Friday, December 14, 2012

Richard Duncan: Wealth Preservation through Diversification

The excerpt below is from the final chapter of The New Depression by Richard Duncan on inflation and deflation.

Wealth Preservation through Diversification

The hard truth is that it is not easy to preserve wealth. If it were, the families who were wealthy 200 years ago would still be wealthy today—and generally, they are not. In the very harsh economic environment that is likely to prevail over the next ten years, it is likely that a great deal of wealth is going to be destroyed. The economic system is in crisis and government policy, rather than market fundamentals, will determine the direction of asset prices. If the government fails to borrow and spend enough, the economy will collapse into a deflationary spiral. If it borrows, prints, and spends too much, there will be very high rates of inflation.

Future government policy simply cannot be foretold with any degrees of precision. Active wealth managers will have to rapidly adjust their portfolios in response to changes in policy. That will be no easy task, even for the experts. Those unable to devote all their time and energy to deciphering the kaleidoscopic changes in the politics and policies of Washington have the option of constructing a broadly diversified investment portfolio that would ensure significant wealth preservation regardless of whether the price level moves up or down.

The following are five components of a diversified portfolio:

1. Commodities generally perform well in an inflationary environment and suffer in times of disinflation or deflation. Gold and silver benefit most from quantitative easing, which undermines public confidence in the national currency.

2. Stocks tend to rise (1) in a healthy economic environment, (2) when central banks create money and pump it into the financial markets (so long as they don’t cause too much inflation), (3) when the government runs a budget surplus and crowds in the private sector, and (4) when the trade deficit is larger than the budget deficit. The last two will be explained below. Stocks tend to perform badly when inflation at the CPI level exceeds 4 percent, in a weak economic environment, and, particularly, during a severe period of debt deflation.

3. Bonds benefit from disinflation or mild deflation and suffer when there is inflation. In the third quarter of 2011, the yield on ten-year government bonds fell to a record low of 1.7 percent. The Fed played a role in pushing the yields down by printing money and buying bonds. There was more to it than that, however. There was also a private sector flight to safety into government bonds as a result of fears that the Greek government would default on its debt, which would have resulted in a systemic banking crisis. Furthermore, U.S. yields seemed to be declining for the same reasons that Japanese bond yields had fallen after Japan’s economic bubble popped: the lack of viable investment opportunities elsewhere in the economy.

The yield on ten-year JGBs (Japanese government bonds) has fallen below 1 percent. It is possible that U.S. government bond yields will as well. However, the risk-reward tradeoff of investing in government bonds with such low yields appears highly unfavorable, particularly given the risk that inflation could easily move very much higher at some point during the next ten years.

4. Rental property can provide a relatively steady stream of income, although, as the experience of the last 15 years demonstrates, the capital value of the property can fluctuate widely. U.S. home prices have fallen by more than 30 percent on average since the crisis began and they could fall further, even significantly further in the case of a severe debt-deflation scenario. Even then, if well located, rental properties would continue to generate rental income. In a worse-case scenario, rents would fall significantly from current levels. If they do, however, most other prices would also tend to be much lower, leaving the owner relatively just as well off.

5. Financing rental properties with fixed-interest-rate debt adds a further element of portfolio diversification. Borrowing at fixed interest rates provides a hedge against inflation. Should inflation move higher, the rents would adjust upward, but the debt owed would remain the same, which would effectively reduce the burden of the debt. The risk, however, is that in a severe debt-deflation, rents would fall so much that the rental income would be insufficient to service the mortgage. A prudent loan-to-value ratio mitigates that danger.

Those are the basic options: commodities (including gold and silver), stocks (preferably stocks with a good dividend yield), bonds, rental property, and fixed-interest-rate debt. In combination, they form a broadly diversified portfolio capable of preserving a significant amount of wealth in practically any conceivable economic environment.

During a period of high rates of inflation, the value of the bonds and the stocks would fall, but the price of the commodities would appreciate. Meanwhile, the rental property would continue to generate cash flow and the inflation-adjusted burden of debt would decline.

In case of deflation, commodity prices would fall. Stock prices would also fall, but the decline would be offset to some extent by dividend income. The value of the bonds in the portfolio would rise. And the rental income would continue to generate cash flow, although in lower amounts if rents adjust downward. Mortgage payments would remain unchanged.