May 12, 2020
With the passing of Kenney Rogers it is wise to remember the chorus from his best known song, the Gambler.
You got to know when to hold ’em,
Know when to fold ’em,
Know when to walk away,
And know when to run.
You never count your money
When you’re sittin’ at the table.
There’ll be time enough for countin’
When the dealing’s done.
Now in markets that span thousands of companies, hundreds of countries and billions of people, it is pure speculation to think you can know the direction of markets from day to day, and given the roaring back of markets, it is even hard to guess at the long term direction.
Most professional prognosticators suggest that the S&P 500 will end the year somewhere around 2,900. Today it starts the day at around 2,935. So if you are investing with a one year time horizon there is a good probability you make somewhere near zero dollars in capital gains (I am ignoring dividends here).
You take the risk that there is more bad news on the economy and prices decline, and you also get the benefit of any good news if the economy roars back to life. Of course the other key issue is what is referred to as ‘TINA’. If you don’t know who (what) TINA is, its the short hand for ‘There Is No Alternative’ which implies that putting your money in bonds (most are paying close to zero percent), government debt (also close to zero percent) or any other asset, provides lower returns than stocks. Of course that is all speculation as well. We can’t know the future.
But the real gamble here is on the inflation/deflation argument. In a recent conversation with a family member, they asked if investing in real estate currently was a good idea. I wish I knew the answer. Twenty years ago I decided that the answer to that question was ‘no’. Turns out I was wrong. With interest rates being forced ever lower, increases in immigration, population and tax benefits, real estate was EXACTLY where I should have been. The question is just as valid for any asset class. Betting on a large purchase or investment going up in value requires an act of faith in inflation.
The big gamble now, whether it is real estate, stocks, bonds or anything else is what will happen with prices now that all of the world’s central banks have flooded markets with money, increased sovereign debt burdens and COVID-19 has crashed the economy. There are a LOT of variables in that conversation, and whether you accept it or not, you are gambling on an outcome no matter what you do.
There are really three possibilities here: (1) Inflation stays muted, say within the 0-2% band that most central banks are targeting; (2) Deflation takes hold as the economic toll from COVID-19 mounts; (3) Inflation comes roaring back as those excess dollars fill the economy with purchasing power. There is also the question of what time period you are considering when inflation or deflation appear.
In many of these blog posts the overriding advice is to stand aside while the world goes mad. That advice is based on the probability that most of us don’t know the answer to this fundamental question, and getting it wrong will be costly. Here is that logic detailed a little more clearly.
- To survive we require food, shelter and enough money to pay for necessities such as electricity, heating fuel, a car and perhaps your favourite cable supplier or streaming service. These prices will fluctuate with the economy, so any pricing risk is essentially irrelevant. The amount of debt and other assets you have is particularly important to the decision you make. Remember relative values of debt and assets will change with inflation or deflation.
- Excess capital can be saved to ward off risk from inflation (prices for necessities rise and income doesn’t keep up) or deflation (asset prices fall, requiring more capital buffer).
- Excess capital can then be utilized to maximize return based on your view of price increases or decreases.
- For most consumers there are three key risks.
(a) real estate – This is a highly leveraged investment which is backed by significant debt and pulls on our cash flow. If housing prices decline and you need to sell, you could owe more than your real estate is worth. Note that real estate was at all time highs before the COVID crash. If you don’t own a home and there is significant inflation, housing will continue to rise in price while cash loses its purchasing power.
(b) Income – Without income, the normal costs of living are not covered and there is exposure to changes in pricing.
(c) Cash – Holding cash is an excellent plan to cover short to medium term risks, particularly when asset prices (stocks, real estate, etc.) are volatile. Over the short term (less than a year for example) the value of money typically is not significant. Holding cash over the long term however has historically not been a good idea as inflation destroys the value of money. If deflation occurs, cash is a wonderful thing.
Currently economists are all over the board with forecasts for inflation and deflation. A key element that is buried in most of that analysis is the time frame. It is an important consideration when choosing how to deploy your financial assets.
In the month of March US consumer prices fell 0.4% and this morning the US labor department announced a decline of 0.8%. The COVID crash is having an impact on prices to be sure, but it is not clear if they will persist. That’s the gamble.
Many individuals, businesses and consumers are considering long term decisions based on what should be a relatively short term event, COVID-19. The actual economic impacts may persist for as little as two quarters, but some effects may extend for many years. The effects on asset prices will be difficult to understand until the economy opens back up.
Inflation is expected to come roaring back by some. The US particularly has thrown substantial money into circulation. M2, a measure of the supply of money in the economy has risen from $7.5 trillion to $17.5 trillion over the past 12 years. That is a staggering number and staggering growth. To this point it hasn’t caused inflation to surface, but typically adding money to circulation increases consumption and therefore prices. Perhaps the latest increase (from about $15.3 trillion at the beginning of the year to 17.5 trillion now) will help inflation along.
If inflation does come, debts will be reduced in value (so you should borrow a lot of money now, perhaps at fixed rates) and hard assets will increase in value (so splurge on that dream home or perhaps a few rental properties; go ahead, get the island you have always wanted!).
Still another possibility is that the economy will be thrown into a deflationary spiral as debt levels force individuals and corporations are forced to direct more money to interest and capital payments. Governments who have dramatically increased their debt burden in the past decade are intent on further increases to fight the COVID crash. The US in particular will increase their debt by a further 20% (about $4 trillion) in this year alone, to backstop the economy from the effects of COVID-19. While interest rates are currently low, the need for revenues is also becoming painfully clear to politicians. When (an optimist might say ‘if’) governments raise taxes, that too will reduce economic activity and thereby reduce the prices of many assets. This is even more obvious in the ‘cash flow’ economy where debts are closely aligned by the ability to cover monthly costs.
In this case of a deflationary spiral, asset prices fall with debt levels remaining the same. Frequently these periods are exacerbated by cascading asset sales forcing prices ever lower while purchasers stand aside waiting for the price declines to stop. The associated debt burdens often weigh heavily on borrowers and can significantly impact future consumption. For many who have never experienced deflation, the effects of negative leverage may not be obvious until after the burden is exceptional and asset sales are forced upon them. If you are gambling on this result, then selling assets that don’t produce income as soon as possible and hoarding cash are wise choices.
It is worth noting that there have been no significant deflationary events in the last 60 years, but that is no reason to think it can’t happen now. Repeating the fact that almost all assets are at all time high valuations by many metrics suggests that a return to the average could result in significant declines in asset prices. Along those lines, debt levels by individuals, corporations and governments are also at or near all time highs, leaving most participants with limited flexibility.
The last outcome is that inflation remains tightly under control. In this situation the slow appreciation of asset prices and the whittling away of associated debts increases financial stability. Of course there is always volatility in prices of equities or homes or even bonds, but they remain in line with prior assumptions and planning.
The decision to gamble on one outcome or another can pay off handsomely. Getting it wrong can leave individuals, companies and governments in a very difficult financial situation. If you are not committed to a particular outcome, reducing risks, with a balance of cash and assets would be a wise choice.