage and the alarm went off to abandon ship. Strapping the bag around his waist, the man went up on deck, jumped overboard, and promptly sank to the bottom of the sea. Asks Ruskin: ‘Now, as he was sinking, had he the gold? Or had the gold him?’
When we discuss gold with clients, we invariably get asked at what price point we intend to take profits and liquidate our holdings. But this skirts over the question of why we elect to hold gold in the first place. We hold gold because we anticipate a perhaps disorderly breakdown in the global monetary system – on the back of that unsustainable mountain of debt. It’s entirely plausible that the ‘resolution’ of the debt crisis could bring in its wake either a messy inflation, or a troubling deflation, or perhaps even both. Fiat currency in any event looks like a poor potential store of value. No unbacked paper currency has ever lasted. Gold, on the other hand, has been a useful and defensible store of value across thousands of years.
The problem with growth is that sooner or later it comes to an end. Now that we can add the threat of trade wars to the other problems facing the world economy, it seems increasingly likely that 2018 will reward strategies offering the prospect of capital preservation as opposed to those seeking growth at any cost.