“It has been said critically that there is a tendency in many armies to spend the peace time studying how to fight the last war.”
– Lt. Col. J.L. Schley
In last month’s article, we cautioned about the dangers of mixing your politics with your investment strategy. This month we discuss how to avoid worrying about yesterday’s problems, including the last financial crisis.
Preparing For Old Challenges
In the history of military strategy, the most common error is to “fight the last war,” preparing uselessly for old challenges rather than planning effectively for the future. This tendency is so common that it has become a popular cliché used to describe military leadership in the United States since before World War Two.
Of course, this institutional shortcoming is understandable and is hardly confined to the military. Human nature, and our natural tendency towards “recency bias,” dictates that people often only react to what they know, and what they know is what has happened to them in the past. As a result, we make plans to protect ourselves from the last challenge we faced.
And so it is with investments. Typically, most people do exactly this: Buy high, sell low, and then repeat, which is why most investors don’t get wealthy. Today, many investors may be distorting logic in a similar way by “preparing” for a repeat of the crisis of 2008.
The Last War
The “last war” investors had to fight was the market and financial crisis of 2008-2009. That was the last time American investors experienced any kind of market or economic distress and was clearly the last time fear was as widespread as today.
That painful experience in our economic history had a specific economic and monetary cause: It was fundamentally a deflationary period. Without becoming too technical, deflation is a monetary phenomenon in which the supply of money declines, resulting in an appreciation in the value of the dollar. Because the dollar is appreciating, anything denominated in dollars, from stocks and real estate to diamond rings and European vacations, will depreciate in value and become cheaper. Indeed, all of these things did become cheaper back in ‘08, which exacerbated the decline in economic activity and caused a severe recession and asset price collapse.
During any deflationary period of time, dollar-denominated cash is a great place to store your wealth. Treasury bonds are even better, and long-term Treasury bonds are the very best. Indeed, between the summer of 2008 and March of 2009, the very best investment in the world was the 30-year U.S. Treasury bond. Many of today’s investors remember this quite well.
Today, as stress levels caused by daily COVID-19 case counts and death tolls rise, so does the ownership of cash and Treasury bonds among the investing public. So much so that today, there is a record $5 trillion in cash assets held by investors. Treasury bond ownership is so widespread that yields fell recently to an all-time record low of 1.2 percent for a 30-year Treasury bond.
The Next War?
There are very few people alive who remember what it was like to be an investor during an inflationary period. The last time any meaningful level of inflation occurred in the United States was about 40 years ago. Since 1983, inflation has only been above four percent for a measly 15 percent of the time, and has been above five percent for only four percent of the time.
During this century, inflation has been particularly non-existent: Since 2000, it’s been running at five percent or higher less than one percent of the time. Many of today’s investors can only recall rates of inflation that are exceptionally tame by historical standards. They have come to expect that inflation is not a meaningful factor in the direction of the economy or markets.
This may be due to recency bias, a very strong behavioral trait that can make us believe that just because something hasn’t happened to us before, it hasn’t ever happened before. But inflation can happen, and it has happened throughout history. Since 1914, inflation has been higher than five percent more than 22 percent of the time, and it was over four percent nearly 30 percent of the time. Investors who remember investing in the 1980s and 1990s were inundated with stories from those who lived through the 1970s about what it was like to have debilitating inflation, as it averaged more than seven percent for the entire decade.
So, is inflation really the “next war” that investors should be preparing for? While it is difficult to make predictions about future monetary conditions, there are several factors that could increase inflation:
- Due to trillions of dollars of new rescue programs paid out to individuals and businesses during the pandemic, broad measures of the money supply have already begun to rise rapidly, as have levels of public debt.
- The Federal Reserve has stated that it intends to keep interest rates very low, and monetary conditions very easy, until at least 2023.
- Consumers have lots of money in their pockets thanks to various stimulus measures and low-interest rates, but the supply side has not kept up because many businesses are closed or running at partial capacity. For the first time in a long time, consumption is greater than production in the United States, and consumer demand is outpacing the economy’s ability to supply that demand.
Legendary Wharton Finance Professor Jeremy Siegel was recently interviewed on this topic and had this to say:
“With this liquidity in the economy, as we say, I expect moderate inflation, not — I’m not talking about hyperinflation. I expect inflation to move up in the next year to 2, 3, 4 percent, 5 percent, and maybe run again in 2022 the same way.
So, cumulatively, I expect inflation may be to go up — the price level, consumer price level go up 10, 12 percent over the next few years, maybe 15. Now, don’t forget, we had almost 15 percent inflation in one year back in the terrible years, of the late ’70s.
So, again, this is what I call moderate inflation. I expect bond yields to rise from the current half percent to one, one and a half, two, two and a half, three.
If we have 15 percent inflation, you wipe out $3 trillion in debt.”
Siegel lays out an interesting scenario here for the next few years. So much money has been sent out to households (with potentially more to come) we could actually see a spending boom when the virus subsides. That spending boom could lead to a big jump in the inflation rate which would effectively wipe out a substantial portion of the debt we’ve taken on this year.
How To Prepare?
At Concentus, we are not in the business of making predictions, so we don’t pretend to know whether the conditions outlined above will cause inflation to materialize after a long absence. Even if inflation does appear, we also don’t pretend to know exactly how investors might react.
If Jeremy Siegel is right, and the economy experiences a moderate rise in inflation, it could be a kind of “best case scenario” for the U.S. economy. It could signal a boom in the post-COVID economy, which could help to clear away some of the massive debt we have incurred. Inflation helps to wipe away the obligations of a debtor by devaluing the currency required to repay the debt.
Historically, moderate inflation has been fairly friendly to U.S. equities and quite favorable for international equities. Could markets finally experience a return of international equity performance after a decade of miserable underperformance? Of course, this scenario becomes less rosy if inflation rises too rapidly or runs out of control. Double digit inflation rates are generally bad for economies and stock markets but beneficial for hard assets like gold, real estate, and commodities.
Guaranteed to “Lose Money”
While it is difficult to predict how equity markets will react to a possible rise in inflation, it is fairly easy to understand the consequences of being a “conservative” investor in an inflationary environment.
Recall that “money” can only be defined as “purchasing power.” The number of little green pieces of paper one owns is not important, what is important is the amount of goods and services those dollars can purchase at any point in time. Inflation erodes that purchasing power every day, as it increases the price of the goods and services you may wish to purchase with your dollars.
In a world of four or five percent inflation, the purchasing power of the dollar is bound to decline by four or five percent. In order to maintain the purchasing power of your stored wealth, you need an investment that will grow that wealth at a rate of four or five percent just to keep up.
Currently, most cash money market funds yield well under one percent. 10-year U.S. Treasury bonds yield around 0.7 percent. 30-year Treasury Bonds yield around 1.4 percent. In a world where the purchasing power of your savings is declining by four percent per year, these investments are almost guaranteed to decrease your purchasing power.
There are many perceived risks in the economy and financial markets today. No one should be blamed for wanting to just “go to cash” and sit things out for a while in hopes of “conserving their money.” While that playbook may have worked in 2008, in a world of inflationary risks, storing your wealth in money market funds and Treasury bonds may just amount to an effort to fight the last war.