Investing in a world with less money
Sam Morris, CFA – Senior Investment Specialist, Fidante Partners
As we move into times of inflation, what do you need to know to direct your portfolio for the future? A look at the forces at play provides insight.
It has been thought that without growth in the money supply, economic growth would fall below what is politically and socially acceptable. But, as Ray Dalio, founder of the world’s largest hedge fund explains, the economy is essentially the sum of all spending, and inflation is an increase in average prices for goods, services and assets. Credit is the most important part of the economy as one person’s spending is another person’s income, facilitating more spending.
Most sovereign nations have enormous debt, which they will need to reduce or deleverage. Confidence that countries can pay back debt is very important.
Dalio points out four methods which governments can employ:
- The first and most popular option, is monetisation – at its peak right now. Basically, central banks print money to buy financial assets like bonds. This lowers returns from ‘safe’ investments and pushes investors up the risk curve, driving up asset prices, but exacerbating wealth inequality and societal tension. It is no coincidence that booms in high growth equities, house prices and speculative assets like crypto have followed.
- The second is austerity, where people and governments cut spending to reduce credit creation and pay down debt. Spending cuts result in falling incomes, unemployment, and worsening debt burdens, which is deflationary and painful. Europe experimented with this in 2012.
- The third is mass default, when borrowers don’t repay, banks get squeezed, bank runs happen and assets are sold for fire sale prices. Financial wealth is crushed, leading to economic depression. China is attempting to manage a controlled default in its over-levered property sector right now.
- The fourth is wealth distribution or revolution, where wealth is redistributed from haves to have nots. This is often facilitated through higher taxes, which raises social and political tensions, like what we have seen in American politics.
The difficulty that central banks face is that by buying government bonds, they give governments cheaper financing to run deficits.
Policy makers have to balance scaling back money creation and spending. They need to slow inflation, but at a pace that doesn’t shrink income growth below debt growth. Current financial market volatility is the result of trying to price assets against dual risks:
- that long-term inflation will erode the purchasing power of investment returns, and that
- if policy makers withdraw stimulus too quickly they remove the force that drove asset prices up in the first place.
So, how do these forces affect your portfolios?
Well, markets will be more volatile, with aggressive monetary tightening expected over the next few years, potentially leading to recession. The war in Ukraine has highlighted the acute vulnerabilities that the world has to shortages in fossil fuel supply, which has direct impacts on the cost of energy and food (via fertiliser costs). Incidentally, this has been exacerbated by underinvestment in fossil fuel supply due to ESG concerns by those in a position to allocate capital. These forces will not resolve soon and will feed into higher inflation expectations and lower consumer sentiment for some time.
Amidst this regime change to higher inflation and higher interest rates, Government bonds and equities have become increasing correlated, increasing the risk and reducing the return potential of typical investment portfolios around the world. The prospect of the developed world’s rapidly aging population drawing down savings to fund retirement complicates the picture further. Investment strategies that can profit from volatility and stay liquid, irrespective of interest rate movements, are likely to be highly sought.
Credit markets generate higher levels of short-term cash than government bonds, but could suffer if economic conditions worsen. Strategies that are flexible enough to find pockets of value in defensive sectors and not overly exposed to lending long to generate yield may be sensible choices.
Removing ‘monetisation’ support for risk assets like listed equities, private equity, real assets and crypto is likely to create a wide range of outcomes. Many emerging markets, trading on attractive valuations with solid government finances, powerful long-term demographic trends and dynamic growth industries have high potential. And in a general sense, active management and investing based on valuation and fair price as opposed to potential, but unproven, future growth prospects are more likely to be prospective in a world with less money creation.
Finally, decarbonisation and natural resource management will be one of the biggest macro trends of our lifetimes. This will have big impacts on future inflation expectations. But the transition will not be seamless, as the gas supply tensions in Europe and oil price spikes show.
Concerns over water and food supplies in places like Asia and Africa will be acute. The Ukraine invasion has effectively removed around a quarter of the world’s traded wheat from markets that would otherwise come from the rich black soils of Ukraine and south-Western Russia. The snow melts that power the great rivers and agriculture of India, South East Asia and China are under-threat from climate change. Trillions will be needed to upgrade energy transmission, build solar, wind, geothermal and hydropower and invest in R&D game-changers like fusion power and new battery technologies. Modern nuclear power like molten salt reactors will need to be considered, but this is a political minefield.
Competition for access to metals like nickel, cobalt and lithium as well as rare earths will be key considerations for decades to come. The effects of higher energy costs and water scarcity on agricultural production could result in more volatility in food supply and prices.
Finally, as investors, corporations and governments exercise their capital allocation preferences towards more sustainable business models, the risk of investing in stranded industries and assets rise, even if those industries are still critical.
But right now, the world has too much money. The biggest question for markets is what happens next. Investors have a key role to play in directing their money towards funding the future we want for our children.
Sam Morris, CFA – Senior Investment Specialist, Fidante