The Duration Paradox (Part Two of Two)
If Treasury bond yields do not currently provide investors with fair, market-determined compensation for the growing risks of inflation and dollar devaluation, what are investors to do? There are several potential options.
First, investors can hold cash instead of bonds. But if price inflation begins to pick up–at present it shows every sign of doing do–sitting in cash for a long period of time begins to look rather unattractive. Moreover, cash does not protect investors from the risk of a weaker dollar which, with an uncertain magnitude and time lag, is going to push up inflation and erode purchasing power.
Second, investors can hold foreign instead of domestic bonds. The Japanese and euro-area bond markets are comparable in size to that for US Treasuries. But interest rates are also so low in both Japan and the euro area that the Duration Paradox is also in effect, holding down long-term yields. So while there might be some diversification benefits to be had in this way, investing in these bonds does not get to the root of the problem.
Third, rather than hold bonds, investors can hold equities. Indeed, it would appear that, in late summer 2010, as the Fed indicated that it would be implementing QE2, global equity markets received a boost. But is this likely to continue? We have written recently about the equity market and have concluded that it appears substantially overvalued in any reasonable historical comparison. Moreover, there is growing evidence of a severe margin squeeze or ‘crush’ now underway which is highly likely to hurt corporate profitability in the coming quarters. The combination of high valuations and disappointing profit growth could be particularly nasty for equity markets in the coming months.
There are also other potential negatives for equity markets at present. China, India, Russia, South Korea, Indonesia and other relatively dynamic economies are all raising interest rates to slow growth and get inflation under control. Last week, even the European Central Bank (ECB) indicated that it, too, is about to begin raising rates. Another potential negative, although difficult to quantify is the increasingly hostile tax and regulatory environment in the US and to a lesser extent elsewhere. So-called ‘regime uncertainty’ tends to weigh on equity valuations. We don’t deny that, according to history, equities tend to outperform bonds in an inflationary environment. But from the current starting point, the potential relative outperformance might not be that substantial. Indeed, the performance of both bonds and stocks could well be negative for a period as financial markets adjust to what is a historically unusually hostile environment for financial assets generally. (Incidentally, one of the most famous bond fund managers in the world, Bill Gross, appears to hold this view.)
If financial assets in general currently fail to provide investors with attractive ways in which to protect their capital, what are the alternatives? Historically, real assets, including property, have held their value in inflationary periods better than financial assets. One rather obvious problem with property today, however, is that a bubble in property valuations in the US and elsewhere was a key ingredient in the financial crisis of 2008 and there remains a legacy of oversupply of various forms of property on the market. (While the US residential property bubble may now have been somewhat deflated, there is less evidence that this is the case with commercial property, in particular retail space and office space in major financial centers.)
Historically, precious metals have offered investors an alternative store of value. Indeed they have served as money itself. While metals (and other commodities) do not provide investors with an income, in that they are not productive assets producing either rent (as with property) or other economic goods (as with capital goods), that is precisely the point: When financial assets in general are overvalued in historical, purchasing-power adjusted terms, and even property is still de-bubbling, the best way to protect wealth is to eschew cash flows entirely. Looked at from another angle, if economic activity is being artificially stimulated in various ways by soaring government deficit spending and highly expansionary central bank monetary policy, do investors really want to chase cash flows when those cash flows are demonstrably distorted and necessarily unsustainable?
But the alternatives do not end there. Global commodities markets can provide investors with far greater liquid, real asset diversification alternatives. Gold, silver and mining shares are normally highly correlated with each other, limiting diversification potential. Yet in a highly uncertain world, diversification is of paramount concern. Investors should be after all they can get. As such, the world’s most widely traded commodity, crude oil, with only about a 65% correlation to the price of gold, is an obvious place to look. Oil distillates, such as unleaded petrol and heating oil, have an even lower correlation to the gold price. Industrial or base metals also trade widely. That said, they tend to be more highly correlated to global equity markets and, as such, are likely to decline in price in the event of a major equity market correction.
Historically, the greatest diversification benefits are provided by agricultural and so-called ‘soft’ commodities. The prices for these are driven by random factors such as the weather. These commodities have correlations with gold and silver of only around 30% or so. That said, some of them are quite expensive from an investment standpoint, due to their perishable nature and commensurately high storage costs. As an alternative, investors could consider a diversified basket of agricultural equities, which would pay a modest dividend.
As the unsustainable sovereign debt burdens grow alongside massive worldwide money supply growth, preserving wealth is not going to get any easier. The pure uncertainty associated with debt and monetary crises continues to grow as policymakers stumble from one unsustainable policy to the next. History demonstrates that this is not going to end well. But end it will. When it does, those who have managed to preserve at least some portion of their wealth will be in an excellent position to exploit what are likely to be the best investment opportunities for at least a generation and possibly several.
Faced with growing adversity at home, peoples have occasionally sought to migrate to more promising lands, notwithstanding the tremendous uncertainty of doing so. Why? Because high uncertainty elsewhere is better than certain suffering at home, however familiar. Before doing so, they gather together into an ark or wagon their most precious possessions and, of course, necessary supplies for the risky journey ahead. Some possessions are going to be lost along the way and most supplies consumed, hopefully not to run out entirely.
The so-called ‘49ers’ of American lore needed to ford dangerously fast, near-freezing rivers and traverse high mountain passes to make it to California. Many lost everything along the way, including friends and family members. But those who made it in one piece found a vast, lush, mineral-rich land and many great fortunes were made by those who had nothing left on arrival but the shirt on their back. There is a lesson there.
It is hard sometimes to be optimistic, but we do try.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]