Invest for Real Returns
Common sense and a bit of moralizing are necessary to construct a prudent investment portfolio for today’s unparalleled economic and market conditions. Invest for positive real returns.
The Big Disconnect
One of the biggest challenges professional investors and investment fiduciaries face today is the disconnection separating their pre-defined incentives, mandates and objectives from the unparalleled set of investment conditions we have today (further discussed below).
Capital markets have never been more efficient in terms of common awareness and real-time price adjustments, but never more inefficient at reflecting sustainable real value. Most investors ultimately sponsoring the capital markets today (e.g., pensioners) are unaware that the markets no longer accurately reflect the economies in which they live and are pricing in negative real returns (returns adjusted for necessary future central bank monetary inflation that will devalue the currencies in which assets are denominated against future prices for goods and service).
And there is no one looking out for them. The grand presumption among regulators is that the markets are priced to reflect the merits and risks of the assets that comprise them, which, in turn, represent the merits and risks of the economies they reflect. Nowhere in the social contract is it understood that stocks, bonds and real estate prices are determined by the ease or difficulty with which they may be contemporaneously financed. And nowhere in the archives of democratic capitalism have decisions exogenous to investors and savers determined asset pricing to the degree they do now.
The cornerstone of investment fiduciary care has always been to “know your customer”. Perhaps it is time to elevate this concept to “know thyself”? Are we fiduciaries in this game merely to provide exposure to markets our constituents think they need or to help them use the capital markets to improve their future buying power?
Like that old Hebrew National hot dog ad, implying that other hot dog manufacturers only meet the standards of the U.S. Food and Drug Administration rather than stricter Kosher laws, maybe it is time investment professionals “answered to a higher authority” than the SEC, FINRA, FCA, ESMA, and other market regulators? Maybe it is time more fiduciaries faced their constituents with appropriate candor: the markets are now managed and manipulated by politicians posing as economists and do not generally reflect the incentives and free market pricing of democratic capital formation, nor generally serve passive long term investors.
Unparalleled Conditions
Maybe never before has the world experienced such a toxic mix of monetary, macroeconomic and market conditions. Consider:
- For the first time in history (since 1971) the exchange rate of no currency in the world is fixed to a scarce item, like gold, which implies that every currency in the world has value only relative to other currencies - not relative to production
- global central banks are explicitly targeting 2% annual inflation, which diminishes a currency’s purchasing power by about 22% over 10 years, 49% over 20 years and 81% over 30 years
- the returns on cash and sovereign bonds are now, for the first time ever (beginning in Japan in 1999, the US in 2008, and Europe in 2012), lower than central bank inflation targets
So, global savers are incapable of saving in real terms and are subject to command economy-like capital markets with implicit 2% exogenously-applied annual pre-tax hurdle rates.
Against this backdrop, monetary authorities continue to apply academically-modeled, increasingly unconventional monetary policies. Their formal objective is to stimulate demand growth through credit creation, a goal they have generally succeeded with since 1982 in the non-competitive flexible exchange rate system. It is unlikely to work looking forward, however, because global household, government and corporate balance sheets have already been leveraged beyond the point at which more debt would form more capital.
And yet monetary authorities, as the purveyors of our currencies, proceed with QE and NIRP, both of which devalue currencies, because it seems they are almost out of options to stay in control. Investors are being forced to try to figure out what central bankers really want – a bigger, unchanged, or smaller money stock. (QE increases the currency supply while NIRP reduces the demand for it.)
Clear evidence shows global monetary authorities are ensuring that the buying power of newly-minted QE deposits will flow to asset markets, which is widening wealth and income gaps among their populations and raising the likelihood of social unrest. They are also ensuring that broad market returns, in real terms, will be generally negative.
Our moralizing will end here with the question: what’s an investor to do? Answer: Invest for real returns.
Asset Positioning
There are a few ways professional investors and fiduciaries can go in today’s peculiar, non-trending environments:
- Focus specifically on a particular asset class or sector to provide investors with exposure to it, not the promise of absolute, relative or real returns
- Allocate to asset classes in a traditional fashion and hope third-order style boxes (growth, momentum, value, arbitrage, etc.) produce positive real returns
- Start the investment process as a saver, treat all investments as speculations, scrutinize assets from the bottom up, and invest eclectically in amounts suited to one’s risk aversion
- Develop a reasonable sense of overall asset class valuations and economic and market conditions, and own asset classes with tail winds while avoiding those with headwinds in an effort generate positive real returns.
- Trade within or amongst assets in the hope of generating a series of winning positions that cumulatively generates positive real returns over time.
All are reasonable investment approaches that can generate positive real, absolute and relative performance in various environments, but we would argue that some are better than others in the current environment.
Our particular reason for being is to identify broad economic and market conditions, to suggest broad asset class allocations that will produce positive and negative performance, and to then further define specific asset classes, sectors, assets and strategies suitable for one, five and twenty year investment horizons.
Our Broad View
We think the best strategy for real performance seeking investors (as opposed to investors matching nominal liabilities) in the current environment takes a higher road than mere market participation (beta investing).
We think asset allocation should be based on an inflation/deflation metric and the objective should be positive real returns in both.
Our view on the future prices of goods and services – in the US and around the world – is that they will generally rise in an inverse fashion to economic growth rates. This is due to the toxic mix of record global leverage across household, government and corporate balance sheets and the necessary slowdown in output growth it naturally fosters. In a declining output growth environment, disinflation or deflation will be driven by debt deflation and inflation or hyperinflation will be driven by the administration of monetary policy (money printing and credit extension) that offsets it. Precedence has already been well established.
Asset prices in this environment should be considered through a different lens than suggested by modern portfolio theory. Some of our polestars include:
- Assets that rely on ever-increasing nominal global output growth should be de-emphasized.
- Strategies that presume the continuation of market trends, higher or lower, should be greatly scrutinized.
- Asset volatility should be implicitly owned rather than implicitly shorted.
- Dividend and interest income, as an investment strategy, should be abandoned.
- The past benefits of certain asset classes during the secular economic leveraging phase (i.e., stocks for growth and bonds for income), should be dismissed during this, the economic de-leveraging phase.
Assets should be positioned across markets for capital gains that exceed goods and service inflation, which we think will grow exponentially in the coming years as economies de-leverage.
Paul Brodsky
Founder / Strategist
Macro Allocation Inc.