Observations by David Robertson, 1/6/23, Outlook edition
Happy New Year! I hope everyone had a nice break over the holidays and got a chance to rest and recharge a little bit.
As I mentioned two weeks ago, this edition of Observations will have a different focus and therefore also have a different format. Last year was a relatively good year for Areté’s All-Terrain allocation strategy and arguably it was good for the right reasons. Since many of the dynamics behind last year’s performance are still in place, I thought it would be useful to review them and incorporate them into an outlook for this year.
In order to do this, I will take a step back and review some of the key features and implications of the current investment environment. This will also involve a broader explanation of how I think about investment challenges and opportunities - which is based on a variety of models and an array of working hypotheses. From there it is much easier to understand the logic of my investment beliefs and preferences. For reference, virtually everything discussed here has been reported in previous editions of Observations; this is more of a compendium than any kind of revelation.
As always, if you ever want to follow up on anything just let me know at firstname.lastname@example.org.
In order to set the stage, I want to first be clear about what I try to accomplish with investing. My investment orientation is to long-term investment. Think saving for retirement over a horizon spanning years and decades rather than days and weeks. While much of what I do can inform shorter-term trading as well, that is not the focus of decision making.
In addition, I work from two major assumptions. One is things change. Because things change, it requires an active effort to maintain an advantageous investment position. “Set it can forget it” can work if you are lucky, but it is not a robust strategy. Sometimes stocks are attractive - and sometimes they are not. Same for bonds. Investment success depends on rigorous, ongoing research and analysis to make those determinations.
My approach serves as a direct rebuke to the conventional practice of employing essentially static allocations based on long-term historical returns. This includes the vast majority of 60/40 funds, balanced funds, and target date funds, among others. My main beef with this practice is it fails to capture the wildly different market environments that occur at different points in history. As a result, it produces wildly different investment results over time. Specifically, a lot of people who are near retirement or recently retired are over-exposed to stocks at a time when stocks are nearly as expensive as they have ever been.
A second major assumption is it is critical to consider multiple perspectives in order to gain a more robust understanding. Investing with a long-term orientation, for example, means it is important to incorporate perspectives from disciplines that span longer periods of time such as history, politics, and geopolitics. It is also important for equity analysts to understand fixed income markets and vice versa. Different perspectives provide important context for understanding and interpreting various phenomena.
In order to assess the landscape, identify opportunities, and manage risk, I employ a three-pronged process:
The first prong incorporates a valuation/allocation model that distinguishes the relative attractiveness of the three most basic investment assets: Stocks, bonds, and cash.
The second prong involves a continuous effort to identify and interpret market narratives.
The third prong evaluates gold and other types of assets that can diversify other holdings and supplement performance.
The valuation/allocation model is an adaptation of the one developed by John Hussman. It forecasts future returns based on current Treasury bill and bond rates, stock valuations, and the assumption that returns revert to more normal levels over time. This provides an objective assessment of the relative attractiveness of the three main asset classes of stocks, bonds, and bills and therefore builds a solid foundation for a broader allocation effort.
The purpose of evaluating narratives is threefold. First, narratives are useful tools to simplify descriptions of complex systems. Second, since many key market drivers are not transparent, it is often useful to develop various working hypotheses as to what those drivers might be. It is simply not possible to know all of the motives or actions of government officials or others in positions of power, but that doesn’t mean they can’t be reasonably inferred. Finally, in a time of ubiquitous and instantaneous communication, those communications often take the form of “strategic game playing” more than honest “translation of reality”. It is important to understand the stories we are told and why they are being told.
On this point, nobody has been more vocal or more insightful about the role of narratives and how they work than Ben Hunt and Rusty Guinn at Epsilon Theory. For an introduction, check out the piece, “The Narrative Machine”.
Today I want to propose a new metaphor for the world as it is – a Narrative Machine – where macroeconomic reality is still understood as a cybernetic system, but where the translation of “reality” (all of those economic fundamentals and if-then statements of the Economic Machine) into actual human behaviors and actual investment outcomes takes place within a larger Machine of strategic communication and game playing.
The key takeaway is increasingly the “information” we receive is delivered with the intent of strategic communication rather than objective information distribution. For those of us in the business of gathering, assimilating, and interpreting information for the purpose of making good investment decisions, this is a critical distinction. Once you understand how narratives work and what they can do, you start seeing them everywhere (see “This is water”).
So, narratives are used different ways in the investment process. They can be used to better understand and articulate fact patterns and they can also used as working hypotheses and tested for explanatory power.
Finally, the process of extending an allocation from three assets to a broader set that includes gold and other uncorrelated or inversely correlated assets is not a purely quantitative one. Although models and analyses are employed, judgment is also involved - and much of that judgment is informed by the analysis of narratives.
In order to determine the best plan of attack for any endeavor, it is crucial to know where one is and how one got there. To that point, the dominant characteristics of today’s investment landscape are debt, demographics, and valuation. As populations have aged and population growth has slowed down, so too has economic growth. This organic weakness has been papered over by the expansion of debt at an ever faster pace. Low rates and easy credit spawned ever higher valuations for stocks. This was never sustainable and now the problems are coming to a head.
The valuation/allocation model provides a good baseline assessment of the investment landscape. Currently, it suggests an allocation among the assets of bills (i.e., cash), bonds, and stocks should consist entirely of bills. The reason is stocks are so expensive their expected returns are slightly negative and bonds don’t yield enough to compensate for the extra risk over bills.
Another important element of today’s investment landscape is related to geopolitics. Since the first priority of any country is its national security, geopolitics resides at the top of the hierarchy of national interests. That means all major policies - whether they be fiscal spending, monetary policy, public policy, whatever, will be designed for and in service to the higher geopolitical goal.
The most prominent geopolitical issue is the tension China’s growing size and influence has caused with the US. While the military superiority of the US and the US dollar’s role as the world’s reserve currency are clearly strengths, they have also facilitated problems such as persistent trade imbalances and free riding. For many years these costs were manageable but as growth potential has slowed in the US, the tradeoffs have become increasingly problematic.
Based on my readings, it appears the US is implementing a much more muscular foreign policy that amounts to redefining its relationship with the rest of the world. One goal of this policy is to push back on export driven economic models such as those of Germany and China. Another goal is to enforce greater participation in defense - both in spending and other commitments. Finally, a critical goal is protecting US interests from various threats from countries such as China and Russia.
Importantly, all of this dovetails beautifully with the domestic goal of reducing the debt burden. The geopolitical wrestling with China and Russia, in particular, provide the necessary pretense and political cover to sustain inflationary policies that otherwise would undergo much greater scrutiny. I don’t believe it is a coincidence that geopolitical tensions are heating up at the same time US debt is reaching dangerous levels.
This characterization stems from the work of various strategists including Russell Napier, Peter Zeihan, James Aitken, Michael Pettis and a host of others. Recent samples of their insights can be found here, here, here, and here, but there are plenty more to be found in previous editions of Observations.
One of the reasons I find this characterization of the landscape so compelling is because it comports so well with events. Why is inflation suddenly an issue? Because the pandemic and the Russia invasion of Ukraine provided the necessary “emergencies” to unleash government spending. Why the suddenly more aggressive stance with Russia and China? Because there need to be “bad guys” to blame.
Finally, one last element of the investment landscape that deserves attention is market structure. Michael Green has been making the case for years now that the proliferation of passive investing has fundamentally changed the market (most recently mentioned, here and here). With large chunks of money flowing into the market based simply on automatic retirement contributions, and not remotely based on investment fundamentals, it shouldn’t be surprising that “market” prices for stocks bear little resemblance to underlying economic value.
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Implications and outlook:
The notion that inflation is coming down is one that is broadly expected but also dangerously myopic. Yes, inflation is coming down and yes, pandemic-induced bottlenecks are getting alleviated.
The bigger issue for long-term investors, however, is not what happens with inflation over the next few months but over the next many years. Over that time horizon, one of the biggest public policy challenges will be managing excessive debt levels in the context of slow growth. By far, the least worst way to do that is to allow inflation to gradually erode the value of that debt. The massive public spending unleashed during the pandemic provides the best clue as to policy objective and trajectory.
Over a medium to long-term horizon, wages are also likely to contribute to inflation. If wages do not keep up with inflation, living standards will erode and that would create a great deal of political backlash. Rising wages will make expensive homes and other goods progressively more affordable, but will also aggravate already inflationary conditions. This will be an important factor to monitor the next few years.
Finally, the debate between inflation and deflation is not a black and white one. I happen to agree with much of the analysis of deflationists. For example, I believe excessive debt impinges upon economic growth. I also believe slowing population growth and aging demographics impede growth potential. Where I differ is in regard to the political reaction function: I don’t believe sustained periods of low or negative growth are politically viable. I also believe politicians have the intent and the means to prevent a deflationary outcome, so they will.
The conventional view of the economy is that rate hikes from the Fed will eventually weigh on the economy and slow it down, perhaps drastically. When that happens, the Fed will need to ease up on policy in order to facilitate economic recovery, but will probably act too late to prevent major harm.
I have a different view. I believe government has taken over as the engine that drives the economy. Massive, unfunded spending prevented a major downturn after pandemic lockdowns and the lesson was taken to heart: The public is OK with large government spending programs and those programs can be used to keep the economy ticking. As a result, while I am cognizant higher rates will cause a drag on growth, I am not too worried about a nasty, persistent recession.
Just like the role of government has changed and become much more interventionist, the role of the Fed has changed too. After the GFC, the Fed took a leading role in guiding markets by keeping rates low and policy loose. Now, however, the Fed is being relegated to more of a support role.
With government spending providing the major economic thrust, the role of the Fed is now mainly one of calibrating the magnitude of that thrust - and preventing any accidents. In doing so, it is also creating a very public effort to “fight inflation”. This provides enough cover for the spending to continue. The main lesson is: Don’t look to monetary policy for insight into broad policy direction any more. Look to government spending.
Several aspects of monetary policy will be important to watch though. For one, the Fed spewed money in response to the pandemic and kept it going for far too long. Now, it needs to clean up the mess through its Quantitative Tightening (QT) campaign. This program is important to maintain institutional credibility and is also important to regain potency of monetary policy tools. There is just too much money.
In order to accomplish this, it will be paramount for the Fed to maintain orderly markets. That means baseline policy will remain slow and gradual. It also means if interventions are required, they will likely be much more surgical and limited than in the past. The Fed is just not in the position to save anyone’s day anymore.
Finally, it is important to understand that a huge transition is occurring regarding the use of leverage. For most of the last twenty to thirty years, credit has been used to refinance and leverage up existing cash flows. Going forward, leverage will be re-directed to the funding of new cash flow streams. This will help industry rebuild and therefore serve important national security interests.
As with other economic and financial phenomena, the future of rates depends critically on one’s worldview. Insofar as the repurposing of leverage is the way forward, rates will have to go higher in order to provide the proper incentives to attract investment in real businesses and to discourage financial speculation.
At some point (maybe a couple years from now?), when new debt issuance overwhelms demand, some combination of coercion and yield curve control will be required to keep long-term interest rates below inflation. This will create spectacularly bad conditions for fixed income investment.
China has a bigger debt problem and a bigger real estate problem than anyone else. At the same time, it is constrained by aging demographics. Add to that list the challenge of a strong US dollar and more expensive commodities and it is hard to get very enthusiastic about China’s prospects the next several years.
Is it possible some relatively better growth will come after Covid races through the country? Yes. Is the country doomed to a deflationary debt spiral? No. Neither of these are sufficient reasons to bet on a huge recovery though. The baseline case for China hinges on the challenge of working down excessive debt and rebalancing its economy away from exports and property development.
The valuation/allocation model currently points to an allocation consisting completely of bills (i.e., cash). This has significant implications for many investors. It means holders of 60/40 portfolios, balanced funds, target date funds, and anything comprised mostly of stock and bond indexes, is likely to underperform cash. It also means the portfolios are likely to underperform their expected return targets. In short, it is a uniquely bad time in history to own stocks and bonds, and yet that is what dominates most portfolios.
There are things that can be done. First, while broad stock indexes are significantly overvalued, there are opportunities to be much more selective. Mostly, however, it is important to find alternative sources of return and to dial up diversification. In the meantime, with Treasury bills yielding over 4% now, it also pays to just wait for better opportunities to arise.
Gold has proven to be an excellent diversifier over time, often serving to limit drawdowns in times just like this when stocks and bonds do not look attractive. Further, gold plays an important role in wealth retention in times of turmoil.
Commodities remain an interesting possibility for long-term investors. They can provide useful diversification, are due for an upcycle, and are supply-constrained due to years of underinvestment.
These positives are offset by a number of negatives, however. For one, higher rates and a strong US dollar are depressing global economic growth which depresses demand. In addition, higher prices have forced consumers to seek substitutes and/or become more efficient with consumption - which also depresses demand. Commodities and commodity stocks also tend to be extremely volatile which makes timing entry and exit an important factor.
While I remain sympathetic to the case for commodities, I also readily admit to the difficulty of incorporating them into long-term allocations. Trend following is one way to gain exposure, but there are only a few ways for retail investors to access this strategy.
If there is one thing to take away about the investment environment it is that it will continue to be more difficult than just about anything realized in the last forty years. This will frustrate hopes for a reversion to “normalcy” and will confound modeling based on the last forty years of results.
Inflation is here and that changes everything. In this sense, the poor results from 2022 were just the beginning of a long retrenchment, not an anomaly to look past. The dynamics that emerged last year will continue to prove challenging for conventional 60/40 portfolios, but also for strategies that involve leverage, illiquid investments, securitization, and structured securities. This will especially affect investments in commercial real estate, private equity, and venture capital, among others.
All that said, there are plenty of good things coming too. Financial engineering will give way to economic value creation. “Vision” will be supplanted by “execution”. In the process, the tools of fundamental research will start working better again and greater weight will be placed on sound contributions in all fields.
The one last caveat, however, is there is still too much money in the financial system. This means there will continue to bouts of speculative behavior and lurches in different directions. This will remain the case until the money supply relative to the economy returns to a more normal relationship.
Good luck and best wishes for a successful 2023!
The positions I have described here reflect my best thinking on the investment landscape as of the beginning of the year. The basic framework proved robust through 2022 so I have some confidence it will remain so for some time. That said, I constantly challenge assumptions, test hypotheses, and update my outlook.
One of the signposts I will be watching for is government spending. Will spending continue apace or will the Republican-led House pull in the reins? I will also be watching the Fed - less so for rates than its reaction if an “accident” happens. In such an event, I would expect a targeted, limited response. If the monetary floodgates are opened as they were during the pandemic, that would cause me to re-evaluate. If inflation quickly drops to the 2% level and stays there, that would also cause me to re-evaluate.
I believe another important signpost will be the US dollar. A strong dollar serves US interests abroad by reducing liquidity for foreign competitors like China and Russia. It also helps domestically by mitigating the inflationary impact of higher commodity prices. As a result, I expect a strong dollar policy to continue for the foreseeable future, allowing for some periods of relative weakness, such as at year-end, to ensure no financial accidents happen. A persistently weak US dollar would be an indication to re-evaluate.
Another point to make is while much of my outlook differs considerably from more conventional views, that doesn’t mean I disagree with everything - or even much of anything - represented by those views. Differences in outlooks often boil down to little more than a difference in assumptions.
Finally, arguably the biggest challenge in investing, as well as in any intellectual endeavor, is to remain objective. As Brent Donnelly points out in his book, Alpha Trader, it is a lot easier to be objective when one is “flat”, i.e., not invested. While this is given as advice for traders, it is both transferable and hugely underappreciated for long-term investors.
The problem is that long-term investors are normally always invested. As a result, they are never “flat”, and therefore never completely objective. It is hugely important to recognize and attempt to overcome the inherent bias of long-term investment. Otherwise, it is nearly impossible to see the risks lurking out there.
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