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).

Why the Crypto Market Is Not a Bubble #Podcast

With the rapid rise in value of the crypto market to more US$500 billion as of December 2017, many are calling cryptocurrencies a bubble simply by looking at the chart that shows prices rising substantially. However, it is important to understand that a bubble cannot be determined with reference to a steep rise in price. Rather, there is a bubble if the price is greater than the intrinsic value of the asset, and cryptos, I will argue, do have very high potential intrinsic value.

Why Save Money If You Love Your Job?

Many people tell me that they love their job, so they don’t want to save up any money. They are happy to spend everything they earn.

When I started working, I noticed that many people had this attitude. They said they loved working and they envisaged themselves working for the rest of their lives. With this carefree attitude, they took on mortgages, got married, and had multiple children. They assumed that their salary would be there forever, so they behaved as if this were the case.

Then the organization I worked for announced that, due to the 2009 global financial crisis, there would be job cuts. A spill and fill was performed and about 40% of people lost their jobs, and many of the people who lost jobs had huge mortgage debts and multiple children.

I don’t know what happened to everyone who got fired. Many of them were old, which makes it less likely for them to find another job. Some were able to get other jobs, but they mainly just grabbed onto whatever they could find because they were desperate for some income to feed their children and pay for whatever obligations they had.

I remember when I started working. I was enthusiastic and passionate. I had just finished university and was entering the workforce for the first time. I thought I would work forever as well.

After the restructure, I realized then that even thought I started off loving my job, the downturn in the economy forced management to fire people, and the working environment became toxic as a result.

Things change, and you must be prepared for change.

Your circumstances today will not necessarily apply tomorrow. The only constant is change.

This is why having money saved up is important. If you have enough money saved up, you can live off your investments forever and never need to worry about working. This is why you must live off dividends.

It was after this painful incident that I realized that I needed to save up and invest. About six years later, I am still working at this organization, and the horrors of the past have been forgotten, and people are once again telling me that everything is fine, the economy is great, that I should get a mortgage, buy a sports car, etc.

But I know from experience that things can change quickly.

This is why you must save money. You must be prepared for change.

The Dismal Future of the Australian Economy

gold price vs asx200 27 august 2015
GOLD vs the ASX200 (Commsec)

The recent volatility in stock markets has gotten me worried. Everyone keeps telling me to relax because “economic fundamentals are sound,” but when I ask them to explain how this is true, it’s revealed that they don’t really know what they’re talking about. It seems that most people just hope for the best and rationalize away bad news.

The Chinese stock market is certainly wobbly. Some say the Chinese economy is very healthy. After all, they have low debt and a massive foreign exchange reserve. They are the biggest lender nation in the world with the USA the biggest creditor nation. However, we don’t really know much about the true size of China’s debt because there is significant activity in the underground economy that is not transparent, and I’m not too confident in official figures provided by the Chinese government. Of course, China has been manufacturing products from t-shirts to smartphones, but the government has in recent years been intervening in the economy to prop up the stock and property markets. It’s uncertain whether these distortions can be held together by the government or whether the market will eventually strike back.

America has resorted to printing money, which has resulted in surges in the stock and bond markets. However, unemployment is still high and wage growth is low. Printing money doesn’t seem to have done anything other than make the holders of stocks and bonds wealthy (these are mostly wealthy people anyway).

In Australia, our economy used to be dominated by two sectors: the banks and the miners. The miners dug resources from the ground and shipped them to China. China makes goods and ships them to US consumer who buys these goods.

But the American consumer (or consumers from any other developed country) is not buying as much as they did before the GFC. This means China is slowing down, the price of resources is dropping, and the mining sector in Australia is getting crushed. We only have the banks left, and how do they make money? The balance sheets of Australian banks is mostly in loans to consumers who buy real estate. Real estate prices have been going up thanks to profits from mining. In other words, banks do well because house prices have been sustained by profits from the resources sector. Now that mining is dead, what will sustain us? Where are our strong fundamentals? House prices only go up with people buy houses, but to buy houses you need to make money in the first place. You can’t make money from houses without putting money into it in the first place.

Many who have bought stocks have made great wealth from quantitative easing, but now that tears are emerging in a bubbling world economy held together by printed money, it’s time to look at investing in gold.

Gold tends to shoot up significantly when stocks tumble, and when stocks go down, gold tends to go sideways or go up anyway, so there doesn’t seem to be any downside to investing in gold.

Personally, I will be buying this shiny metal from now on.