3 January, 2020

If something cannot go on forever, it will stop.

We are living in an age of bad money. I originally thought that the rot set in in 1971 when Richard Nixon explicitly decoupled the US-$ from its legal gold anchor, in recognition that the USA’s deficits and debt, partially necessitated (if that is the correct word for a senseless and unnecessary foreign military adventure) by the exploding cost of financing the Vietnam War, were becoming a significant security threat to the nation. My recent readings around the Great Depression and the policy responses to it both by the Hoover and FDR administrations in the US and the beginning of the Keynes worship cult by the successive governments around the world, indicate quite clearly that the seeds of our monetary debasement were planted almost 100 years ago and showed their first blooms in the 30s and the aftermath of WW II. Rather than being ancient history with little significance for our modern age, the decisions taken and institutional structures erected then – both physically and in law – have a direct relevant bearing on the state of our money and continue to inform policy and the financial dogma today. We are merely experiencing the logical conclusion of almost 100 years of unsound monetary practice and debt accumulation as the age of fiat money draws to its ineluctable end.

Doom mongering is, however, a dismal occupation and particularly unhelpful if it is not accompanied by clear advice or guidance as to what to do next. As I have written elsewhere, modern prophets of the apocalypse – of whom there have been quite a few, specifically in the 1970s and 1980s, have a) seldom been right and b) made to look extremely foolish by subsequent events as they have played out over the last three decades.

“Don’t fight the Fed” was one the first maxims I learnt as I a rookie financial advisor in the mid-80s and given the growing power of Central Banks around the world and their seemingly limitless ability to expand their balance sheets to procure their politically mandated goal of permanent prosperity, heeding that advice has been prudent (and highly destructive to anyone foolish enough to challenge it). If asset prices and the ensuing wealth effect can be permanently rigged through the creation of fiat money without that monetary expansion spilling into the real economy and causing unrestrainable inflation (as we have today) then what’s to complain about? Nonetheless, it is becoming increasingly apparent – at least to a certain congregation within the financial community, whose views and orthodoxy is primarily informed by the Austrian economics school of thought – that this state of apparently riskless and endless debt financing and asset support operations to prop up increasingly distressed banks and profligate governments is, at best, unsound and at worst courting catastrophe. They surmise that the end of this system – if it can be deemed to be called a system at all – is due soon and that the collapse of the currency and the debt supporting it, along with all the assets and financial institutions propped up by those inflated asset prices, will be creatively destroyed, in the best Schumpeterish meaning of the phrase.

What remains devilishly difficult, if not impossible, to forecast is the timing of that collapse or repricing, particularly so given that we are in uncharted territory and have next to no historical data with which accurately to define upper limits of central bank balance sheet expansion. The Fed and the ECB, being the two largest and most economically critical institutions are currently retesting their previous upper limits, having come within sniffing distance of the $5 trillion mark in recent years. We simply do not know the level at which either confidence is withdrawn from the central banks’ ability to continue operations or monetary creation spills over into the productive economy, setting in motion a hyperinflationary spiral. Can governments and their agents continue to keep the plates spinning for another year? Two? Five? A decade? without having them crashing down around their and our collective ears? We simply do not know.

I belong unreservedly to the congregation of observers and market participants who believe that this will end badly, but I have no confidence in my ability to predict when that might happen. As I learnt very early on in my career, from the then head of investment policy at Morgan Stanley, the much-admired Barton Biggs “Being right too early is indistinguishable from being wrong”. I remember pontificating about the unsustainability of the Euro about 10 years ago, firmly believing that its inconsistencies and destructive deflationary effects would lead to its abandonment sooner rather than later. I had not considered the sheer bloodyminded determination of the EU’s politburo to trash every vestige of prudent money management by throwing its full political weight behind the “whatever it takes” policy. Don’t fight the Fed in another guise. So I have given up guessing or pretending to know when this will all end, instead asking myself the question of what to do until then and what to do afterwards.

Howard Marks the erudite Chairman and Founder of Oaktree Capital and author of a regular, highly readable memo wrote in January 2018 that his firm’s investment policy was to “move forward, but with caution.” This is excellent advice for any time, but today, at the start of 2020, it is even more prescient. Returns to financial assets have been way above average over the past few years, attributable almost exclusively to ultra-low interest rates and the financialisation (see Ben Hunt and Rusty Guinn at Epsilon Theory for much more on this) of equity markets in which share buybacks are replacing real operational profit growth as the key driver of valuation. As a result, caution is now needed in larger doses than ever before.

At the same time liquidating all financial and operating assets, converting the proceeds to gold and going to live in a nuclear bunker is also not a very practicable course of action, given the uncertainty of timing and the very real possibility that this state of affairs could continue for a good while yet. So here are my current guidelines for moving forward with caution.

Move forward…

  • Don’t obsess about things you cannot change and sail with the wind you have. Any good sailor will always have an eye on the weather and be making assessments as to the probability of change on the horizon. Weather forecasts tend to be accurate, market forecasts are invariably not. Sail with the wind you have and make headway while you can. That means keep doing what you are doing.
  • Do what you do best and extricate yourself from peripheral activities and investments. If there are projects, investments, ventures in which you are reliant on others, are a junior partner or just in it for fun, consider selling your stake to the lead investor, senior partner or significant stakeholder.
  • Tighten and hone your investment and capital allocation criteria. Whether you are a financial investor or an operating manager, this is good time to revisit your investment criteria and to make them more restrictive, focusing on bargain opportunities (components of assets are currently not priced as highly as finished investible assets – Tobin’s Q works in your favour at the moment), moat-widening investments and balance sheet additions that immediately add intrinsic value. The reason Berkshire Hathaway Inc. currently has $130bn in cash is primarily that they refuse to deviate from their fairly restrictive investment criteria. It looks like timing, but isn’t, it’s discipline. The countercyclical effects are the same, but one is speculative the other rational. Be rational.

…with caution

  • Use excess cash flows to pare down debt and strengthen your balance sheet.
  • Stress-test your business operations for a downturn. How storm-resistant is the business? How would it perform under a repeat of 2008 / 2009 or worse?
  • Consider building a stockpile – however small – of gold bullion or coin. Just don’t store it in the bank. Build the stockpile over the coming years to a defined maximum level of net worth. The opportunity cost of holding gold compared to cash or liquid assets is non-existent currently and makes sense irrespective of your perspective of the financial system. Remember the intrinsic value of every fiat currency is exactly zero.
  • Prepare mentally for the crisis. Assume that in a crisis of the magnitude that we may face repairing our debased currencies and unrepayable debt burden, the price of financial assets will be decimated (in the true sense of the word meaning reduced to a 10th of their previous price) or worse. Assume further that in the ensuing chaos, “when the smoke cleared from the economic rubble, a handful of wealthy people had become wealthier still, a vast number of ordinary people had become impoverished and a good number of the already impoverished had become even more so.” (John Butler, The Golden Revolution revisited, writing of John Law and the Mississippi Bubble). Being mentally prepared for a severe dislocation, will be the distinguishing factor in recovering and re-establishing personal prosperity, in whatever shape the world emerges “when the smoke has cleared”.

I will freely admit that I am working my through this whole subject at the moment and that reflections on the state of our monetary envrionment and the end of the age of financialisation will be a recurring theme in my writings this year. I will be reviewing literature that has helped me refine my thinking, interviewing thought-leaders and specialists in the Good & Prosper podcast and crafting guidance to help prepare for the worst. This I think is useful, even if I my hypothesis turns out to be completely misguided. Fire drills are important and need to be practised regularly when the sun is shining.