The optimist thinks this is the best of all possible worlds. The pessimist fears it is true….J. Robert Oppenheimer

The optimist thinks this is the best of all possible worlds. The pessimist fears it is true….J. Robert Oppenheimer

Ok, let’s first get our mandatory chapter on inflation out of the way.

As loyal readers of this newsletter know, in the battle of opinions, between on one hand, the (official) position that the inflation surge is due to temporary distortions of supply chains, commodity prices and workforce claiming higher wages, and on the other, the fear that creating money out of thin air, in a way that would have made Napoleon blush, is bound to erode the purchasing power of money, I am more inclined towards the second position, but again, as an investor, one should always consider the following about your convictions: What if I am wrong?

Markets were somewhat shocked last weeks by the declaration of the Federal Reserve that they brought forward the time frame in, when they plan raising interest rates. However, the central bank gave no indication as to whether when it will begin cutting back on its aggressive bond-buying program, (this is called “tapering”) though Fed Chairman Jerome Powell acknowledged that the issue was discussed.

I am thus not the only one who is not entirely convinced that higher inflation is temporary and will just go away. If this were what they really believe, why would they consider interest rate hikes earlier than initially foreseen?

If ever the Fed would have hinted towards tapering, this is the central banks buying less bonds, the markets would have reacted pretty violently and an immediate correction of 10% or more would have been the likely outcome.

US government’s debt increased by 5 trillion $ in 2020. This represents an increase of over 20% just in one year!

Markets are hooked on the massive creation and injection of new money by central banks. In addition, governments are counting on central banks directly financing public debts through creating money and with this money, buying bonds emitted by the governments in order to finance deficits.

Because, let’s face it, who else is going to buy all the bonds at current negative real interest rates.

Foreign investors are certainly no longer massively buying treasury bonds from the US government. In order for the public to have another look at bonds it will take some convincing that some honest money can be made from buying these bonds. Imagine inflation at 2% and investors demanding a 2% return, on top of inflation, for the privilege of being authorized to lend their hard-earned savings to the US government. The return on treasury bonds would rise at 2+2% or 4%. (Currently it is around 1.5%, coming from 0.5% last year) Paying a 4% interest rate on all treasury bonds would imply that around a third of the US tax revenue would have to be reserved for interest expenses. And believe me, similar situations in Europe and Japan. So, governments would need to start cutting down on expenses and/or drastically raising taxes? Very bad for politicians’ re-election odds.

Therefore, it is not a coincidence that Jerome Powell and other central bankers did not mention the option of “tapering”. Central banks no longer financing public debt would put an immediate end to the Ponzi scheme that financial markets, housing prices and public finances have become. Nobody can afford higher interest rates without these houses of cards crashing down. So expect more re-assuring messages in the coming weeks/months that inflation is dropping again and no need for higher interest rates and tapering.

So, as I mentioned before in this newsletter, investors are squeezed between a rock and a hard place.

On one hand, real net interest rates have never been lower. The German interest rate minus inflation approaches minus 3 percent. Thus by investing in a 10 year bond of the German government you loose 3 % of your savings per year. No need to say, more or less the same outcome if you leave your savings on a savings account. Your bank may even charge you for the privilege of keeping on to your cash for you.

On the other hand, markets are historically expensive. In the month of May, the S&P 500 real earnings yield (the inverse of Price/earnings minus inflation) went negative. Never happened in 40 years. So the return on investment that companies make, minus inflation became negative.

Investors’ options thus come down to in choosing between a sure loss by staying out of the market or investing in a market that is expensive by all historical standards.

I know, in the long run, shares outperform bonds and cash but how long is “the long run”? Since the start of the 20^th century there have been several periods of up to 20 years where investors had a near-zero or even negative return. Think not only the thirties and forties but also the seventies of last century. Good luck if you retire at the start of one of those periods and you were counting on a return from your investments to spice up your pension time. Better start living healthy then.

OK, so the US market is priced “over-the-top” by all standards and other markets such as Europe and Japan are also priced above averages. Moreover, we currently see alarming signs such as young, new investors flocking to the market and plenty of IPO’s (Means owners of companies selling (part of) the shares they own and/or call for extra capital from investors. Mostly these people do not sell their shares to investors at discount prices, rather the opposite; they take advantage of the overvalued market to cash in)

What to do now as an individual investor?

First, I would not start massively liquidating your positions and turn towards bonds, cash and/or gold. What is expensive can stay expensive for a while and even get more expensive. We had a fine example of this in the last decade. Some guru’s have been predicting an imminent crash +for the last 10 years or so and the markets kept steaming on and investors standing on the sideline were pulling their hair out of their skull in misery. (This is the reason you see so much bald guys on investment events). In addition, as we established before, cash, bonds (certainly), and gold are not risk free. For the time being, I would not go against the crowd and get on the sideline. This bull market can be more durable than expected.

So, do nothing then and hope for the best? Not really.

First thing to keep in mind, when you do your financial planning: lower your expectations! I see no scenario in which investing in stock markets, during the next decade, will bring you the returns we got used to in the last decade. Therefore, I would hesitate before buying the sailing boat you intend to take around the Mediterranean. Same goes for that apartment in Marbella. Do not expect recurrent costs, above your regular income from salary or pension, to be financed from a return on your investments. There will be numerous years where that revenue will not be there and if you are obliged to start tapping into your capital in order to finance your lifestyle, the edge of the cliff is nearing quickly. And if the shit hits the fan you are on going to be able to sell these expensive apartments, villa’s, yachts, luxury cars at fire sale prices

So if you like travelling, when you have the money, book a plane ticket and a hotel room in a wonderful and far-away place you want to visit. If you have less money, well some short city-trips can also be very rewarding. But by all means do not take on board huge recurrent costs.

I would also focus my investments towards some lower-risk options such as reasonably priced (I know – good luck on that one) well run companies that have a long history of paying dividends with a lower volatility. Stay away from hyped investments and be somewhat contrary. Our last month’s bet on oil shares did not turn out badly at all did it?

During the last decade, US markets widely out-performed Europa, Japan and the Emerging markets. Result is that now US markets are currently priced for perfection so some diversification could be advised. Have a look to which markets are still reasonably priced. Funds but also growingly ETF’s will allow you to focus on specific geographical area’s. Currently Russian, Japanese, Chinese shares are still reasonably priced. However, take care, I am now talking about shifting maybe a couple of percentages of your portfolio towards these accents. Do not go distorting the composition of your entire portfolio by massively investing in these countries. Geo-political events and internal politics can lead to a lot of bad stuff and profits in these countries can be wiped away in a matter of days

I would also keep a somewhat larger cash portion in my portfolio. When markets correct, you can take advantage by buying some quality shares at lower prices but for that you do need some cash on the side. Take care, for many years now, investors have been pre-conditioned that every (small) correction was a buying opportunity. Result is that corrections get smaller and smaller before investors start shooting from the hip again. One day in the future, the correction will go further than the current up-to-five-or-ten-percent. If you fire away all your ammunition after the first small downturn of the market and we are in for a big one, you will still wish you had some ammo left. Hence, I always state, a successful investor nibbles a lot. Buying on the way down and selling on the way up.

In this way, you will probably not out-perform popular indexes in the near future but when the market will, one day, turn towards a long-lasting bear market you might avoid sitting in the park with a library book and a can of beer from Aldi during your retirement age.

Currently markets seem like being at a turning point. We are hitting again the summits of May 2021 and either markets steam on to reach new heights (this would be a very positive sign) either we bounce of this top and go for a correction and towards choppy markets for the rest of the year.

My bet is the second option as a lot of good news (rising profits, inflation being temporary, Covid being under control) look already priced in and besides TINA, I do not see any triggers for further rising prices. Again, my bet is as good, or as bad, as any’s.

What could trigger a correction that would turn out to be a crash?

Galloping inflation that would force central bankers to consider and communicate more often about interest rates and tapering would be one thing. I did get a bit worried when I saw Chinese producer prices rise by 9% in a year. These rising Chinese inflation will be exported with every container that is off-loaded in Antwerp or Los Angeles harbor.

However, I more fear a real “Black-swan” event. If hackers can block a crucial pipe-line in the US for days they may also create havoc in the international payments, and financial system.

International tensions are also growing. The US is currently still militarily superior but measured by traditional standards (Aircraft carriers, jets, missiles). These could however turn out to be the standards by which last war was fought. The possible use of cyberattacks, drones, and high-speed missiles could tempt China and other nations, such as Iran, to challenge president Biden. With the mid-term elections upcoming and not a guaranteed win, he can not be seen as being weak. Not after retreating from Afghanistan.

Ultimately, public finances in developed countries are a Ponzi scheme and either we will one day go towards “The big reset”, John Mauldin has been talking about for many years, either governments would count on money depreciation/ hyperinflation to eliminate debts and future obligations. (Yes, that includes your pension rights)

For this reason, a fare portion of physical gold in your portfolio is very defendable.

In the meantime, enjoy your summer and stay safe and positive. In life there is only one certainty, in the end we all die, so you better make the best of it.