I’d hate to say it but this time really is different. Never before has there been coordinated global money printing of the scale of today. Ever. Japan intends to double its money in circulation in just two years. This is incredible stuff. But it only mimics the U.S. Federal Reserve which has tripled the amount of dollars in circulation since 2008.
Most stock brokers and mainstream media will tell you that this money printing is what’s needed to stimulate economies and whether it succeeds or not, the outcome will be relatively benign. Don’t believe them. It’s highly likely that this is not a normal economic cycle and the consequences will be more extreme: success will mean all the printed money filters through to economies resulting in double digit inflation or failure will bring serious deflation. In other words, the most probable outcomes aren’t pretty and you need to prepare your investment portfolios as such. Today I’ll suggest some ways that you might be able to do this.
Sayonara to Japan
First to Japan. You’ve got to love mainstream media, investors and stockbrokers. The Japanese central bank’s plans to end deflation have been widely greeted as having surpassed expectations. They’re described as “bold”, “inventive” and just what Japan needs after sitting on its hands for 20 years. Nowhere have I seen words such as “stupid”, “insane” or “half-witted”. Because anyone with a brain can tell you that Japan’s plans will have terrible consequences, whether they succeed or not.
First, let’s look at what Japan intends to do:
- It will double current stimulus to 7.5 trillion yen (US$81 billion) per month. This means buying the equivalent of 70% of the total long-term government bonds in markets.
- It will buy Japanese government bonds with maturities of up to 40 years, seeking to push the average duration of Bank of Japan (BoJ) bondholdings to seven years, from the current three years.
- It will increase purchases of financial instruments linked to the stock and property markets to lift the prices in those sectors and encourage other investors to buy them. More specifically, the BoJ will increase purchases of exchange traded funds (ETFs) by 1 trillion yen per year and real-estate trust funds (REITs) by 30 billion yen per year.
- The BoJ put a timeline of two years on its prior promise to achieve 2% inflation.
To put this into some context, Japan’s stimulus of US$81 billion a month compares to the U.S.’ own US$85 billion program. But Japan’s economy is much smaller than the U.S.. Adjusted for GDP, Japan’s stimulus will be twice as large as America’s. It makes Bernanke look like a patsy.
Now I’m not going to detail the reasons why the BoJ package will be a disaster for Japan, as I’ve done it previously here, here and here. Suffice to say, if Japan succeeds with its 2% inflation target, interest rates will rise at some point and they just need to reach 2.8% for the interest on government debt to equal government revenues (currently, interest of government debt takes up 25% of government revenue). The bond market will revolt well before it reaches that point though.
If Japan fails in its bid to increase inflation, you’ll see government debt balloon. Japan’s current government debt to GDP is 245%, by far the highest of any country. The debt is also 20x government revenues. Bondholders aren’t going to sit there earning less than 0.6% on Japanese government bonds while debt increases and the yen tanks.
And to reiterate a point that I’ve made previously, those that assume the Japanese government bond market can never blow up as domestic Japanese own 91% of the market are looking through the rear-view mirror. Ageing Japanese need to fund their retirements and won’t be able to support the government bond market as they’ve done in the past. Foreign investor holdings of government bonds is 9% and rising. They’re going to be want better returns for the risks that they’re taking on.
I’m on the record suggesting that I don’t think the BoJ plans to lift inflation will work. Whether right or wrong, it seems inevitable that the yen will significantly depreciate from here. And that the bond market will crack at some point, though putting a date on that is very difficult given extreme government intervention in the market.
Others will follow suit
Japan is likely to prove a prelude of what’s to come in much of the developed world. The West, like Japan, has way too much debt and economies haven’t been restructured to make them competitive again. And the West is falling into the same trap as Japan by trying to inflated its way of over-indebtedness. You can be certain of more desperate measures from western central banks as they try to stave off a Japanese-style deflationary slump. Investing in this type of environment will be tricky, to say the least.
Take the U.S. for example. Many of the country’s cheerleaders suggest that the economy is recovering, led by the housing sector. What they don’t tell you is that GDP growth of 2.2% in 2012 is still way below the 3.2% average since World War Two. Nor do they emphasise the still very high unemployment rate, above 11% if you include people that have dropped out of the workforce since 2008. More importantly, all the evidence suggests deflationary forces – principally households intent on paying down debt – are beating the Federal Reserve’s (Fed) best efforts to lift inflation.
The velocity of money is one of the best indicators that deflation is getting the better of the Fed. Since the financial crisis, the Fed has flooded the economy with printed money, trebling the so-called monetary base. That base consists of highly liquid money, such as coins, paper money and commercial bank reserves with the central banks.
Under normal circumstances, increasing the monetary base to this extent would be highly inflationary. But the problem is that this money is not making its way into the economy or changing hands (money velocity). That’s why money velocity in the U.S. has dropped to a more than 60-year low.
Rising money velocity indicates that the same quantity of money is being used for several transactions. It’s turning over, signalling a robust economy. Declining velocity, on the other hand, indicates money isn’t changing hands and that the economy is anything but healthy.
What declining velocity of money suggests is that banks are sitting on excess money because households aren’t willing to borrow as they’re busy paying down debt. Meanwhile businesses, which are less indebted, aren’t confident enough in the economy to borrow money and invest it.
If you’re thinking that Japanese businesses and households may have exhibited similar behaviour over the past 20 years, you’d be right. That’s why Japan also has money velocity reaching multi-decade lows.
Declining money velocity is one of several signs that the Fed is failing in its battle to produce inflation in order to revive the U.S. economy and reduce the country’s debt.
The larger point is that as long as this remains the case, Bernanke will continue with stimulus. And if stimulus continues to fail, he (or whichever like-minded academic takes over from him) will get more desperate and use unconventional methods like Japan is now (such as buying stocks directly, for instance).
How do investors position themselves?
The question then becomes: how do you allocate your assets given this atypical economic environment? In investing, no bet is a sure thing. But what you can do is look at the facts, the probable outcomes and invest where the odds are in your favour.
So let’s take a look at the probable outcomes. I see four possibilities:
1) Mild inflation and a global economic recovery. This is the outcome that stock markets are currently betting on. If it happens, stock would be the place to park your money, while bonds, precious metals and cash wouldn’t be.
2) Inflation does lift off but central banks tighten policy early, resulting in economic contraction, and likely recession. Stocks would initially benefit then suffer. Bonds would initially perform poorly, then outperform. Precious metals would rise with inflation, then probably fall as contraction takes place. This outcome appears unlikely though as central banks will be loath to switch off stimulus early. Ben Bernanke is obsessed with the Great Depression, when stimulus was stopped too soon before recovery could happen, in his view.
3) A global economic recovery happens but inflation gets out of hand as all the printed money flows through to economies and central banks seem powerless to stop it. In this instance, stocks, bonds and cash would get punished. Precious metals would benefit most.
4) A more serious deflationary depression happens. Stimulus fails and debt compounds until the weight of it kills economies. Under this scenario, long-term bonds would outperform, though low current yields make substantial outperformance unlikely. Cash could outperform if you’re in the right currencies. Precious metals may also outperform if confidence in currencies dissipates. You wouldn’t want to own stocks if a deflationary depression occurs.
As you may have gathered, I think the most probable outcomes are 3) and 4) with 4) being the most likely. Precious metals should outperform under both scenarios 3) and 4) and therefore overweighting this asset class makes sense. Holding some cash also makes some sense, though it could suffer under serious inflation. Long-term government bonds may be worth holding, though currently at almost all-time low yields, upside appears very limited. Meanwhile, you’d want to stay almost entirely out of stocks if scenarios 3) and 4) turn into reality.
Channelling Harry Browne
How you invest your money will obviously depend on your own circumstances, including which country that you’re located in. Some of you may feel uncomfortable holding large quantities of precious metals or staying out of stock altogether. This is understandable.
If that’s the case, I’d guide you towards a safe, easy-to-follow investment portfolio that’s likely to perform under any of the probable outcomes mentioned above. The portfolio was first advocated by the late Harry Browne.
Browne was an American investment newsletter writer who wrote numerous books and found fame after writing the 1970 bestseller, How You Can Profit From The Coming Devaluation. That book accurately forecast the 1970s slump and the need to be substantially overweight precious metals, particularly silver. He went on to run as a Libertarian Party candidate for the U.S. Presidency in 1996 and 2000.
Later in his career, Browne advocated what he called a bulletproof portfolio, which could perform under any economic environment. This portfolio turned into the Permanent Portfolio, a mutual fund that’s now listed in the U.S..
Browne’s original idea, outlined in his book Fail-Safe Investing, was that a safe, easy-to-follow investment portfolio should consist of 25% in long-term government bonds, 25% in cash (money market funds), 25% in stocks (growth style mutual funds) and 25% in gold.
His thesis was that each of these assets would outperform during one or more economic environments, whether it be prosperity, serious inflation, recession or depression. And this outperformance would outweigh the underperformance of some of the other assets during particular periods. For instance, gold’s outperformance during the 1970s inflationary period more than offset the underperformance of stocks, bonds and cash.
Browne surmised that such a portfolio would deliver good long-term returns with limited volatility. He’s been proven right as the Permanent Portfolio has done just that, outperforming the vast majority of mutual funds in the U.S. with very few down years. Note that the listed fund has deviated somewhat from Browne’s original proposed allocation, though not by a lot.
Now I’m not advocating that you necessarily go out and invest directly in the Permanent Portfolio fund as it depends on your particular needs and circumstances. However I am suggesting that Browne’s ideas may be worth considering as a potential guide to navigating the uncertain economic environment ahead.
Interestingly, investment guru Marc Faber has proposed a remarkably similar investment portfolio to that of Harry Browne, the only difference being that instead of owning long-term government bonds, he suggests real estate instead (he thinks inflation is on the way and is a well-known bear on long-term U.S. government bonds).
This post was originally published at Asia Confidential: http:asiaconf.com