In the times of the ancients, rulers like Roman emperor Nero would ‘debase’ their sovereign currencies by adding lower value metals to gold and silver coins to increase the supply of money. Throughout history, this has seldom ended well because of the inevitable inflation in consumer prices that follows currency debasement.
In today’s world of fiat currencies, it is a simple matter for central banks to print more money or to create it electronically. Indeed, central banks in Europe, North America, and other parts of the developed world have been running massive stimulus programmes since the Great Financial Crisis in order to fuel economic growth in a time of anaemic demand.
In the wake of the national shutdowns and economic devastation of the coronavirus, governments and central banks have responded by ratcheting up their stimulus programmes to even higher levels. Money is cheaper than ever, with zero or even negative interest rates in many countries. So, what are investors to make of this situation?
One of the first important points to note is that today’s currency debasement has yet to translate into significant consumer-side inflation. The enormous supply of money flowing into the financial markets is barely propping up existing consumer demand – spending may remain suppressed in an age where consumer confidence is at rock-bottom. The Fed has indicated, however, that it might allow some inflation, so the picture could change in time to come.
Asset versus consumer inflation
Where we are seeing inflation, instead, is in asset prices, particularly equities, with some signs that property markets in select regions are also beginning to trend upwards. This is explained by the fact that returns from cash and bonds are low, zero, or even negative. In this environment, investors are piling into equities because there is no value in holding cash and there are few other places to find returns.
That explains quite neatly why we have witnessed such strong performance in equity markets since the March lows – bouts of volatility notwithstanding. Assets are appreciating to compensate for the debasement of the currency. This is a correlation that will be familiar to anyone who lives in a developing country like South Africa that has a volatile currency and traditionally higher inflation. When the rand falls, the JSE usually climbs as the rand-hedge component provides a boost.
Perhaps counterintuitively, this dynamic offers an argument in favour of global equities which could continue to rise in the medium term, even as many investors and analysts fear that stock markets are overheating. When there is nowhere else to get a return, a modest dividend yield of even 1-2% looks attractive.
Diversification is key
How does all of this translate to you as an investor? It means that structuring and diversifying your portfolio to achieve an optimal balance of growth and risk mitigation becomes more important than ever before.
We, at Dynasty, are approaching this challenge in a number of ways. As per our other article, we continue to focus on quality stocks, notably proven reliable performers in resilient and countercyclical sectors. This is a way to cushion portfolios against volatility, while still reaping some returns from these companies’ ability to grow their underlying businesses.
Furthermore, our perspective is that in a world of asset price inflation – and one where consumer inflation might return – a strategy of holding cash or low-yielding bonds is also not without risk over the medium to longer term.
For clients who are anxious about the possibility of a bear market, we are implementing portfolio insurance in our proprietary funds. This allows them to participate in stock market growth while capping their exposure to the downside.
The vices and virtues of cash
Some investors prefer to hold a large portion of their portfolios in hard currency cash – a stance that may provide a bulwark against rand depreciation but one that will deliver low returns over time. We believe that options such as investment grade short-dated corporate credit offer a compelling alternative for these investors, as it provides a moderate return at low risk.
We are also holding gold in some local and global portfolios as a hedge against future asset inflation. However, this is not a long-term play for us because it does not provide a yield or increase in volume, but nevertheless may provide a store of value.
For each investor, we would need to look at a range of instruments to address their individual appetite for risk and their long-term goals. This principle applies irrespective of market return prospects.