Chancellor: The battle for investment survival

Reuters
Reuters

LONDON (Reuters Breakingviews) – In a world dominated by passive investors, financial genius consists of owning an index fund in a rising market. That’s been the happy experience of American investors in recent years. But several of the forces that have underpinned financial markets for decades are now going into reverse. Investors need to hedge their portfolios against inflation and bursting bubbles. That requires a more active investment approach.

Four long-term trends have propelled the great bull market in U.S. stocks: the decline of inflation, ever-lower interest rates, the rise of globalisation and the embrace of shareholder value by corporate managers. Quiescent inflation allowed central banks to support financial markets with unconventional monetary policies during periods of turbulence. Falling interest rates helped push up the value of stocks and bonds. The advance of globalisation further dampened inflationary pressures.

Not only did China provide the developed world with cheap exports, but Western companies boosted profits by manufacturing in low-cost regions. Companies that pursued shareholder value – which deems that management’s main role is to maximise the market value of a business – used cheap debt to buy back their shares, thereby boosting their earnings per share, and their stock prices.

All these trends, which over the years have created trillions of dollars of financial wealth, are now going backwards. Inflation in the United States approached 8% in February, its highest level since 1981. Caught asleep at the wheel, the Federal Reserve is now in inflation-fighting mode: it raised the federal funds rate by 0.25% in mid-March, with a further six hikes expected over the course of the year. Russia’s invasion of Ukraine has further shaken faith in globalisation. Corporations face rising input costs and need to reconfigure their supply chains. Higher interest charges are set to make buybacks less attractive.

Milton Friedman’s claim that the company’s social responsibility is to maximise its profits finds fewer advocates in today’s boardrooms. Instead, management teams are prioritising social and environmental concerns. The Securities and Exchange Commission is also making life harder for activist investors and wants publicly traded companies to comprehensively report their climate risks. Whatever the merits of these regulations, they are likely to push up costs in the near term.

Passive investors are therefore in a perilous position. Despite some wobbles in recent months, the U.S. stock market remains at bubble levels. Having captured all the upside of the bull market, index funds are exposed to whatever downside is in the offing. As long as inflation persists, the traditional buy-and-hold investment approach is likely to deliver volatile returns and, given current valuations, the real possibility of permanent capital losses.

Whether they know it or not, investors are engaged in “The Battle for Investment Survival”. This is the title of the 1935 investment classic by an American stockbroker named Gerald Loeb. Loeb’s investment philosophy was shaped by the harrowing experience of the Great Depression. 

In his view, financial markets were dangerous places and the business of preserving capital, let alone compounding it, was fraught. Loeb rejected conventional nostrums: he didn’t believe investors should be fully invested at all times. Nor did he believe that one should buy and hold stocks. He also rejected diversification. Instead, Loeb recommended that capital should be “deployed like a rabbit darting here and there for cover”. For most of the time, investors should keep their powder dry.

Markets are roiled by so many unexpected events – politics, war, and shifts in public sentiment – that safe investment was impossible. To protect capital it was necessary to speculate, said Loeb, taking large bets when the opportunity arises and cutting losses whenever they appear. Forget about the long run: it was easier to tell what lies immediately ahead than in the distant future. Short-turn trading, Loeb claimed, is “certainly the safest form of speculation that exists”.

In every respect, Loeb’s advice is the opposite to that of his more celebrated contemporary, Benjamin Graham, the author of “Security Analysis”. But while Graham suffered major losses in the Great Crash of 1929, Loeb claims to have sold all his stocks before the market tumbled. 

In later editions of his book, Loeb considered the problem of inflation. In his view, the preservation of purchasing power should be the prime aim of investment. But this was no easy task: “The investor buying inflation hedges is more apt to get into trouble than keep out of it,” he wrote. “Stocks are only good inflation hedges if bought at the right time and at the right price.”

Inflation-hedging is also the subject of a thought-provoking recent essay https://www.ruffer.co.uk/en/thinking/articles/the-ruffer-review/2022-02-perils-of-yesterdays-logic by Henry Maxey, chief investment officer of London-based Ruffer LLP. Inflationary pressures may be around for a time, Maxey points out. The path to inflation is not straight but has many twists and turns. Since the modern financial world is highly leveraged, it is acutely sensitive to rising interest rates. The danger is that when the Fed taps the brake pedal in order to slow inflation, Wall Street will fly straight through the windscreen.

Given these circumstances, it is pointless to invest for the inflation endgame. Instead, Maxey says investors should hedge against inflation volatility – the prospect that the market’s psychology switches abruptly from fears of inflation to concerns about deflation, and back again. This requires an active approach to investment. It’s time to turn off the investment autopilot, proclaims Maxey. As the great management guru Peter Drucker once wrote: “The greatest danger in times of turbulence is not the turbulence. It is to act with yesterday’s logic.”

The Fed is now tightening. Positive fiscal and monetary policies are in retreat. Inflationary pressures, Maxey predicts, will fall sharply when the tripwires are hit. At this point policymakers will hit the gas pedal, again. Passive investors and inflation-hedgers are likely to get whipsawed. There’s one simple way to stay out of trouble, recommended by both Loeb and Maxey: hold plenty of cash in reserve. As Loeb points out, while inflation erodes the value of money over a period of time, stock markets can evaporate fortunes in a flash. Let the battle commence.

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(Editing by Peter Thal Larsen and Oliver Taslic)

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