Then and now… financial uncertainty

Welcome to 2021. Normally I would write something in December, a reflection on 2020 and what I think 2021 has in store for us. Instead, I wrote an irrelevant piece on losing cell phones. Hope it was amusing. Why did I do this? Because frankly I was at a loss as to what to make of 2020, and 2021. It feels unlike 1987 (stock market crash), 1999 (financial crisis) or 2008 (US housing bubble). From what I have read of the great depression in the 1930’s, it is unlike that too.

2020 was a year of crisis, invented or real, it doesn’t matter. A year of uncertainty, a new reality, unprecedented fiscal stimulus and money supply expansion. The results felt unsustainable and the underlying threat felt present at all times. A year of holding your breath, a bit like France in the spring of 1940, the phoney war.

It’s all ok though, the sun is still shining, the music is still playing and life, while changed in some ways, is still ‘good’ for most. But as we welcome 2021…

1. The world is in various degrees of living with Covid and its mutations while enduring the continuing management / mismanagement of government responses.
2. We leave 2020 with the USA in political, economic, and social disarray. Other countries will endure a similar fate in coming years, and I expect more countries to welcome strong governments in the future.
3. Our borders remain closed; however, Kiwis overseas are still returning home to a perceived Covid-free homeland.
4. Foreign migration has dropped to a trickle, and foreign students are all but absent.
5. Governments have absorbed, increased public debt, and the financial system has been bloated with cheap credit fuelled with printed money (quantitative easing).
6. The independence of the Reserve Bank has been compromised and the Fiscal Responsibility Act was nothing but paper.
7. Interest rates have descended in real terms net of tax to negative rates at what historically are very high levels (high negatives!) and asset prices have increased across the board without such increases being backed by increased real economic returns, i.e., increased profits, rents, or dividends. 
8. Consumer inflation is muted, mostly contributed to by low interest rates, but food, consumer goods, and imported consumer durables are beginning to inflate strongly.
9. Capital goods and construction costs are inflating strongly, and construction capacity is severely constrained, (mostly on the public works front), with roading, rail and all manner of public works consuming design planning and construction capacity.
10. International logistics and production disruption in Europe (and elsewhere) is resulting in stock outs, and the lead times to get stuff made or repaired is extending out. It is only a matter of time before a small, imported part breaks in a critical network. Of course, this risk has been compounded by just in time logistics and inventory management practise. Bugger, the balance sheet efficiency and finance sector analysis of business that drives such behaviour agnostic to risk.
11. The ‘Green’ spend and defining global warming as a crisis, is consuming time, energy and absorbing investment etc. It is increasing the costs of production.
12. Minimum wages and living wages are squeezing profit margins.
13. Wage subsidies have secured businesses that would otherwise have failed – thus weakening the strong.
14. And obviously the size of government is increasing rapidly which has the effect of squeezing out the private sector.

Dystopia, i.e., general dissatisfaction and unrest identified as a major issue in 2008 by the World Economic Forum is gaining momentum. Previously focused on income and wealth disparity generally, it is now focusing on wealth disparity on a demographic age basis. We now have talk of active trans-generational wealth redistribution from the ‘Baby Boomers’ of their wealth, prior to their death. Umm remind you of any other history? Obviously and ultimately, we all die, and the wealth redistributes generationally. Appropriating from the Baby Boomers to the state is a misappropriation from the Boomer children.

I could go on, there are so many nuances, economically, emotionally, and socially that it is incomparable in combination. 

It is so different from what has come before any comparison is dangerous. The root of past crisis’s, at least in my lifetime, was confidence or fraud and mismanagement.

1987 was a 1929 event where in effect asset values fell. The assets were, in reality, the same as they were before, simply confidence changed direction suddenly. In short it was a confidence-led crisis. This led to a banking crisis, as the assets that secured the bank lending had lower values, and when capital confidence eroded, sure as night follows day, consumer confidence followed.

1987 was a little different to 1929, in that central government understood the power of fiscal stimuli and provided it (within the constraints of some semblance of prudence) and we had a safety net to deal with real rather than relative poverty.

2008 was different again, this time it was a banking crisis, that led the confidence collapse with the banking crisis being induced by poor lending and disclosure practises and arguable fraud on a massive scale within the banking sector. With liquidity drying up, asset values fell following the banking crisis. Confidence fell in response to asset value declines. The governments found new tools, including the tool of printing money and guaranteeing bank deposits to restore confidence.

2020, was different. We have a crisis induced by a physical event, a pandemic. This is on top of the long and enduring demographic wave of aging populations and consequentially a wealth concentration in a sector of the community, and a slowing in both innovation and long-term investment as a consequence (old people don’t buy green bananas).

Add to that a debt expansion cycle running over 80 years, and any observer would say the debt crisis is beyond anything in our lifetimes. Real economic activity in the private sector has declined, yet the population remains confident enough to re-rate the required rate of return for risk across the board to historically unheard-of levels.

In short, all asset classes have inflated to the point where any observer of history would say we have an absolute bubble bath!

In every other crisis that I have faced as an investor, I have always been clear on what I needed to do and what my businesses needed to do. I was also clear in early 2020 as lock down started on what I needed to do. But I enter 2021 uncertain. Perhaps this uncertainty is symptomatic to the end of economic and business theory as we have known it for the last 100 years. Perhaps this is the end of one cycle of madness, and the beginning of another. Perhaps we are witnessing the death and rebirth of the world as we know it, perhaps we no longer know anything, Perhaps, it is a ‘new paradigm’ The only thing that is certain is that the sun will come up tomorrow.

So, what did I do in 2020?

As I have written before, in March I was in the USA, just as the pandemic was breaking out. The market response was a rapid collapse in listed company share values across the board globally. I underrated the human response to the pandemic initially, and assumed it would be short lived, and thus bought retail, airlines, and resources as the prices of these assets fell, I just bought too early.

I assumed that 2020, was a SARS or 1999 event. 

My initial response to crisis is to buy when others are selling quality assets. As the fall continued, I paused, and when we got back to New Zealand I prepared a more considered plan.

My 2020 plan in a nutshell, was:

• Build cash to protect the business’s that matter if necessary.
• Triage my investment portfolio between those that will thrive in a pandemic, locked down world from those that can’t, doubling down on those that could, if the opportunity arose.
• Hold the remainder, rather than sell into what might be a short-lived correction.
• And from this list of the businesses that don’t matter or can’t grow, attempt to sell the poorly led or poorly governed ones. Poor leadership no matter how resilient a business appears to be, usually results in them failing anyway.
• Keep the eyes open for opportunities at a sensible price in sectors that I believed would be favoured in a post-pandemic world.

The triage of listed equities was easier. Hold what I had and sell all that have at least three or more warning indicators. If that didn’t generate enough cash, move it down to two indicators.

 The warning indicators being:

• A post pandemic business model that will struggle.
• A lack of an effective digital presence.
• Too much debt (measured relative to income, not assets).
• Poor leadership or governance.

This led me to sell Air New Zealand having just bought it, at a loss. Who would have thought it would double from April to now?

In the businesses I governed or lead a simple mantra:

• Focus on cash.
• Pay your team fully and ensure you give them a sense of security.
• Check in on your customers and support them when necessary.
• Understand your supply chain and ensure that you support it – as without a community of suppliers, customers and team, there is no cash flow.
• Above all else, keep walking and ignore that which you can’t control or influence.

Eventually by the middle of the year I stopped listening to the news.

That was then (2020), 2021 is a new box of chocolates!

2021 is a year when risk has increased considerably to investment portfolios and returns have dropped – classic bubble indicators. In thinking about 2021, it might be easier to simplify. Firstly, the key settings for 2020 endure:

1. Buy businesses that have an edge in a digital world, at a sensible price.
2. Focus on the basics of the thing’s humans will need, and the logistics of how goods and services are delivered.
3. Understand the changes in human behaviour that appear to be enduring post lock down.
4. And when the un-favoured assets become cheap, buy them too.

Beyond this to get a clear survival plan, strip away the noise and rethink core beliefs, find the essence of what ensures endurance and sustainability.

Fundamentally cash is a hedge on asset value decline, and a resource for future consumption or investment on favourable terms. 

Assets are priced in the market which is prone to be irrational. Fundamentally they are worth the net present value of their future cash flow opportunities. A judgement, not a fact. When you exercise the option value of cash to buy later by buying now, the opportunity loss is the lost opportunity to buy it later, cheaper.

We are in a situation where cash now virtually has no return. Why we ever thought of cash as an asset is beyond me, it is just a hedge or a method of obtaining future optionality. The cost of this option and the risk of holding cash is a devaluation of the buying power of that cash through inflation, consumer, or asset.

Real returns on assets, be it property, listed equities, private equity, VC, you name it, are declining. This flat or declining return is being repriced upwards, and that trend has to reverse, assets carrying pricing risk, is extreme.

The psychological setting is optimism within capital markets, and the optimism doesn’t appear to have any rational base to it, risk is increasing rapidly.

The bubble-believers are selling assets, but the main herd behaviour is to borrow at low interest rates, and use the cash to buy assets no matter what the price, agnostic to risk.

If I go back to my base instinct of do the opposite to everyone else, then what do I do? Pile into cash, also an extremely risky strategy? Umm no, too many others are doing that. Most are running around, very few are sitting and doing nothing. My answer is, do not panic, do nothing, keep and protect what I have got that I care about and matters, sell the rest if some idiot wants to buy them. Gently increase cash and when head room on cash emerges, start buying new stuff that looks sensibly priced ignoring the current madness.

If I take a portfolio view on an investment portfolio and start with the simple split between cash and assets, it feels like the most sensible thing to do is to move the cash component up by 50% on the long run asset allocation, just as an insurance against a significant asset value decline and to increase the cash available to buy cheap assets later, i.e., sell assets that don’t matter.

If I had negative cash, i.e., debt I would equally sell assets to halve the debt loading, and lock in interest rates on half the remaining debt. This said, there is no government or banking will to increase interest rates for the foreseeable future.

In the past I would have placed a bet on market direction, now it is so uncertain, the only thing that I am certain about is hedging my bets. As most of you know I am no fan of modern portfolio theory.

Most are either holding high levels of cash, betting on a crash in values, or buying assets at crazy prices running cash to zero or negative territory i.e., absorbing debt and betting on inflation.

If ever there was a time for ‘don’t put all your eggs in one basket’ (in terms of asset allocation) now is that time.

For the avoidance of doubt, this is not intended to be financial advice, I am not an authorised financial advisor.