Discounting the Future: The Year 2021 and Beyond. Part 2.

Describing the events of the past is undoubtedly easier than trying to describe what we can expect from the future. The future will undoubtedly be different from the past. But it is based on our past experience, which allows us to make certain assumptions about what it might look like. So, where are we going?

Where are we going…

Economy. We have already mentioned that the economy is evolving cyclically. And at the same time it is under the influence of several cycles simultaneously. What are the reasons that prevent the economy from evolving in a fully "planned" and predictable way? The short answer is because supply cannot react quickly enough to meet changes in demand. One can mention medium- and long-term demographic, technological and other cycles here. But most clearly this can be demonstrated by using the example of shorter business cycles. The period preceding the global financial crisis of 2008-2009, when prices for many assets grew at a huge pace within short periods of time, clearly demonstrated not only the importance of objective economic and financial factors in shaping demand, but also the role of psychology. The essence of these psychological factors is very well reflected in the expression of the ancient Roman author Publilius Syrus: "Everything is worth what its purchaser will pay for it." In other words, the psychological branch in finance ("behavioral finance?) argues that, firstly, a human is not a robot and is rather a "semi-rational" being who does not make decisions based only on rational, fundamental factors; secondly, a human is a biologically social being who makes decisions based also on biological and social factors, for example, by reacting to the level of hormones in the body or to trends ("traditions", "fashion") that dominate in his or her social environment; third, for a human psychology is more important than fundamentals, so a successful investor devotes time to analyzing the behavior of other investors rather than studying the fundamental value of companies. What does this mean in the context of 2021? First, it means that the economy, sooner or later, will recover, despite the gloomy state of affairs today. Second, demand in the post-pandemic world is likely to differ from demand today. This, in turn, will affect the supply of certain goods and services. It can be assumed that the pandemic will stimulate the demand for "contactless" communication, work, entertainment and recreation. It can also be assumed that it will affect the demand for sanitary and medical services. It is quite possible that it will, for some time, limit the speed of "physical" globalization, meaning less activity in the movement of people and goods. For sure, it will make people think, in general, not only about the pros, but also about the cons of intensive use of natural resources. But we can also assume that, despite the lessons of the current crisis, in 7-11 years, at most, the world economy will face another crisis. Unless, of course, economic management is entrusted to "artificial intelligence", which will govern human society and control its desires and mood with an iron hand. But, for now, it remains only a plot for a futuristic horror movie.

Pandemic. The course of epidemics and pandemics of the last hundred years indicates that with the correct implementation of quarantine measures, one can expect that their acute phase usually lasts about two years. Vaccines that can prevent infection, or drugs that can successfully treat people who are already infected, can shorten this phase. The degree of mutation and contagion of the virus can prolong this phase. In any case, people will begin to adapt to the new situation. Moreover, it can be assumed that the new coronavirus will continue to circulate in the human population by mutating and adapting to the human body, just as the flu virus does. It still infects people, causing, however, much fewer deaths. Thus, the pandemic is definitely not the "end of the world", but it can exacerbate the dynamics of political, economic and financial processes that are already taking place. The relationship between China and the United States, the growing debt burden of most countries, remote work and entertainment, the pace of globalization and the relationship with nature, the income gap between rich and poor, alternative types of investment: all these phenomena existed before the pandemic. The pandemic has only accelerated and exacerbated these processes.

Financial markets. The question of how long equity markets can grow in an era of zero and even negative interest rates, despite pandemics and crises, arises in the minds of many investors. This question can be viewed from two perspectives: from the point of view of available alternatives and from the point of view of Japan’s experience. From the point of view of available alternatives, the demand for shares of American companies persists, among other things, due to the lack of other realistic investment options. The expected return from investing in shares[1] of the leading American companies included in the Standard & Poor's 500 index reached its lowest level in 20 years in the fall of this year at about 3.7%.[2] At the same time, over the past 30 years, the average value of this indicator has reached almost 6%, and the maximum value is 8.75%. But, at the same time, the prices of alternative assets grew even faster. So the average yield on high-yield bonds, that is, speculative debt securities issued by US companies, in December reached the lowest level in history at about 4.35%. Under these conditions, investors make decisions according to the TINA and TRINA theories ("There Is No Alternative" and "There Really Is No Alternative"). That is, while the return on equity investments is quite low, other asset classes offer even lower relative returns, adjusted for different levels of risk of securities issued by leading and speculative companies. It can be recalled that over the past 30 years, the average yield on high-yield (speculative) bonds of US companies was about 9.50%, while the maximum values reached almost 20%. Now take a look at the experience of Japan over the past 25 years. What conclusions can be drawn: first, the era of extremely low interest rates can last for a very long time, perhaps even decades, gradually changing the psychology of investors; second, Japanese banks now offer customers deposits denominated in the currencies of developing countries (in South African rand, Turkish lira, Mexican peso), which offer higher interest rates; third, investors are forced to be more actively involved in the investment process and more actively manage risk due to the fact that the era of?"safe" investments is over; fourth, very low interest rates do not guarantee a rise in real estate prices due to the poor demographic situation. Price growth is observed only in certain segments, which requires a more careful approach to long-term investments in this sector too; fifth, the stock market is almost the only investment opportunity. But this is more likely to apply to the younger generation and requires resources for their education. There is no doubt that people will look for alternative investment options trying to diversify away from stocks, but this may require time and resources.

Central banks, governments, and financial markets. The policy of zero or even negative interest rates implemented by many central banks helped "put out the fire" during the global financial crisis. In fact, the governments of most countries have taken over the debt obligations of the private sector, thereby removing the unbearable burden of servicing the debt accumulated in the "boom" years from the shoulders of companies and individuals. But how effective is this policy from a long-term perspective? One can agree with the former head of the Bank of England Mervyn King, who believes that the policy of negative interest rates will be effective only if negative interest rates are imposed on the cash balances of depositors.[3] Otherwise, the monetary policy mechanism fails. King points out that, despite the implementation of quantitative monetary policy over the past 10 years, economic growth has been very slow: in the eurozone, it was 1.3% annually in 2010-2019, compared with 2.4% in 1998-2007. Overall, the world's average annual growth rate fell to 3.7% in 2010-2019, compared with 4.2% in 1998-2007.[4] For how long can this monetary policy be implemented? Again, we can recall the experience of Japan: potentially, for a very long time. In the case of Japan, this has been going on for 25 years. But there are nuances that make us doubt that in other countries it can be similarly carried out for a long time: first, Japan, as a whole, is a fairly monoethnic, monocultural, monoconfessional country with one of the lowest levels of income inequality among different segments of society. Secondly, the Japanese culture is stoic in nature. Both of these factors contribute to the stability of society. Third, Japan could "export" its problems, since the rest of the world was in a completely different economic state. Therefore, the era of zero and negative interest rates on a global scale is likely to require a more immediate solution. To do this, it is necessary to decide what to do with the huge debt burden of many countries. First, there are many examples in history of solving economic and debt problems through military conflicts. After all, the economic problems of the Great Depression period after the "roaring" 1920s were finally resolved only during World War II. In our time, with large arsenals of nuclear weapons, such a solution to the problem, fortunately, seems unlikely. Second, many governments, having accumulated large debts, especially denominated in foreign currencies, often resorted to default or bankruptcy. But there are undoubtedly huge downsides to this decision: restoring the trust of creditors sometimes takes many years and even decades. In addition, in an environment where large holders of government bonds are pension funds, default can lead to major problems in the pension system with all the resulting political problems. Third, countries can solve the problem of debt denominated in their own currency by "monetizing" it or, to use a popular expression, by "printing" money. But for this, there must be several factors available, which we will discuss below. Otherwise, as the experience of Japan shows, this way is also not always effective. Not to mention the fact that by resorting to this method, we launch a mechanism for redistributing financial resources between borrowers and lenders, in which lenders, again pension funds and ordinary depositors, are the certain losers. The experience of Germany during the Weimar Republic in the 1920s, when during the monetary reform 1 trillion old marks were exchanged for 1 new reichsmark and people were often paid wages twice a day, is a clear proof of this. Fourth, a faster rate of productivity growth and technological innovation can accelerate the pace of economic growth. This can facilitate the servicing of debt obligations and their gradual repayment and, in principle, is an ideal solution. But, first, implementing structural reforms aimed at improving efficiency requires political will. And, secondly, increasing investment in technology will undoubtedly have an effect, but it is impossible to know when and to what extent this effect will be felt.

Inflation. Is inflation possible? This requires the presence of several conditions. First, if the epidemiological situation normalizes, there may be an increase in prices in the service sectors due to the fact that not all companies in this area will survive the pandemic. This may have a negative impact on available supply. Second, in a post-pandemic world, people can change their habits and preferences, which can increase demand for new goods and services that are currently limited in supply. Third, central banks can change their inflation policy priorities, allowing inflation to exceed a certain level, such as 2%, for a longer period of time to "compensate" for deflation in previous periods. Finally, inflation may appear in the event of disruption of the "supply chains" in the event of a revision of relations with China and the transfer of some production away from China to countries with higher costs. In the end, central banks, having used up the resources of the "first" (buying assets in financial markets), "second" (easing credit conditions for commercial banks) and "third" (lowering interest rates even deeper into the negative territory) line of defense, can resort to using the last resource: direct lending to companies and individuals ("helicopter money"). But this requires a catastrophic drop in demand with serious consequences for social and political stability.????

What to do?

What should a person who is not experienced in the field of financial markets do? How to navigate them? It is best to adhere to certain principles regarding the formation of an investment portfolio and increasing your human potential in a broader sense.

Investment portfolio. When building your investment portfolio[5], you can adhere to the simple principle of "60/30/10". This means that 60% of investments should form the "core" of the portfolio and consist of assets whose value is related to the current structure of the economy. For example, in the context of financial markets, these may be securities issued by companies that form the backbone of today's economy. 30% of investments can be directed to investments related to "promising" industries and areas that can become the "backbone" of the economy in the future. A classic example is mobile communications and the Internet, which in the 1990s were "promising" areas, and now have become essential services. There is no doubt that the process of identifying "promising" areas is not easy and requires self-study or consultation with investment professionals, but it is extremely important in order to ensure your future financial well-being. 10% can be invested in classic defensive assets (precious metals), speculative assets ("cheap" shares of problematic companies) and assets to feed one’s soul (shares of companies whose products one is very passionate about). Finally, observing the principle of diversification – "do not put all your eggs in one basket", "do not transport all your goods on one ship", etc. – was, is and will be the basis of a successful investment process.

Capital is not just about finance. The principle of diversification should be extended to other areas of the investor's activity. Capital is usually understood as financial resources. But the physical and psychological health of a person is no less important component that determines his well-being. This component can be called "biological" capital. In turn, the presence of qualities that allow you to function normally in a social environment - education, experience, sociability and communication skills - allow a person to build his "social" capital. All these three types of capital interact with each other. The greater the "biological" and "social " capital of a person, the greater the risk he can afford in relation to financial investments. And, conversely, the single-minded pursuit of an increase in financial capital at the expense of one’s health and social skills is also not a promising direction. It is no coincidence that economists actively discuss the one-sidedness of gross domestic product as an indicator of well-being since it reflects only the total amount of goods and services produced, while suggesting the introduction of alternative indicators of quality of life. After all, according to psychologist, economist, and Nobel Prize winner Daniel Kahneman, "It's nonsense to say money doesn’t buy happiness, but people exaggerate the extent to which more money can buy more happiness"

References.

[1] Expected?return is the ratio of a company's anticipated profit to its market capitalization (the market value of all its shares).

[2] Bloomberg

[3] Negative Rates Won’t Work, Warns Mervyn King”, “The Daily Telegraph”, 19 October 2020.

[4] International Monetary Fund, “World Economic Outlook”.

[5] We exclude from this concept the maintenance of a certain level of liquid funds ("liquidity cushion").