Winning the War

The volatility we’ve seen in financial markets this week is but the latest skirmish in an ongoing battle that dates back to the beginning of the GFC, and indeed the multi decade credit binge that led to it.

The market crash that we saw back in 2007 and 2008 was a natural response to the investment world sobering up (temporarily at least) and realising that there is a limit to all asset bubbles and indeed to economic expansion themselves, especially when they rely on the perpetual expansion of credit. The flight from overvalued risk assets was hardly unexpected.

The recovery in asset markets that we have seen since early 2009 has also been quite natural, as trillions in QE and over 600 interest rate cuts have pushed investors into risk assets, even though economic growth remains weak, debt levels are higher than they were pre GFC, and company earnings have been goosed up by financial engineering.

And so we come to Q3 2015, a time where market historians will note a handful of important forces are at play.

• The worlds second largest economy, and most important contributor to global growth over the past 15, and especially last 5 years, China, is experiencing significant growing pains.

• At the same time, the central bank of the largest economy in the world, the United States Federal Reserve, threatens (and that really does seem to be the appropriate word) to increase interest rates for the first time almost a decade.

• Meanwhile, commodity prices, despite the extraordinary growth in emerging market economies in the past 15 years, have plunged, with the Bloomberg Commodity index of 22 raw materials this week closing at it’s lowest level since August 1999.

• Finally, despite the greatest credit binge in history, and the mathematical impossibility that developed market sovereigns will be able to honour their debts in dollars, euros, yen or pound sterling, sovereign borrowing costs are at their lowest level in 5000 years, dating all the way back to the Babylonian Empire.

That is the field of battle that we are all on, and once one recognises it, increases in volatility, and the wild swings in risk assets we’ve seen the past 5 days can hardly be seen as a surprise.

But what should investors do? How do they win this war that is raging between the real economy and financial markets, and ensure they can protect, and hopefully grow their own wealth in the period ahead.

In an article dealing with the tragic death of Adelaide Football Club coach Phil Walsh earlier this year, journalist Mark Robinson reported on a conversation Walsh had with an SAS leader during Walsh’s time at the West Coast Eagles.

According to Walsh, the SAS leader commented that only three things determine a battle, which were

• Field Position

• Fire Power

• Morale of the Troops

The article went on to comment that the morale of the troops was really the only thing that was in the control of the SAS leader, and indeed a football coach, so he saw great merit in spending a lot of time focusing on that factor.

I was re-reading that article overnight and thought those comments were highly relevant to investors today, and how they should be thinking about their portfolios.

For ultimately, there are three primary factors that will determine returns in the coming years, which are;

• Global economic conditions

• Global monetary settings

• Valuations, and the price investors are paying to own financial assets

And if we draw a line between the SAS leaders comments and financial markets, we can see that global economic conditions and global monetary settings are much like the field position and the firepower.

They are outside of our control!

We can have a view that the global economy will improve in the coming years, or that it won’t, but we don’t really know, and whilst we all play our own little role in it, none of us is big enough to drive the good ship GDP in any particular direction.

Similarly, we can take a view on where interest rates and monetary policy will head, but again we can’t really know. Perhaps it will tighten, but then again, perhaps we will remain in a world of ZIRP and real NIRP, with QE on top for years to come.

And perhaps those monetary settings will continue to exert their somewhat benign influence on the real economy, through eased borrowing costs and minimal official inflation, whilst continuing to support asset prices.

But it is also possible that in the coming years, as in every other occasion in history where such desperate monetary policy measures have been undertaken, unintended and largely negative consequences of QE and ZIRP will rear their ugly head.

Richard Fisher’s warning that "Inflation is a sinister beast that, if uncaged, devours savings, erodes consumer’s purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency”, is something all investors should be aware of, even if the threat is not on the immediate horizon.

Again, when it comes to where monetary settings will head, and what their impact will be on the economy, none of us can be truly sure.

Instead, much like a SAS leader or a footy coach can only fully be in control of the morale of their troops, the only thing we as investors can control is the price we are willing to pay for the assets we buy.

Are we comfortable buying developed market sovereign debt at negative real yields, when they’ve been in a bull market for over 30 years?

Are we comfortable buying Australian property when it too has been in a bull market for the better part of three decades, with prices at all time highs, and rental yields at all time lows.

Are we comfortable buying international shares, which if we use Shiller CAPE as a guide, are already trading at 25 times earnings, fully 50% above the long term average and at a historical entry point that suggest a high risk of significant losses in the decade ahead?

How investors approach this battlefield in the years ahead is a personal decision, but I for one will not concentrate too much of my own, or my families money in financial markets today.

The valuation that I would need to pay, which is the only thing I can truly control, is simply not attractive enough, and warrants a more cautious approach.

And whilst none of us can know with 100% certainty what will happen in the economy in the years ahead, and what the impact of the extraordinary monetary largesse we see being deployed around the world will be, we will not ignore economics, or history, to paraphrase Ray Dalio.

As such, we will continue to keep a portion of our wealth in physical gold and silver.

As Bill Bonner once commented. Gold may go up. Gold go may go down.

Gold will not go away

Until next week

Disclaimer

This publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance. Any prices, quotes or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.