Why real assets should form the cornerstone of your portfolio - June 2020
The environment facing long-term investors is treacherous. We are in uncharted waters for our generation. Last week, the IMF lowered their South African 2020 GDP forecast to -8% (2.2% lower than in April and the biggest decline since the 1930s); Finance Minister Tito Mboweni announced an expected fiscal deficit of -14.6% this year and made a commitment to cut government expenditure by around 9% per year to avoid a debt trap; and Stats SA calculated annual inflation at 3%, the lowest rate in 15 years.
In a deep recession, consumer and business demand collapse. The IMF forecasts a global output loss of more than $12 trillion as a result of the pandemic, as social distancing and lockdowns caused commodity prices to fall and unemployment to surge. At the same time, unlike the experience in previous pandemics, Covid-19 targets the economically inactive more than those seeking work, meaning labour availability is unaffected. A decline in asset values and increased market volatility create a negative wealth effect, making households less confident and less likely to consume. The post-Global Financial Crisis (GFC) experience taught us that loose monetary policies, such as negative interest rates and quantitative easing, are not necessarily inflationary. It is therefore unsurprising that market expectations are that inflation rates will remain benign. If there is a concern, it is focused on the risk of deflation.
An unprecedented monetary experiment
Yet, at the same time, we are witness to an unprecedented monetary experiment coupled with a relentless increase in indebtedness around the world. The ratio of US government debt to GDP is expected to increase by 33 percentage points in 2020 to a level higher than the World War II peak. Local debt levels are also setting records, with Treasury expecting an increase of 18 percentage points in the debt ratio this year to a best-case scenario of peak debt at 87.4% three years from now. Monetary policy is extraordinarily loose. The Fed increased its balance sheet by 70%, or $3 trillion, in three months, with forecasts of another $4 - $5 trillion of asset purchases over the next year. Nearly all advanced economies have similar asset purchase programmes and the bond buying strategy is increasingly being used elsewhere too. To stabilise financial markets, the South African Reserve Bank cautiously joined 11 other emerging market central banks in launching a bond-buying programme during March. The local policy interest rate has been lower only once, briefly, back in 1973.
Repaying the debt
All this new debt will have to be repaid eventually. Some argue that repayment can happen over several decades, given that the pandemic is a once-in-a-lifetime event. The painless way to reduce the debt burden over time is through economic growth. As a country becomes more productive and thus wealthier, it is relatively easier to raise the taxes required to support current spending and repay accumulated debts. This was the happy outcome for South Africa before the 2010s, when our debt ratio fell dramatically.
Unfortunately, there are headwinds that will make it much harder to repeat this outcome. Globalisation, the major engine of low prices and rapid growth over the past three decades, is in reverse gear. This is partly due to geopolitics, with increasing tension levels between the great powers. The level of international coordination is already significantly lower in this crisis than during the GFC a decade ago. This is compounded by a change in risk appetite. Columbia University’s Willem Buiter calls it the move from just-in-time to just-in-case economics, as companies increase stock levels, diversify their supply chains and relocate manufacturing closer to home. Demographics will also weigh heavily on growth and savings, as the global population continues to age.
It is therefore likely that some of the costs of more debt will have to be socialised through different mechanisms. One obvious route is higher taxes, which, if targeted at the wealthy, is also seen by some as a way to address growing inequality. We know that this is not the core approach planned for South Africa in the near term. In recognition of significant past increases in the tax burden and a severely constrained economy, Treasury placed more than 90% of the debt stabilisation load on spending cuts, and less than 10% on additional revenue through higher tax rates.
Enter higher prices and financial repression
When debt can’t be repaid through growth alone and default is unpalatable, higher inflation provides a route out of the quandary. Couple higher prices with financial repression, where governments adopt policies that result in savers earning a rate of return below inflation, and debt can gently be inflated away over time. This was part of the approach adopted in the United Kingdom post World War II, when government debt peaked at 250% of GDP. In the twenty years after the war, inflation averaged 4.3%, compared to 1.75% in the preceding two decades. The net result: The real value of the war debt was reduced by an extra 40%, in a way that was much easier to digest than a large haircut upfront.
While a repeat of an inflationary episode over the coming decades is not unavoidable, it is a distinct possibility. Investors should ensure that they protect themselves against this risk by including real assets in their portfolios. These include inflation-linked bonds, precious metals such as gold, platinum and rhodium, shares in diversified commodity producers and equities in other businesses with pricing power.
First published in Business Day on 29 June 2020