What to invest in?
Investors are at their wits’ end. What should they do to protect their assets?
Well, your choice of assets depends on what you think central banks will do – especially if the stock market rout goes on. Will they
- extend/revive QE, keep rates low and print more money?
- will they go on trying to return to “normality”, and raise rates, as the Fed has started tentatively to do?
One has to reckon the probability of extreme scenarios: e.g.a collapse of equities by 30% or so of their current level. This would be a reversion to levels of mid-1980s (with the Dow Jones Industrial at about 4,000) with a rough adjustment for the rise in productivity and global spread of capitalism since then; this would put the Dow Jones at about 11,000 compared to 16,000 now.
Or one could anticipate a rise of, say, of another 30% or so on the assumption central banks will be pushed into more QE; that puts Dow Jones at 20,000. However, this could easily trigger the much-forecast surge in inflation, with a fall in longer-dated bonds.
On a five-year view, consider the following possibilities:
1. Equities: 30% probability of equities rising in real terms; 70% of a fall:
2. Bonds: 20% chance of government bonds rising; 80% chance of a fall in real terms:
3. Deposits: 20% chance of stability or appreciation in the real value of money with deflation; 50% chance of a moderate fall in the value of money (i.e. central banks reach but do not exceed their inflation targets); 20% chance of a steep fall in the value of money (inflation of 25% over the period, with expectations of rising inflation at the end of the period); 10% chance of a banking crisis putting large deposits at risk,
Some extreme scenarios could materialise from the above probabilities; for example, a large fall in equities and in bonds combined with a financial crisis; or a rise in equities combined with a spike in inflation.
A further worry is that asset classes are increasingly correlated, so that it is more and more difficult to achieve protection from extreme scenarios through asset diversification.
Stay with equities?
Having said this, there is a big difference between equities and other asset classes. With equities the investor can select a few companies out of a universe of several thousand public companies (In the US, despite a fall in recent years in the number of listed companies, about 4000 companies are actively traded in NYSE or Nasdaq and another 10,000 stocks are traded over the counter). About 2,000 companies are traded on the London stock exchange. In addition new vehicles for raising and trading equity have been created through equity crowd-funding and similar internet-based innovations, potentially greatly extending the equity universe.
Each company is unique in its specific set of attributes: management, sector, objectives, technology, skill set and in terms of the demand it creates for its products and services. For people who have the time and capacity to do the research there is no substitute for investing in equity shares of individual companies, large and small.
Central banks can’t walk away
I expect central banks will be ready to take large risks with long-run stability in an effort to prevent a market collapse, which would endanger near-term financial stability. New monetary stimulus would benefit equities over bonds.
However, in a market collapse, the central bankers will probably take action only after a nerve-racking interval when they will try to brazen it out. They have some lovely new macro-prudential tools of which they are very proud and which, some of them hope, will avoid the need always to use the interest rate weapon. Bank capitalisation has improved, and so on.
But still pressure could be irresistible. The decisive action could take place in the corporate bond market, where large defaults would threaten the central banks’ balance sheets through weakening the quality of the collateral banks have placed with them.
This action, if taken, would, however, heighten the chances that central bank policies would lead to accelerating inflation, reducing the value of money. Meanwhile, the scope of the safety net is being reduced.
In sum, the central bankers cannot escape their entanglement with stock markets. They will remain a decisive influence on prices. My guess is they will prop markets up as long as they can – and prepare the public to blame governments when it all goes pear-shaped. So expect even more speeches telling governments to implement more “structural reforms”.
Where is the money going?
In Japan, housewives keep large holdings of yen banknotes; on average it is thought that the Japanese hold about $6,000 in bank notes per person, mainly in safes at home. In the UK, they are more likely to seek investments in buy-to-let properties. In many countries, notably China, the art market is attracting growing attention as an asset class. Gold bars and coins are also seeing strong demand: gold bought for investment purposes – the total of bars, coins and ETFs – jumped by 27% in the third quarter of 2015 to 229.7 tonnes. US retail investment demand jumped to 32.7 tonnes, growth of more than 200% year-on-year. According to the World Gold Council, this signalled a level of interest in gold investment not seen since the global financial crisis. Central banks are themselves buying about 150 tonnes every quarter. They are also buying equities. Why not imitate the central banks themselves?
This points to selected equities, gold, insured deposits and bank notes “under the mattress”.
New systemic risks, worse social divisions
It will be a dizzying ride.
Also, central banks risk creating more risks for investors and deeper divisions in society.
There is the problem of the growing correlation of asset classes globally. This is a function not only of globalisation but also of the similarity of central bank methods and mindsets. Central banks have created a new and very dangerous type of systemic risk. They have made it more difficult to diversify risk.
All this is also making for deeper divisions in society. For example, investors have benefitted personally from the weakness of the recovery, as it has given central banks every reason to maintain QE and ultra low rates. Such divisions fuel resentment and the sense that capitalism is failing.
The real answer is to spread the benefits of equity ownership far more widely. But that is a topic for a future column.