Tags: debt | cards | gold | currencies

Is Your Portfolio a House of Cards?

By    |   Thursday, 05 June 2014 01:46 PM

The S&P 500 continues to hit new all-time highs, but is your portfolio built on a house of cards? The politics to kick the proverbial can down the road might unleash dynamics that could be hazardous to your wealth.

The one thing politicians throughout the world have in common is that they rarely ever blame themselves. They tend to diffuse responsibility or place blame on groups such as political opponents, the wealthy or foreigners.

If you now add that we have very real and major challenges in the world, it might be reasonable to assume that policymakers will continue to remain engaged in "fixing" things by blaming others. As an investor, if nothing else, this means asset prices may continue to move away from fundamentals and reflect the next perceived intervention by policymakers. This presents challenges for investors trying to maintain the real purchasing power of their portfolio and avoid a major drawdown at the wrong time.

Going forward, we might continue to see less political stability, as weakness in the real economy breeds discontent. In the United States, they vote for more populist politicians, helping to explain the rise of the Tea Party and the Occupy Wall Street movement. In the Middle East, where rising food and energy prices make up a much bigger portion of disposable income, people revolt, as they can't feed themselves anymore. In Japan, Abenomics is introduced by a populist prime minister.

Meanwhile, both monetary and fiscal policy create a more challenging landscape for real economic prosperity to emerge. Instead of a rebirth following the global financial crisis, we get a phony house of cards that might come down on the heads of investors who think that policymakers have their best interests in mind.

One of the most relevant dynamics for investors to be aware of is that the interests of a government in debt are not aligned with the interests of investors. A government in debt has an incentive to debase the value of its debt, whereas investors have an interest in earning a positive real return on their savings.

Last week, I attended a conference at Stanford's Hoover Institution, where academics, as well as four acting Federal Reserve presidents, pondered about the future of central banking. One of the presenters, Stanford Professor Martin Schneider, had some blunt words that were as obvious as they were controversial: monetary policy cannot be conducted in a vacuum and is very much dependent on fiscal policy. He pointed out that as interest rates rise, taxes would have to go up to pay for the higher cost of servicing the debt.

Schneider presented a simplified model of the world, arguing that in the United States, in today's environment, both government and citizens would benefit from inflation — the losers are foreigners. Now anyone can take issue with a simplified model. And I could also argue why everyone loses with inflation. Such details should not distract from the message, though:
  • Inflation debases the value of government debt.
  • Inflation debases the value of consumer debt.
  • If you are a consumer with savings, sorry, you are in the minority and your interests will have to take a back seat .
  • Given that foreigners hold large amounts of Treasurys, they are on the losing end in an inflationary environment.

We can argue whether inflation is a problem today or whether it is not. But it's difficult for me to argue with the above. The conclusions I draw are:
  • Political stability throughout the world will continue to decline.
  • Traditional diversification can't be relied upon, as asset prices reflect the next perceived move of policymakers rather than fundamentals.
  • Asset bubbles will be fostered.
  • Bonds are vulnerable.
  • The U.S. dollar is vulnerable.
  • Investors may need a toolbox to counter the toolbox of policymakers.

The investment tools we have been focusing on to tackle these challenges at the core are currencies and gold. Gold might do well as the value of debt (and with it the dollar) is debased. Gold also has historically had a low correlation to other asset classes, thus serving as a candidate diversifier going forward.

Currencies can also serve as valuable tools. With currencies, one can design a portfolio that has a low correlation to other asset classes and currencies are historically less volatile than gold is. On the other hand, other countries also face challenges, so some thought has to be put into a currency-driven strategy.

We can't know for certain that either currencies or gold will protect investors against a collapse of the proverbial house of cards, but we are afraid that ignoring these dynamics could be perilous.

We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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The S&P 500 continues to hit new all-time highs, but is your portfolio built on a house of cards? The politics to kick the proverbial can down the road might unleash dynamics that could be hazardous to your wealth.
debt, cards, gold, currencies
Thursday, 05 June 2014 01:46 PM
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