The future is always unclear, and therein lies the chief source of risk in the investment challenge. The degree of risk isn’t continuously steady. It ebbs and flows, like market prices and the careers of Hollywood actors.
The fact that risk levels are dynamic suggests a connection. But our ability to model the connection and draw lessons is limited. In fact, at some points the relationship between risk and expected return is especially foggy.
This is one of those times, a state of affairs that creates unusually large opportunities and equally above-average risk. As such, all the usual caveats, and then some apply. Yet recognizing this condition is the first step toward exploiting the opportunity and/or defending oneself against the higher risk.
Macroeconomically speaking, a major risk overhanging the capital and commodity markets relates to the question of deflation and inflation. That is, which one will prevail? Moreover, will one dominate only to give way to the other? And if so, what will the timing be? Being on the wrong side of this uncertainty will be painful, perhaps financially fatal, and so it’s the rare investor who can afford to make an all-or-nothing bet. Regardless of your view, a bit of hedging never looked better—just in case.
Certainly there are strong arguments for each possibility, including deflation first, then inflation, which happens to be your editor’s bias. But others argue that deflation will linger for a lengthy stretch and so the practical risks of inflation are virtually nil for the foreseeable future. Still others forecast that inflation remains the imminent risk, even if it’s not obvious in current data. The chief evidence for this outlook comes from the massive surge in the Federal Reserve’s balance sheet, i.e., the printing of money on a scale rarely seen in order to combat the current economic slowdown/contraction.
The fact that intelligent analysts and economists can debate the future on such starkly different terms only highlights the higher levels of risk of late. That’s in sharp contrast to debates of the recent past, when dismal scientists were arguing if the economy was set to grow by 2.0% vs. 2.3%.
A telling example comes in the current issue of Barron’s and its roundtable discussion. Consider this exchange between Fred Hickey (High-Tech Strategist); Mario Gabelli (Gamco Investors); Marc Faber (Marc Faber Ltd.); Oscar Schafer (O.S.S. Capital Management); and Bill Gross (Pimco):
Hickey: It’s hard to predict the market when you don’t know what the Fed will do. The Fed has tripled the size of its balance sheet and is plowing ground we have never seen before. Here are my facsimiles of deutsche marks from Weimar Germany [holds up sheaf of papers]. They collapsed in value when Germany started printing money after World War I. It happened very quickly and it can happen again.
The Germans were successful at reflating. But they weren’t successful in saving their economy. [Federal Reserve Chairman Ben] Bernanke is on record saying, “I will not make the mistakes of the 1930s. I will not make the mistakes of Japan in the 1990s.” He is pushing the limit right now.
Gabelli: So you’re saying he’s going to make the mistake of the Weimar Republic?
Hickey: There is a possibility of that. Every month that there is a horrible employment, report the government prints more money.
Gabelli: It took Weimar Germany a brief time.
Faber: The worse the economy, the more they will print. It is like in Zimbabwe now, and Latin America in the 1980s. They had large deficits and printed money, and in local currency everything went up. But the currency collapsed.
Schafer: Isn’t the federal government increasing its balance sheet to offset the private sector?
Gross: Exactly. The situation isn’t similar. The Weimar Republic basically reflated to get out from under its wartime debts. Zimbabwe is a situation unto itself. In the U.S. there has been asset destruction in the trillions of dollars that has to be repaired. To say the Fed’s balance sheet has expanded by a few trillion dollars and that this will create hyperinflation is a miscalculation.
Faber: I’m prepared to bet Bill that in 10 years the U.S. has very high inflation. With growing fiscal deficits that may reach as high as $2 trillion next year, it will be hard for the Fed to lift interest rates in real terms. Once they push up rates again, there will be another disaster.
Gross: Marc, you’re smarter than that. You know that credit creation is at the heart of economic growth, and to the extent that credit creation has been thwarted, stultified, basically cut by 10% or 20%, economies can’t grow.
Faber: The U.S. economy is credit-addicted. In a sound economy, debt growth doesn’t exceed nominal GDP growth. Would you agree with that, or do you think debt should always grow at a faster pace than nominal GDP?
Gross: I’m with you there.
Faber: We come at this from different perspectives. You run a company that manages money, and I’m an outside observer of the U.S. financial scene, though I have to admit I bought some U.S. stocks for the first time in 30 years.
The fact that smart people can see such wildly divergent possibilities on inflation and deflation reminds that the potential for instability is alive and kicking. As Abby Joseph Cohen, senior investment strategist at Goldman Sachs, explained in the roundtable talk, “It is important to recognize that we are not starting from a point of equilibrium, where the economy and the credit markets are working properly. Instead, the Federal Reserve is acting aggressively to provide liquidity not just to the U.S. economy but the global economy.” She added: “In many ways, the Fed is acting as the central bank to the global economy.”
It doesn’t take a genius to recognize that the Fed’s not designed for such a broad increase in its mandate. Yes, to a certain extent the U.S. central bank has, for some time, been dispensing monetary medicine for the globe. That’s one thing, when the global economy was humming along nicely; it’s something else in a time of severe asset deflation and recession, the likes of which we haven’t seen in decades.
So, yes, there are huge opportunities in the current climate, but those are tempered with huge risks. As such, a prudent risk management strategy is essential. For strategic-minded investors, that begins with taking advantage of sharp discounts on price at those times when available. In fact, the discounts were unusually large about a month ago. Prices have since popped. Did you take advantage of the pessimism? Or are you inclined to jump on the bandwagon now?
The macroeconomic risks are unusually large these days, but the biggest threat to investment success remains a familiar monster that dwells inside each of us: emotion that favors running with the crowd for, say, asset allocation decisions. Taming that beast is still the greatest challenge.