Portfolio Protection against Persistent Inflation
As I have alluded to over the last few weeks, I believe inflation is here to stay. To be clear, I cannot see the 5.4% reading of the US Consumer Price Index (CPI – a measure of the change in the price of consumer goods such as food) staying this high, but I can envisage it being above 2% (the generally accepted rate) for some time.
Since COVID-19 sent markets into free fall from March 2020, the level of Government support has produced mounting debt globally. The now termed ‘Quantitative Easing (QE) Infinity’ has produced debt piles in the UK not seen since World War II, with public debt exceeding 100% of GDP in June 2020. I believe the current macroeconomic outlook, with supply shocks, surging commodity prices, and heavy debt burdens will create a lasting bull market for precious metals (Gold, Silver & Platinum).
What is inflation, QE and why do central banks matter?
Inflation is the decline in the purchasing power of money over time. Think about how much you could buy with £100 in 1950 compared to today. Moderate inflation is good for an economy, but if it is too high, it can lead to run-away price surges, destroying a currency and economy. You need to look no further than Venezuela for evidence of this today.
At present, it is such an important topic because US CPI inflation is currently at 5.4%, with UK and EU inflation rates rising toward this level also. Central Banks (CB’s) have insisted since last summer that the rise in inflation rates is ‘Transitory’, i.e. short-term, and will fade as the pandemic recovery continues. But the longer the inflation data remains at such elevated levels, the less the market believes the transitory case. And now the Central Bank in the US, the Federal Reserve, is stating that inflation may be more persistent than previously expected.
So, where does the Central Bank come into all this?
For every currency, there is a CB controlling the supply of new money created via monetary policy. This policy includes interest rate changes and money supply (liquidity) changes. These are the two most important factors affecting financial markets today. A rise in the money supply is called QE and a fall is called Tapering (or Quantitative Tightening).
The single most important CB is the Federal Reserve (the Fed) because the US Dollar is the world reserve currency. World reserve currency status means that every country’s financial institutions and the government hold a certain percentage of US Dollars in its accounts, as a safe-haven currency because of the historic stability of the US Government and Dollar, and the strength of the country as a world leader. These reserves are then used for international transactions. A lot of foreign debt is also issued in US Dollars, for example, if the Somalian Government was to issue a bond (an I owe you or loan) to pay for healthcare, it would issue a US Dollar-denominated bond, because investors would not trust the Somalian Shilling as a stable currency in which to receive their repayment. All commodities are also priced in US Dollars.
Because of these reasons, the Fed is the single most important CB in the world as it controls the US Dollar, which in turn is vital to the world monetary system.
A brief history lesson
During any financial crisis, what typically happens is that once an economy enters a downturn, the CB will reduce interest rates. This encourages the population to take on debt, therefore spending more, and the economy recovers in the subsequent years. As the economy recovers, the CB can then raise interest rates again, and prepare for the next crisis, where the cycle repeats (I recommend this video for a simple explanation of cycles). As each crisis has unfolded, however, CB’s have not been able to raise interest rates to the same level as before, as you see below.
US Interest Rates are in long term decline, Source: Federal Reserve website
Once the 2000 Dotcom Bubble popped, the Fed cut interest rates from 6.5% to 1% to save financial markets. During the 2008 Great Financial Crisis (I recommend ‘The Big Short’ on Netflix for a full explanation of this), the Fed cut rates from 5.25% to 0.2%, and in March 2020, it cut them from 2.4% to 0.09%. Interest rates are in a long-term down trend and retail banks have been told to prepare for negative interest rates during the next crisis. Negative interest rates mean that you will be charged for the money you hold in your bank account, and banks will get less money back than the amount they lend out. This is already in place in several countries in Europe.
In addition to the manipulation of interest rates, the rise of Modern Monetary Theory (MMT) has taken over previously astute spending practices by governments/CB’s and replaced it with irrational exuberance. MMT is the idea that CB can print (literally produce out of thin air) as much money as they want to fund government spending. This has encouraged the world powers to over-spend, with the last 15 years being evidence of that, as you see below.
The Fed’s balance sheet has exploded since COVID-19, Source: Federal Reserve website
QE is all about the supply of new money. What is happening in all major economies today is this: the government issues a bond worth billions of Dollars/Pounds/Yen/Euros, and the CB of that region buys it. The Government is the borrower, and the CB is the lender. This creates a liability for the Government and an asset to the CB, which is supposed to receive this money back from the Government in the form of semi-annual interest payments (coupons) and a full repayment (principal) at the end of the bond’s lifetime (2,5,10 or 20 years).
The Government then uses this printed money to, rebuild banks (in the case of 2008), or send to the population through furlough schemes, business reliefs, and so on (as is the case today). To give you an idea of the scale of the QE programs, the Federal Reserve is currently purchasing $120bn of government bonds per month.
Many market commentators today have stated that inflation will not be serious because the QE released in 2008 did not cause high inflation. However, the difference is that during the financial crisis, the money printed was used to rebuild the banks crippled balance sheets. In contrast, today the money has been poured into the real economy in the form of stimulus cheques and business relief, finding its way into all our pockets. This has resulted in record savings rates and debt repayments.
Bearing this in mind, what do you think will happen in the next crisis? Even bigger spending, and even lower/negative interest rates around the world.
Too much debt to handle
As I stated at the beginning of this article, the problem with this spending is that the debt burden is now huge. We are in a debt trap with global debt to GDP at 360%, compared to 200% 20 years ago. If CB’s try to raise interest rates to any substantial level, there is a risk of a huge crash. The Government cannot afford the debt repayments if it raises interest rates too high.
“Debasement is the only credible solution to the huge debt pile”
There are a number of solutions to this, only one of which is plausible. First, the Governments could cut public spending. This is a non-starter, as budget cuts to the beloved NHS in the UK or infrastructure plans to fight climate change globally would cause uproar. Second, they could increase taxes on the rich. They have already raised taxes here in the UK, and although many speak about taxing the top 1%, the 1% accounts for 40.1% of tax payments, compared with 28.6% paid by the bottom 90% of the population – credit to legendary investor Dr. Michael Burry for those figures. And even if they were to increase this further, it would not create much relief for the monumental debt burden. The only other options are default (don’t pay the debt back), which would cause the largest financial crisis of all time, or debasement, the only credible option.
Financial Repression is calling
I briefly touched on this topic last week, but what it means is that Governments will keep interest rates lower than inflation, so to reduce the value of their respective debt in ‘real terms’ (including inflation) over the long term. For example, if debt interest payments are 3% and inflation is 4%, the value of the debt will be falling by -1% each year (3%-4%) because the real interest rate is -1%. This hurts those in the population who save in bank accounts, as the real value of the savings is being eroded every year, destroying purchasing power.
Although I do believe yields and interest rates are set to rise, as we have seen recently, I cannot see them rising higher than the inflation rate. The real interest rate is the key driver of the value of precious metals.
Think of Gold like a long duration zero-coupon bond i.e., a bond with no interest payments. If the ‘real yield’ on government bonds (yield minus inflation rate) is rising, investors will sell gold and buy bonds, as traditional bonds pay a semi-annual or annual coupon and gold does not. However, if real yields are falling/negative (because inflation is higher than bond yields, as is the case today), investors will buy gold instead of bonds, as the yield is now negative in real terms, compared with gold’s zero yield.
So why isn’t gold booming today since inflation has been higher than bond yields for some time? Because investors have been listening to the CBs ‘transitory’ inflation narrative, and the belief that it is short-term has caused investors to sell gold. However, this belief is now starting to be challenged.
Since a lot of the issues involving inflation are on the supply side, monetary policy intervention by CBs can do little to reduce it. Monetary policy cannot increase semiconductor chips, produce more lorry drivers, or reduce gas/oil prices. In the UK, there are record job vacancies and at the same time, more people are in work than before the pandemic started. Labour shortages lead to higher wages, another inflationary issue the CB can do nothing about that.
Inflation is here, Source: Twitter
As the famous saying goes, ‘History doesn’t repeat itself, but it rhymes’. Looking at the 1970s seems very similar to what could happen in the near future. The 1970s was a period of stagflation, which is a term describing a period of higher taxes, high debt levels, and slower economic growth coming alongside higher inflation. This is a huge issue because CBs cannot raise interest rates to tackle inflation without crippling their economies further.
During times of stagflation, physical assets typically perform best. Beef prices more than doubled in the 1970s. Corn prices nearly tripled. Wheat prices quadrupled. Does this sound familiar today? Residential real estate did well, and farmland produced a 14% annual return from 1970-79. Does this also ring true today? Gold opened the decade priced at $36.56. By late 1979, the gold price had risen to more than $400, so gold investors made 10x their money during the decade. And Silver actually outperformed gold, rising from less than $2 in 1970 to more than $30 at the end of 1979.
Labour shortages will cause wage-price spirals. Once wages rise people will not accept a drop in pay. Another inflationary factor. Source: ISMWorld website
The benefits of precious metals in any portfolio are two-fold: (i) it protects investors from currency debasement (or inflation) and will do especially well during financial repression or stagflation; and (ii) it provides diversification benefits, as its performance tends to be uncorrelated to many other asset classes and does well when uncertainty arises in financial markets.
Of course, there are several risks associated with holding precious metals in the current financial environment. The biggest risk is the potential for an early interest rate rise in 2022 would cause the US Dollar to strengthen. This could hurt precious metals as yields rise, however as I have outlined above, this is a short-term issue as interest rates continue to trend lower longer term. Also, a large rise in interest rates could cause a global debt crisis, and investors would look to safe havens such as gold under these circumstances. Another risk is that higher inflation does not materialise, but in my view, there is a limited chance of that occurring with the wealth of evidence and indicators suggesting otherwise.
Gold has just broken out of its recent trendline, Source: TradingView
Due to the current macro-economic uncertainty, I believe that precious metals are a good way to diversity The Spark’s portfolio in preparation for the volatility that may lie ahead. With tapering starting in November 2021, 2022 could become volatile. I like holding physical precious metals, which I bought here. However, a more convenient way to get exposure is through an Exchange-Traded Product (ETP) on any investment platform. This simply tracks the price of the underlying asset, in this case, gold and silver. I will be adding a 4.7% position in WisdomTree Physical Gold (PHAU), one such ETP, a 3.1% position in WisdomTree Physical Silver ETF (PHAG), and a 3% position in Polymetal International (POLY), an attractively priced precious metals miner with a strong balance sheet and 3.7% dividend. Prices are taken from the close of markets on Friday.
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.