CHAPTER 12

The Investors’ Guide to Secular Stagnation

“I’ve been around, seen some things, I slept in dumpsters, got high with kings”

—Kid Rock

I have had numerous meetings with investors where the main message is something like this:

The investor feels stocks and bonds are very expensive, that private equity is too risky, and that low rates and devaluation put at risk their savings. What can they do?

The first—and most important—step is to really understand your profile as an investor.

How Risk Averse I Am

One of the things that financial repression has done to the average investor is to completely obliterate tolerance for volatility.

I remember once being called to appear on TV to talk about the “stock market crash.” I asked myself what the hell had happened because I didn’t notice. It turned out that the market had fallen 2 percent. Two percent. “A crash.”

Media and mainstream consensus fell so comfortably under the central bank trap that perception of risk disappeared and, with it, the idea that stocks and bonds do become too expensive and the marginal buyer loses confidence.

Look in the mirror and ask yourself which type of investor you really are.

I heard once from a client: “I am very conservative; I am OK with 5 to 6 percent.” This in an era where the lowest risk assets were yielding negative returns. Obviously, he did not analyze risk appetite adequately.

The central bank trap can be a good source of returns, but we also must understand that, by 2016, there are two consecutive generations of traders that have seen nothing but expansionary policies.

Therefore, we must understand our risk appetite and at the same time find good managers that are able to discern value and opportunities without repeating that “long term everything goes up.”

Bonds

When we hear, correctly, that there is a large bubble in bonds, might be too simplistic.

Not all bonds are the same.

Let us understand first why we see the bubble in bonds. Low-risk sovereign bonds yield negative or virtually zero returns and inflation expectations are rising. Therefore, bondholders that have some of these assets in their portfolio are likely to see three things:

• Negative nominal and real returns, that is, losses, on the portfolio

• Outflows of capital from ultralow yield bonds, which make them even less liquid

• A global perception that there is more value in equities, creating higher volatility

So, the first thing that the central bank trap shows us is the disproportionate risk-reward ratio in the allegedly safest assets. They become very expensive and very illiquid quickly.

The second area of risk is in High Yield. Many investors might perceive that, when inflation rises and the U.S. 10-year bond sees a better yield, it does not make sense to buy bonds of companies with very high risk and challenged fundamentals because the risk-reward is, again, disproportionate.

But there are plenty of other options.

As the Escape from the Central Bank Trap should dictate, investors must seek to cover their portfolio from the risk of stagflation and recession at the same time ... and inflation-linked bonds from Investment Grade¹ companies and sovereigns.

Inflation-linked bonds (ILBs) are designed to help protect investors from the negative impact of inflation by contractually linking the bonds’ principal and interest payments to a nationally recognized inflation measure such as the Retail Price Index (RPI) in the UK, the European Harmonized Index of Consumer Prices (HICP) ex-tobacco in Europe, and the Consumer Price Index (CPI) in the United States.²

Together with inflation accrual and coupon payments, the third driver of ILBs’ total return comes from the price fluctuation due to changes in real yields. If the bond is held to maturity, the price change component becomes irrelevant; however, prior to expiration, the market value of the bond moves higher or lower than its par amount.

Just like nominal bonds, whose prices move in response to nominal interest-rate changes, ILB prices will increase as real yields decline and decrease as real yields rise. Should an economy undergo a period of deflation—a sustained decline in price levels during the life of an ILB, the inflation-adjusted principal could decline below its par value. Subsequently, coupon payments would be based on this deflation-adjusted amount. See Figure 12.1. However, many ILB-issuing countries, such as the United States, Australia, France, and Germany, offer deflation floors at maturity: if deflation drives the principal amount below par, an investor would still receive the full par amount at maturity. So, while coupon payments are paid on a principal adjusted for inflation or deflation, an investor receives the greater of the inflation-adjusted principal or the initial par amount at maturity.

This instrument is flexible enough to provide the type of security that some investors demand and a certain kicker if inflation grows. But they are not zero-risk instruments, the investor must assess the ability of the issuer to pay the maturities and coupon, as well as the risk of suffering in the price of the bond if inflation happens and the issuing country or the currency of the issuer is significantly devalued.

Figure 12.1 Inflation-linked bonds have become very popular

Source: Barclays; PIMCO.

Bonds are not a zero-risk asset; there is no such thing as an asset with no risk.

Other popular bonds in this environment as we escape the central bank trap are those of emerging market companies whose revenues are in dollars because they are well diversified and their debt is in local currency or fully linked to the currency of their revenues. Especially if these companies have costs in local currency, these instruments have proven to be a good hedge against aggressive devaluations, sudden stop, and fluctuations in commodities.

Equities

Equities have been a tricky asset in the period of financial repression. Returns vary between sectors and the overall good performance of indexes has also been clouded by a diminishing inflow of capital.

Calls for a “great rotation” from bonds into equities did not happen in the years of the central bank trap because the entire focus of governments, central bankers, and companies was on the fixed-income market. This made investors prefer an asset class that everyone is adamant to protect over equities, where volatility and yield appeared attractive but not enough to make the switch. The prospects of profit warnings, capital increases, and weak returns in a secular stagnation did just that.

However, as we escape the central bank trap, we see that the global earnings recession that we entered in 2008 could be close to an end thanks to a pickup in inflation and improved fundamentals in countries that look to boost growth through tax cuts and supply-side measures, such as the United States.

Escaping the central bank trap involves enormous volatility, and the investor must acknowledge this risk. This is no time to talk macro and make grand statements about stocks in general.

The investor will have to focus on picking stocks where fundamentals remain attractive despite the asset inflation of the past years.

In order to do that, investors will have to analyze trends and multiples. For me, the most important combination is that of strong Free Cash Flow Yield, a Return on Capital Employed that stands a few points higher than Weighted Average Cost of Capital (WACC) (as we explained in previous chapters), and a strong balance sheet. What is most important is that the company’s management interests are aligned with those of minority investors, by having a sizeable part of their remuneration in shares and solid targets that can be monitored on a quarterly basis as the company publishes earnings.

Diversification is key, but so is recognizing the strength of the equities portfolio that investors create. Such strength will only happen if we have one sentence in mind:

Cycles are becoming shorter and more abrupt, and portfolios should be protected by being active at selling once decent returns have been achieved and churning the portfolio to adapt to new opportunities that come from the change of cycle. See Table 12.1.

Keith McCullough explains how cycles matter:

The run-up is supported by cold-hard economic data. U.S. growth and inflation are finally accelerating and the investing implications are actually quite simple. You sell bonds. You buy stocks.

Here’s why.

Unlike casual macro “tourists,” I’m not wedded to opinions or how something “feels.” The only thing that truly matters is the data. On that front, U.S. economic data has been decidedly bullish for two straight months:

Industrial Production: U.S. Industrial Production registered its first positive reading in 15 months this week, or +0.5 percent year-over-year growth. That snapped the longest streak of negative growth ever outside of protracted U.S. recessions.

Consumer Price Index: Headline Inflation accelerated for a 5th consecutive month, taking consumer price growth to its highest level in 32 months (since May 2014) at +2.1 percent in December. This effectively ended 30 straight months of inflation readings that were stubbornly below the Fed’s 2 percent target.

Add this to the long list of economic indicators now realizing positive year-over-year growth:

• Wage Growth

• ISM (Institute for Supply Management) Manufacturing

• Durable Goods (ex-Defense and Aircraft)

• Auto Sales

• Retail Sales

• Disposable Personal Income Growth³

Table 12.1 Sectors that perform in economic cycles

Economic cycle stage	Characteristics	Business cycle industries that do well in this stage	Examples
Expansion: Early Stage	Low, increasing inflation Low, increasing interest rates High unused capacity Low inventory	Cyclicals Consumer credit: Firms that are tied to the housing industry Energy: Companies that produce energy-related products Consumer cyclicals: Manufactures of consumer products that respond to the changes in disposable income	Savings and loans, regional banks Oil, coal Advertising, apparel, auto manufacturers, retailers
Expansion: Middle Stage	Moderate inflation Moderate interest rates Moderate unused capacity Moderate inventory	Basic materials: Companies manufacturing materials (not machinery) to produce finished goods Technology: Companies manufacturing high-tech products for consumers and businesses	Chemicals, plastics, paper, wood, metals Semiconductors, computer hardware, software and services, communications equipment
Expansion: Late State	High inflation High interest rates Low unused capacity High inventory	Capital goods: Companies manufacturing machinery used to produce finished goods Financials: Firms tied to loans that are in demand due to economic expansion Transportation: Companies that transport goods and passengers	Equipment and machinery manufactures Corporate and institutional bankers Airlines, trucking railroad
Recession	Decreasing inflation Decreasing interest rates Increasing unused capacity Decreasing inventory	Defensive Consumer staples: Manufactures of basic consumer products that are purchased at largely the same level through all economic cycles Utilities: Regulated companies providing products and services such as electricity	Food, drugs, cosmetics, tobacco, liquor Electric gas, water
Independent of Economic Cycles	Varied economic circumstances	Growth Industries and companies in the early stage of a life cycle: Expanding quickly and not subject to economic cycles	Biotechnology

Source: Wayne Thorp.

These are extremely important factors to understand opportunities. Growth accelerating versus growth slowing. It might surprise some that these trends change in six months, but that is because we are sold by central planners to believe that cycles are five years long or more. They are not.

That is why it is so important to follow the advice of real-time investors that have no agenda to prove and who simply follow the hard data, providing recommendations that include indicators of cycle turns, oversold and overbought, and differentiated views from consensus.

Consensus leads only to mediocrity, as I stated in my book Life In The Financial Markets, and it is very important to understand the macro and micro elements of investing while at the same time following a unique approach.

Stocks are complicated, but only if you follow the same approach as everyone else and trust investment bank recommendations. However, once one understands that the macro elements do not have to be awesome or terrible, just accelerating or decelerating, and that real multiples of cash flow and returns growth matter, the challenges of equity investment are greatly reduced.

The Escape from Central Bank Trap trade follows the simple, and at the same time complex, rule of analyzing the short-term trends and how they affect earnings to pick stocks that will give us a winning portfolio by recognizing cycles.

Some of the trends that seem to be clearer in this race to win against the central bank trap are:

Rise in Inflation comes mainly from commodities, so cycle must be analyzed to see whether the supply-demand picture of those commodities is delivered or becomes another trap.

Most economists are expecting a big increase in inflation. While there is obviously an important base effect from 2016 levels due to the stabilization of commodities, the underlying factors that drive inflation expectations remain weak. Not only is China’s growth likely to disappoint, and with it its imports and purchasing power, but the compounded effect of technology, aging population in the OECD, and overcapacity count as stronger forces against inflation expectations than the rise in oil and food prices.

The biggest risk to this prediction is that the rise of protectionism affects world trade in a more severe way than expected and price rises due to lower trade are added to weak growth to cause stagflation. Core inflation, which is what matters to the economy, is likely to remain subdued, whatever happens with commodities. Oil is likely to lose momentum as supply cuts are proven ineffective, demand—especially from China—disappoints, and U.S. and Canada supplies surge.

The EU could emerge stronger from Brexit and local elections.

It is tempting to think that the EU will collapse and the euro will break up because of political turmoil. However, with each new local crisis, the underlying factors that strengthen the euro as a currency, technical and practical, overtake the evident threatening elements. This does not mean that Europe is going to grow above estimates to 2020, but the elections and banking crises continue to make the euro project more resistant, whether we like it or not.

China will not collapse, but will likely continue weakening further. China’s imbalances were not reduced in 2016. The accumulation of debt and the massive real estate bubble, added to capital outflows, show that China is unable to tackle overcapacity and strengthen its growth model. However, growth of middle class, young population, and the fact that most imbalances are well known and denominated in local currency prevent a 2008-type collapse.

Emerging markets are likely to face sudden stop adequately and avoid collapse from strong dollar and capital outflows. Foreign exchange reserves in emerging markets have remained strong and recession and capital outflows have been tackled in the right way by most central banks. Although they are likely to face tough years, emerging economies are better prepared in 2017 for a difficult environment.

Gold and Bitcoin

A Nigerian citizen tweeted a very interesting case in 2016. He feared that his country’s central bank would break parity with the U.S. dollar. Worried about losing all his savings and faced with a huge devaluation, he decided to move his deposits to a platform that makes transactions in gold backed 100 percent by physical gold. The currency fell almost 50 percent against the dollar overnight. His small savings appreciated.

This case is paradigmatic of a trend that is happening all over the world among citizens who are looking for an alternative that protects them from financial repression, allowing them to store value, and at the same time is compatible with traditional means of payment.

Those who have accumulated a portion of their savings, even their wages, in platforms fully backed by physical gold have not only seen their money grow, but platforms allow making transactions in different currencies without suffering fluctuations and volatility.

At the same time, the central banks of emerging markets have increased their reserves of dollars and gold.

Gold multiplied in value in the period into financial repression driven by the fear of many that the economies would suffer hyperinflation. Many investors were wrong because, as we explained, QE is disinflationary as it perpetuates debt and overcapacity while money velocity falls.

This “mistake” made gold lose its speculative appeal and gold-linked financial positions (ETFs) fell from almost 3,000 metric tons to less than 1,500, according to Goldman Sachs.

However, the risk of financial repression did not end, and many investors, from China to India, saw the risk of large devaluations and the demonetization of currencies, which could put their savings at risk. Risk perception of a global currency war increased.

Fear of the confiscation of savings through monetary policy also sky-rocketed, particularly in China, as capital flights increased.

And that is why those looking for a store of value, an inflation hedge and a risk hedge, a certain element of security in the face of an uncertain environment—or a very true fear—find gold attractive.

Despite the increasing Chinese, Russian, and Asian demand, Gold has been oversupplied since 2009 and reached its peak (almost 20 million ounces of overcapacity) in 2010. That trend has reversed over the past two years, and by 2016, supply is tight.

The problem for the Escape from the Central Bank Trap trade was that, for many, the purchase of gold as a reserve of value or investment was mainly via financial derivatives that are as risky as other financial products in a crisis, and are not backed by the physical precious metal. The difference with physical gold platforms that are growing all over the world is that they democratize the access to the physical trade by selling small parts of a bar of gold, but always clearly stating that it is 100 percent backed by such ingot.

Even those who, like me, think that the risk of a crisis like 2008 is moderately contained and that what we are facing is more a period of low growth and poor inflation due to saturation of stimuli, the continuous policy of attacking the saver and devaluing supports holding a portion of savings in gold.

It is not surprising that families and companies seek to mitigate the impact of financial repression via gold with guaranteed physical platforms.

Bitcoin is a completely different proposition. A digital currency that cannot be manipulated by central banks. The digital currency, whose supply cannot be increased by political decisions, has seen record inflows from Chinese and Indian citizens on expectations of huge devaluations of their local currencies.

The resurgence of the shelters against the destruction of currencies by governments was not a novelty of 2016, but was accelerated with the generalization of financial-repression policies.

The search for ways to preserve wealth in a society which owns most of it in deposits makes citizens seek any way to avoid the assault on their savings from the massive printing of money through increase of money supply.

For this reason, the search for a currency whose control is not in the hands of States has been a constant in preserving capital for many years now.

Whenever government’s imbalances soar, the “solution” almost inevitably comes from “dissolving” the wealth of citizens and appropriating it via inflation—the tax of the poor—and devaluation.

The difference between bitcoin and gold in recent years is basically that, while one has been rising fast as a possible currency and as a store of value, gold was seeing a more stable increase in value.

“Bitcoin is the beginning of something great: a currency without a government, something necessary and imperative.” Nassim Taleb

Bitcoin is not yet a reality as a free currency for global use; its evolution depends on the ability to implement it globally and clarify doubts about its security against hackers and its value as a refuge.

Bitcoin is a currency start-up. A means of payment where States cannot interfere in the amount and cost of money available, where it is not possible to create fake money not backed by savings, and where one can “escape” and take refuge from the assault of central banks on the saver. Doubts come because the “shelter” is virtual and therefore always subject to computer attacks.

Bitcoin is proving to be a powerful exchange network and its revaluation shows that those who trust in that network maintain their positions in the medium term. As the increase in supply is limited, it is revalued in the face of increased demand.

A financial asset where its scarcity, future demand, and quality are valued against the possibility of exchanging it for other currencies, goods, or services in the future.

The fact that you can liquidate that asset and pay debts and taxes with the profits generated is positive. But it is not a currency until it can be used as a generally accepted means of payment for goods, services, taxes, and debts.

What bitcoin and the revaluation of the gold in 2016 showed us is that a growing part of the population continues to look for ways to shelter their savings against devaluations.

The Central Bank Trap and the Risk Hedge

At the end of this book, what I try to show is that even if the reader is a casual investor or a professional, we need to be used to the idea that:

• Believing that central banks will be there to shelter savers from risk does not work.

• Monetary policy may have succeeded in hiding the perception of risk, but accumulation is happening and volatility will rise.

• By definition, it does not make sense to find shelter from systemic risk by investing in the same assets that are accumulating such systemic risk.

Financial crises always happen due to the accumulation of exposure in assets that consensus and mainstream believe have little or no risk.

Economic cycles are not changed by macro policies, the effects of trying to cover imbalances with monetary laughing gas come back again with much more aggressiveness when credibility is lost.

Our Escape portfolio does not try to provide a one-stop solution for investors—that depends on their risk profile. There are no bad asset classes, just bad risk decisions when we deny cycles and decide to hold on for too long to winning bets.

That is one of the clearest mistakes that happen when we ignore that cycles are shorter, failing to take profits on good ideas.

Escape from the central bank trap can only be achieved by avoiding consensus bets and diversifying exposure so that our savings can be protected from the voracious appetite of inflationists.

A solid combination of sound fundamental bonds linked to inflation, rock-solid earnings and return-generating equities with maximum alignment of interests between shareholder and manager, and gold and alternative currencies, well diversified and managed actively, is, in my opinion, the best way to secure wealth and capital appreciation in this end of central-planned faith in alchemy.

Conclusion

The reader may have seen that this book is critical, but it is also hopeful and offers ideas based on pragmatism.

Central banks will continue to exist, and what I have tried to present here are ideas that some may share and others may not, but that can be implemented to cement credibility and avoid the enormous risk that is building up all over the world by denying the existence of bubbles and placing no interest in the rising tide of anger against mainstream monetary and economic policies.

The fact that there are risks should not preclude us from deciding to put our money to work, because if we do not, there is one certainty. Our savings will be worth less and less.

There is a tremendous opportunity for the world to show that financial operators, governments, and central banks can reorient their incentives to put their enormous power to reignite the growth of the middle class.

This growth of the middle class and improvement of the economy will come from a much more prudent approach to monetary policy: Make increasing disposable income the highest priority and let the private sector decide when and how investments should be made, allowing productive debt to overtake gratuitous deficit spending.

The central bank trap was not created in bad faith, and we must acknowledge that there have been some positives as we tried to note from the messages and policies of some of the governors. But the key message here is that we are dangerously close to crossing a line where uncertainty is taken over by panic and where citizens may simply lose any small element of trust in the system.

If panic was to arrive, it would catch central banks with no tools at all to mitigate the risk. Moving to negative rates after multiplying central bank balance sheets would not solve anything. Another QE after all that has been done would cause a total loss of faith in the system and blaming the wrong guys for the mistakes of policymakers.

It is time for supply-side policies and lower taxes and to allow companies to invest if they see opportunity, letting them seek those opportunities without constant bureaucracy burdens. Let families save, if they so desire, and consume the money they have earned working hard every day.

This will, in turn, lead to a more sustainable growth, where taxation is a means for improvement in public services, not a burden for growth and a perverse incentive to increase imbalances.

There are two sides to every story. The Keynesian reader may think that central banks have been the heroes of the crisis and that all the negatives happened due to reckless private companies. If that is the case, the Keynesian reader should also be alarmed at the insanely low bond yields and the amount of money created to generate such poor growth.

Whatever you want to believe, even if you still believe in “it would have been worse,” “this time it’s different,” and “we have to repeat,” there is one certainty.

The indiscriminate creation of money not supported by savings is always behind the greatest crises.

The escape from the Central Bank Trap is urgent.

It can be done in a way in which growth is stronger, citizens are better off, and perverse incentives are, at least, controlled.

Inflation is not an objective, it’s an outcome.

Real productive investment is not decided by a committee that suffers no consequence if it fails.

Central Banks Don’t Print Growth.

Let’s rebuild the middle class.

London, January 2017

¹ Those companies whose credit fundamentals are highest rated.

² Source: PIMCO education.

³ Buy Stocks, Sell Bonds! The Economy Is Accelerating.