How to Prepare for Upcoming Stagflation

Recently markets have been shook by rising interest rates in the US. Interest rates around the world are somewhat correlated because of globalization. Australian banks often borrow from overseas (even from the US), so if interest rates rise overseas, this affects the cost that Australian banks pay to borrow money. The ASX200 chart below shows the correction in recent weeks.

the beginning of an xjo crash september 2018
Source: Bloomberg

How may the stock market crash?

Even though it is not wise to try to predict markets, my hunch is that a very large correction is near, but it may be delayed until around 2020. During the 2009 GFC, the threat was deflation i.e. prices going down, which means prices of e.g. property and shares went down as well. The solution to this was unprecedented money printing around the world. The printed money was used to purchase government bonds (in the US) or even stocks or ETFs directly (in Japan). When there is deflation, money printing is an easy fix because money printing puts more money into the economy, generating inflation, which cancels out deflation.

However, this time the fear is that when the market crashes, it is not a deflationary crash. Rather, we have a downturn while there is inflation at the same time. Why would there be inflation at the same time as a downturn? For example, take the US-China trade war. If US companies and consumers cannot import cheap goods from overseas, consumers and US businesses face higher costs. Higher costs cut into margins, which reduce profits, which reduce stock prices. If the trade wars heat up, US equities should decline futher as inflation increases. Usually when there is inflation, the central bank can combat inflation by raising interest rates. However, US businesses are already highly indebted. If the US central bank (the Federal Reserve) increases interest rates to combat inflation, businesses face higher interest expenses, which cuts into their profit margins and reduces stock price.

This dilemma that the Fed faces, in my opinion, will present a problem in the future and may usher in a 1970s-style stagflationary recession.

What can be done to protect against a downturn?

In a previous post, I spoke about the importance of the “age in bonds” rule. The “age in bonds” rule is just a guide. It doesn’t literally mean you must hold your age in bonds (e.g. if you are 30 then you hold 30% bonds).  “Age in bonds” is a rule of thumb. The complication comes from the fact that some bonds are risky (e.g. emerging market bonds, corporate bonds, etc) whereas some shares are arguably safe (e.g. utilities, gold mining stocks, etc). The basic principle behind “age in bonds” is to reduce risk or volatility in your portfolio as you are nearing retirement so that you are not exposed to e.g. a 50% decline in your wealth just before you retire.

“My personal, non-retirement accounts are about 80 percent bonds and 20 percent stocks, reflecting my old rule of thumb that your bond allocation should roughly equal your age. It’s spread across different bond funds, like the Vanguard Intermediate-Term Tax-Exempt (VWITX). I’m a pretty conservative guy.”

~Jack Bogle, Vanguard Group Founder

Given that I live off dividends, consider myself somewhat semi-retired, and don’t really have a fixed retirement date, I feel it is wise for me to reduce risk in my portfolio much moreso than the average person. For the average person in their 20s or 30s, they may feel that they don’t need to worry about a huge market correction because they can simply make up for the lost wealth by working longer. However, I don’t like the idea of being forced to work when I don’t need to.

Furthermore, even though many people feel as if they can withstand a huge market crash, if a 70% decline eventually does occurs and the reality hits that they have lost hundreds of thousands of dollars without any guarantee that the market will recover in the long run (remember that in the recovery may be many decades away and may be in the next century), I feel that many people would succumb to panic.

Which ETFs perform best in a bear market?

During the recent market correction, I was observing the reaction of different ETFs. What I found interesting is that MNRS, a gold mining ETF, shot up as the XJO went down. See the Bloomberg chart below, which shows MNRS (in yellow) shooting up as the XJO (in black) heads down.

xjo MNRS HBRD QAU and BOND during september 2018 correction
Source: Bloomberg

The large increase in gold mining stocks contrasts with the price of gold, which is represented above by the QAU ETF (in red), which holds physical gold. This makes sense since holding pure gold only provides you with access to gold whereas gold miners usually hold debt, which means they are leveraged to gold. The blue and aqua above show hybrid and bond ETFs, which both remain very stable.

Looking at the last six months, we can see how these ETFs perform not only during a bear market but also during a bull market. We can see that as the XJO goes up, the gold mining ETF and physical gold ETFs go down, which is not ideal. The bond and hybrid ETFs are stable as expected.

Gold miners and bonds vs stocks
Source: Bloomberg

What does this tell us? If you were shaken up by the recent market correction and feel that more risk is coming, a quick way to reduce risk in your portfolio is to buy physical gold and gold mining ETFs. This can be ideal if you don’t want sell shares and trigger capital gains tax. Gold miners are also legitimate companies in their own right. However, the problem with physical gold is that it pays zero passive income, and gold miners historically pay little in dividends. In contrast, the government bond ETF (BOND) pays about 2% in yield whereas the bank hybrid ETF (HBRD) pays about 3% to 4% in monthly distributions, so if you feel you have far too much risk in your portfolio, you can correct it fast by buying gold, but once you have derisked your portfolio sufficiently but still want to tread cautiously, you can take advantage of passive income with bond and hybrids, as well as some high dividend ETFs as well (e.g. IHD, VHY, EINC, etc).

Trump Inflation Will Hurt Families

Many people complain that government spending and debt was high under an Obama Administration, but government spending and debt will still rise under a Trump Administration.

Whereas the Democrats tax and spend, the Republicans will spend and spend.

Trump will increase government spending with a massive government infrastructure program. He will also lower corporate and income taxes.

Lower taxes and higher spending means more money going out and less coming in. You don’t need to be an accountant to know that if there is more money going out and less coming in, you need to either go into debt or print more money.

Either way, the amount of money in circulation will increase, which will cause inflation (see “Investors are betting that Trump will be the inflation president“).

This is very bad for families because although money can be printed from thin air, value cannot be. The more money there is, the more inflation there is, which means the cost of living is higher, and families tend to spend a lot.

Thankfully, I am am single and childfree. No wife and no children means I don’t need to spend much money. I only feed one mouth rather than three to five.

My recommendation to others is to live a minimalist lifestyle and invest your money in assets that go up with inflation (e.g. stocks, property, gold, and inflation-indexed government bonds). The breadwinners in families with massive costs of living will need to slave away in a desperate attempt to keep on top of the inflation that will ravage their household finances.

How Money Printing Can Fail

The world economy came crashing in 2009 but was rescued through money printing. Standard economic theory would say that money printing would increase inflation, but we haven’t seen that.

If anything, the threat has been deflation (prices falling), and central banks lower interest rates or print money to cause inflation and fight deflation.

Lower interest rates encourage more people to borrow, and borrowing increases the money supply, so the effect is similar to money printing in that there is more money in the economy.

When people are confident, they tend to borrow money so that they can e.g. expand their business or buy more shares or real estate so that they can make even more money. However, when people are bearish, they don’t borrow because they may not be able to make enough money to pay off the loan, and so they tend to focus on paying off the debt. If going into debt increases money supply, paying off debt does the opposite, which is reduce the money supply. Paying off debt destroys money, which leads to deflation.

The game central banks seem to be playing is to wait for a dip in the market or a time when there is falling confidence and hence there is deflation. Then they lower interest rates or print money. People then expect the higher money supply will push up the prices of the property, shares, businesses, etc that they hold due to higher money supply increasing inflation, and then they borrow or leverage more, which pushes the market back up.

In theory, this can go on forever. As deflation occurs, just stimulate more.

There is one problem with this, which is what happens when money is printed but the recipients of printed money don’t do anything with it because they are concerned and want to “wait and see.” If interest rates are lowered, the expectation is that people will borrow more, but what if they don’t? Even if interest rates are zero, if returns on investments are negative, it’s not worth borrowing to invest. Likewise, if the recipients of printed money feel that all investments are poor and that the best use of money is to just leave it as cash, then this reduces the so-called velocity of money in the economy, which is deflationary.

In the past, assets produced great income. However, as money is bring printed in record quantities and interest rates are lowered, people are grabbing that easy money and investing it. If, say, a house in South America produced a rental yield of 10 percent, then as investors borrow money and buy the house, the prices go up, which lowers the rental yield. As the yield goes down, investors search for other assets. This is the so-called global hunt for yield.

As the global hunt for yield continues, investors need to search far and wide to find returns. Two ETFs have been released for the ASX that satisfy investor appetite for yield. There is an ETF that invests in junk bonds, i.e. lending money to bad companies (iShares Global High Yield Bond (AUD Hedged) ETF). There is also an ETF that lends money to emerging market governments (iShares J.P. Morgan USD Emerging Markets Bond (AUD Hedged) ETF).

As interest rates and money printing intensify, investors may reach the point where the global hunt for yield ends because all avenues will be exhausted. Investors then either don’t borrow at all or if money is printed and thrown at them, they do nothing with it. This bubble in yield pops.

This is when stimulus fails, and it looks like we are getting close to that day.