By Eric Peters, CIO of One River Asset Management
“Today’s announcement has the potential to be a game-changer,” said Biden, from the White House steps, directing attention to the Port of Los Angeles and its newly extended hours of operation. “Private sector companies need to step up as well,” pleaded the President, scrambling to grease America’s rusty supply chain.
Nearby, the Bureau of Labor Statistics released its consumer price index for September. The CPI rose +5.4% from 2020. And a few blocks away, the Social Security Administration considered the arguments for and against transitory inflation, then hiked next year’s benefits by +5.9%. That’s the largest cost-of-living adjustment in 40 years, and a reminder that the lags in inflation are integrated into public policy. In 2020, the inflation adjustment was just +1.6%. But that was before consumer prices jumped +5.4% – inflation cut 3.8% of purchasing power from seniors living off social security. And they’re not alone. This time last year, investors who sought the safety of risk-free 10yr Treasury notes (+0.74% yield back then) lost -11.19 % when measured on an inflation-adjusted basis. What connects these two stories is that both Social Security commitments and Treasury securities represent government liabilities.
And the net present value of those liabilities is impossibly large to meet – in real terms, at least. So the government’s long process of lightening its burden from that real liability has finally begun.
If successfully coordinated and executed by the Fed, Treasury, IRS, regulators and elected politicians, inflation rates will be guided to remain well above nominal interest rates for decades. That’s what the inflation-index Treasury market is signaling. By design, the process will destroy vast sums of capital because private-sector assets are the government’s liabilities. And our job as investors is to adapt to this new environment. The starting place is to view it all as neither good nor bad, but rather an inevitable process that simply is – a world of nominal illusion.
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After decades of coordinated government policy that prevented widespread capital destruction in each and every recession, we unsurprisingly find ourselves with an overabundance of it. Interest rates remain so low not simply because the Fed set rates at zero and buys $120bln of bonds per month. When there is too much of any commodity, its price declines. And until the supply of capital shrinks meaningfully, or demand for it rises materially, the interest rate that borrowers are prepared to pay for something so abundant will remain low.
Of the many lines that divide our fractured world, the darkest separates young and old. For decades, Baby Boomers advocated for an economic and entitlement structure that favored the old relative to the young. The ageing now overwhelmingly control societal wealth and have granted themselves entitlements that claim an outsized portion of future economic output. The young are expected to produce this for them. Baby Boomers also saddled their offspring with a climate crisis. And the young are no longer willing to tolerate the status quo.
Much of the tension we see today emanates from competing interests between young and old. This gets obscured by those with an interest to divert attention. But economics doesn’t lie for long. And systems that swing too far from balance are usually drawn back toward center. So the pressures to deprive the old of the wealth they accumulated and the entitlements they granted themselves has begun. The path this process takes will define markets for decades. The fight will be wicked. Agonizing. It has started by haircutting the wealth of those who own bonds.
The worst possible investment environment for wealthy old people is a high inflation environment with (1) very low yields on risk-free bonds, and (2) extremely high valuations for risky assets. Low yields deprive old people of a way to mitigate their loss of buying power. So they grow poorer unless they take market risk. But when asset valuations are historically high and increasingly disconnected from economic reality, old people who buy them run the risk that prices crash. Without income to recover from such losses, such a situation is rightly terrifying.
US inflation over the past year was +5.4%. Old people who own risk-free 10-year Treasury notes to secure their retirement lost -11.19% of their real purchasing power in that period (bond prices fell and inflation rose). Those who owned investment grade corporate bonds lost -4.8% of their real purchasing power. In a great irony that foreshadows the generational stresses ahead, old people who own gold to hedge inflation lost -12.8% of their real purchasing power in the past year (prices fell -7.4% and inflation rose +5.4%).
The people who maintained their real wealth in the past year did so because they owned risk assets. The S&P 500 return including dividends was +30.3%. After discounting that by the +5.4% rise in the consumer price index, the real return was +24.9%. House prices rose +19.7%, and on a real basis were +14.3%. Food price indexes jumped +30% over the past year, gasoline and copper prices leapt +50%, oil doubled, and natural gas surged +150% in the US. But few old people own such things. They consume them. And the one thing old people are unwilling to risk their money on is digital assets. Bitcoin surged 441%. Ethereum soared 920%.
There are two good things about being young and broke. The best part of course, is that you are not old. But you also have little to lose. And that is liberating for a person with decades to recover from taking risk in ventures that might fail.
Having a large group of such youth is an invaluable asset for the older citizens supported by their innovations and output. But powerful forces, if improperly managed, create havoc. So all successful societies strike a healthy balance between the competing desires of old and young. Nations that favor the former to the detriment of the latter suffer upheaval. This is roughly where we are now - nor are such dynamics limited to the US. And they are amplified by a world with a rising proportion of unproductive elderly.
Our youth, in a system they increasingly recognize as profoundly unfair and biased against their interests, are doing as they should: advocating for vast spending programs to build a green infrastructure and social system that reflects their priorities, unconcerned by the resulting inflation that will erode the wealth of their elders.
With powerful new blockchain technologies, many are building businesses to bankrupt their parent’s incumbent industries whose lobbyists calcify what our youth see as an unjust status quo. They are fleeing high tax states with bankrupt entitlement systems, for cities like Austin which they then remake in their image. As elderly gold owners writhe in portfolio pain, confused why the price of yellow metal is falling with inflation rising, our young people look to the digital future, buying bitcoin, ether. Solana. NFTs.
And as investors, our job is to recognize such trends, capitalizing on the opportunities they create, mitigating the risks such periods of upheaval produce. And in this new world, transitioning from old to young, unsettling inversions emerge. The strategies we previously turned to for safety have become risky. While unfamiliar investments that at first appear risky, provide safety.