Focus: Cash continues to gain strategic importance
as an investment asset class in the current deflationary stage of the long
term economic cycle which has persisted, in indebted developed western
markets, since the turn of the millennium. As one of only three asset
classes expected to outperform during this 15 to 25 year phase, it has
become increasingly important not only to allocate an adequate proportion of
investment portfolios to cash but also to actively manage that money in
order to achieve optimal returns in a low or zero interest rate environment
against a backdrop of ongoing fears of a global depression.
Implications: During such a deflationary period,
two key issues come to the fore:
* Strategically managing asset allocation with due regard to the risks and
rewards of each asset class - recognising the three most suitable asset
classes for this long term phase (namely gold, bonds and cash), whilst
exploiting tactical allocation to other assets, notably risk assets such as
equities and property, so as to capture counter trend reversals.
* Maximising the potential returns of each of these three strategically
appropriate asset classes.
These issues need to be considered from a wide range of
currency perspectives and all investment criteria, in terms of the global
asset and currency opportunity set, noting that the most favourable long
term returns and investment opportunities are likely to be found within
un-indebted, higher growth economies, such as those in South East Asia.
Although a short term US Dollar rally seems likely, international assets
will become consequently less attractive. Depositors need to be aware of
this from a currency perspective and choose the optimal exit point from any
Outlook: A sharp retrenchment is expected in the value of risk assets
throughout 2012 and 2013. Currency volatility is also expected to increase,
leading to both elevated levels of risk and greater opportunities.
Zero interest policy causes problems for investors: all that’s gold,
does not glitter - The consequence of uninhibited lust for credit, which
has defined economic and capital market activity for the last thirty years,
is slowly, inch by agonising inch, reaching its inevitable conclusion as
both people and nations are starting to learn the hard way about the need to
live within their means. Yet the UK, the US and Europe continue pumping
billions more Dollars into their economies in a bid to stimulate a recovery,
while many other countries have started to follow suit. Most notable and
most alarming of these is China, in view of both the sheer scale of its
capital base and the worrying inadequacy of Chinese regulatory oversight or
Capital flows have caused unintended consequences increasing the daily cost
of many consumer staples beyond the ability of many societies to cope,
constrained as they are by their increasingly unequal income and wealth
dispersion characteristics. Evidence of this has spread from Athens, through
the still continuing Arab Spring, via the streets of many UK cities to the
Jasmine riots in China.
An intellectual debate continues to rage about what actions the Fed, IMF,
ECB and all central banks or supra-national bodies can or should take;
whether Federal Reserve Chairman Ben Bernanke’s handling of the Global
Financial Crisis (GFC) - based on the narrow and seemingly incorrect
historical perspective of monetarist economic theory - can win the day.
Investors could learn a great deal about the current situation and future
outlook by studying long term market cycles - especially MBMG’s Kondratieff
Seasons (see graph this page).
The policies that have been adopted are justified with reference to economic
theory but the justifications provided are spurious and, therefore,
investors should not expect better or different outcomes to the previous
instances of the global ‘Winter’ phase of the economic cycle.
Accepting that cash, gold and bonds are the three strategically appropriate
assets for this phase, investors need to understand the challenges
associated with each of these. For bonds and gold that challenge is not to
get caught holding the time bomb when these asset values fall off a steep
cliff, although that may not be imminent. For cash, the test ahead is to get
any kind of returns in a zero interest environment.
This is a very challenging investment environment but awareness of the
larger context will help investors to find the most appropriate solutions.
Professor Bernanke’s academic lack of interest
Even proponents of the policies that have taken the global economy to the
brink, such as Bernanke’s predecessor Alan Greenspan, admit that these
policies are a huge experiment, lacking any scientific grounding or
Indebted western economies currently remain deeply mired in the depths of
Kondratieff’s winter despite the unconventional stimulatory economic policy
and smorgasbord of bailout packages. The three asset classes which perform
best during this winter phase are, as previously stated, gold, bonds and
cash. Gold has already risen from below USD250 per oz to a peak of
USD1901.35 per oz last year. It has the potential to climb rather higher
than that before the end of the winter period, but it also, in the longer
term, appears inevitably condemned to fall back below USD1000 per oz,
meaning that investors holding gold need to keep an eye firmly on the exit
door. Bonds and cash each face the horns of a vicious dilemma.
Central bank policy has created a feedback loop where, in a kind of
Pavlovian nightmare, investors are, in the short term punished for prudent,
strategically appropriate asset allocations and rewarded for wild, excessive
and speculative behaviour. Sadly, unless you are prepared to take a leap of
faith based on blind belief in the power of central banks, this will
inevitably end in the failure of these government sponsored speculative
excesses. It is a difficult challenge for many portfolio managers, let alone
individual investors, to maintain the required focus, understanding and
discipline in the face of such manipulations. The best performing portfolio
managers ask two key questions -
* Which asset classes offer better risk/reward than cash?
* How to get the best cash returns?
US Bond and T-Bill rates dictate both global interest rates and investment
returns, but one month T-Bills now pay annualised interest of just 0.05% and
one year bonds just 0.13%, a negative real return once inflation is factored
in. The benchmark 10-year note has been gyrating around the 2% per annum
level for some time. To get a 3% annual return you have to buy long-dated
(30 years to maturity) treasuries with the added caveat of price volatility
between now and maturity, i.e. if interest rates increase by just 1% then
the capital value of 10-year notes would instantly fall by the best part of
10%. For thirty year notes the price drop would be almost three times as
bad. This becomes even worse if interest rates increase more.
Flawed theory: Bonds and Bernanke’s blind man’s bluff
Bond prices have pretty well reached their apex with interest rates on US
Treasury Bills having fallen to almost zero. This is likely to endure for as
long as Bernanke & Co. continue to press ahead with flawed stimulus
Although negative real rates (interest rates minus inflation) look as though
they are here for some time and longer term rates (such as 30-year
government bond rates) can fall, especially if manipulated by government
policies, interest rates look certain to move higher over time thus pushing
down the price of bonds. While this scenario may not be imminent - MBMG’s
near term expectation is for prices to continue to increase - it is all but
inevitable, and may be dramatic once it takes root, so investors need to
know where the exit door is located.
Given the heightened risks surrounding investing in gold
or bonds, cash emerges as the hardiest asset class in times of economic
winter despite the pressure that investors face to chase
higher-yield/higher-risk investments. This is the ultimate central bank
manipulation and is generally justified by reference to a range of economic
theories including The Taylor Rule which is a formula developed by Stanford
economist John Taylor in 1993. It was designed to provide central banks with
guidance on setting interest rates in response to changing economic
conditions by systematically reducing uncertainty and increasing the
credibility of the central bank’s future actions through the process of
fostering predictable price stability and full employment.
One of the key elements of the theory is that any rise or fall in inflation
should at least be matched by relative increases or decreases in base
interest rates, thereby dampening growth with higher interest rates when
growth leads to inflation, or by stimulating economic activity (spending and
investment) by cutting rates in times of low growth. As it is not possible
for interest rates to drop below zero, an implied negative rate from
Taylor’s Rule would seem to justify “printing money” - the introduction of
new money supply by central banks, now universally known as Quantitative
Easing (QE) - as means of stimulating growth.
A problem arises, however, from the fact that in 1999, Taylor wrote a
further paper in which he discussed and tested a number of variants to his
original theory. It is these variants that have been cited by Bernanke when
defending his fiscal and monetary policies. This strongly contrasts with
Taylor’s position as he is now distancing himself from these departures to
his original theory due to their failure to stand up to historical
experience and investigation (see graph this page).
Specifically, the variants of Taylor’s Rule suggest very different responses
to the financial crisis. Whereas Taylor insists that his original theory,
which better stands up to historical evidence, suggests only limited QE in
the initial stages of a financial crisis, Bernanke is citing an unproven or
even discredited variant of the rule, which is based on forecasted rather
than actual inflation and a larger gap between actual and potential economic
growth. Bernanke’s monetarist postulate supports loose monetary policy and
massive levels of QE. - H. J. Huney, 2011
To be continued…
The above data and
research was compiled from sources believed to be reliable.
However, neither MBMG International Ltd nor its officers can
accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of
reading the above article. For more information please contact
Graham Macdonald on [email protected]