How to build wealth strategies for now

Today we face a tough economic environment with unseen actions of the central banks all over the world. How to build or maintain wealth in these conditions?
I want to share some strategies, which work in this condition and what are their advantages and disadvantages depending on the economic environment.

The Challenges

Before we can install or discuss a strategy, we have to think about possible scenarios, which may occur in the near future.
Because we face some serious growth problems in the developed countries, the Central Banks in Japan, Europe and the United States print a lot of money, which they call Quantitative Easing. Even though the amounts of printed money are higher than ever, the economic output is poor. In Japan we have a deflation for several years, the Euro zone is struggling and has some serious problems with some members, as Cyprus and Greece, which need the support by the other members. Countries like Italy, Spain or Portugal have a lot trouble with unemployment rates, especially with youth unemployment, economic growth and particularly an overvalued housing market in Spain.

One big factor for economic growth is the growth of the population, but in Japan the population is shrinking and older people do, what old people do. They “eat” their savings. The Euro zone has a similar population pattern like Japan, but Japan is some years ahead. So the big demographic problem in Europa will occur in the next years. Even the United States face alike demographic problems and all three regions have only very small productivity gains. Furthermore they build up a huge public debt, combined with a big household debt. The burden of the interest payment and debt reduction is to big to increase economic growth.

From this initial situation we face 4 possible scenarios:

Stagnation

The economic behaves like in Japan the last years. The interest rates will remain low, inflation and deflation will stay low and the economic growth will be low. The asset prices, like stocks, houses will become more volatile than today, but the asset prices will go slowly down. Maybe this scenario will be accompanied by financial repression, as already discussed in my other article: Fed interest rate history – overcome fear and get success.

Haircut

We will see a haircut on several debts and the creditor will lose their money. This would cause a drop in many asset prices, because much more bad debt would be obvious and the debt holder had to pay for it. After this haircut the economy could recover, but the prices would be lower than today, because of the bad demography and (hopefully) the missing public spending.

Monetarisation

The Central banks have to buy more and  more debt (= Quantitave Easing). This would lead into a loss of trust. Which then leads in modest(?) inflation.

Some people suggest to take this concept one step further. The Central banks buy the public debt as today but the debt becomes interest-free and the redemption would be cancelled.

In this case the above mentioned problem of interest and debt payment would be erased. The big question and unknown answer are: How would the public react to this behaviour? Would the people lose their trust in the paper money? If this happens, we will become an inflation and this could be the end of the currency that is to say crash.

Crash

All attempts to solve the economic problems fail or the government ignores the economic problems and in the long run the problems become obvious to everybody. The huge debt leads suddenly to bankruptcy. This causes problems with the next debtor or creditor and this goes on like in the financial crisis. But this time it is different, because the public or government can’t rescue anyone, because their debt is too high, or they aren’t able to pay their own debt. Anyway, all leads to falling asset prices, companies and banks close. Interest rate would go up, because nobody trust anybody (like 2008) and liquidity would dry out. Central banks would be nearly unable to solve the nascent crisis without risking the trust in the paper money.

I think that these are the main possible scenarios. You can divide these general paths into more detailed ones, but this would give you no more in sight.

How to invest in each scenario?

As  a normal investor, we are able to diversify in different asset classes. I put these asset classes in one column and the four possible scenarios in four additional columns. By this manner we get a spreadsheet which describes the behaviour of each asset in each scenario:

Stagnation Haircut Monetarisation Crash
Cash + +++
Public bonds +
Foreign public bonds
Stocks value 0 + + ++
Stocks growth + 0 + ++
Houses, reits, properties + +++ ++ ++
Gold, Silver +++ + ++
Debt 0 0 ++ 0

+++ means the best case and  means the worst case.

In the following paragraphs I will discuss the advantage and disadvantage of every asset class in each economic environment.

Cash

In case of stagnation cash is slightly positive, because I assume, that there will be rather a deflation than an inflation, which favours cash, because it will become more valuable.
In case of a haircut, it is obviously better to stay in cash, then to be the creditor who has unrecoverable claims.
In case of a monetarisation you won’t like to stay in cash, because this scenario would lead into a inflation. The only question is, whether it will be a one digit inflation rate or a two digit inflation rate.
If it comes to a crash, your cash would be worthless, because the “old” money would be declared as worthless and a new currency would be established.

Public bonds

In a stagnation the public bonds would pay the interest and the initial amount. Inflation and / or deflation will be low, but the government will tax every income. Therefore I assume, that they will be neutral or slightly positiv.
A haircut would be the worst thing for any buyer of public bonds.
In case of monetarisation bonds would perform bad, because it is the aim, to lose the debt without paying the “real” amount.
In case of a crash, the public debt would be worthless and therefore you would not like to have it in this scenario.

Foreign public bonds

In case of a stagnation in the country of the issuer, the outcome depends on the exchange rate. In the stagnation the economy does not grow and therefore the demand of the foreign currency will be less. This leads to diminishing exchange rates. As a consequence the interest income and the repayment is less valued in your own currency. So you will lose money.
A haircut would be the worst thing, as always, for a creditor.
In case of the monetarisation in the country of the issuer, again it depends on the exchange rate. If the exchange rate diminishs more than the interest rate, your earnings turn into a loss.
A crash in the country of the issuer would make the bonds worthless.

Value stocks

Value stocks belong to big companies, which are affected by the stagnation. This means, that they won’t make as much money as they could in a growing economy. Therefore they will perform poorly, as the whole country.
After the haircut of bonds they might perform a little better, because the burden of debt is away and the people can start to invest and buy again. Therefore it could perform better after this occurrence.
In case of the monetarisation they might perform a little better then in case of the stagnation, because if this experiment is a success, the people can spend a little more and this will help the companies to increase their profit and value.
In case of a crash you have to have your wealth in value asset, which produces an income as a cash flow, dividend or interest income. Value stocks provide you with this income even though their value will fall in this scenario.

Growth stocks

Companies, which are in emerging markets in the own country are called growth stocks. Today a lot of these companies deal with the internet, like Amazon, Google or Netflix. But in general, it are companies, which still are unknown to the public.
Even in an environment of stagnation, these companies are able to prosper and make good profits, which make them superior compared to the value stocks.
In case of a haircut they may perform worse than value stocks, because their supply is still unknown, has a smaller demand and it is less necessary than the products of the value companies.
In case of monetarisation they behave similar to the value stock, may be slightly better because they act in a growing niche.
In case of a crash you have to have your wealth also in growth assets, even if they may perform a little worse than value stocks but still good.

Houses, Reits, Properties

In an environment of stagnation you will still get your cash flow from these assets, as long as you have tenants, which can afford your house. I suggest, to invest in houses, which would have demanded in slightly worse economic than today.
If it comes to haircut of public debt, houses, reits and properties would be great to own.
In case of monetarisation this asset class would perform well too, because you own real value, which would less affected by this environment.
In case of the crash, you still have real value, which is really good.
Even though this asset class seems to superior to all other asset classes, you should keep in mind, that this asset class can be precisely targeted and taxed by the government. History shows us, that the government did this in past crisis, which makes a statement really difficult.

Gold and Silver

In a stagnation you will not get lucky with these assets, because their value will not increase much and you don’t get any interest payments or cash flow.
On the other hand, gold and silver are great in case of a haircut, because they are not affected and their value should increase.
In case of monetarisation they will increase in value, because we will face some inflation. Depending on the degree of inflation, their value will increase.
In a crash gold and silver are great too, because after this event you can change them into producing value, as stocks or houses.

Debt

In this survey I assume, that you use debt only as a leverage for an investment.
In case of a stagnation the outcome is more or less neutral, because it depends on your investment. (See asset classes above)
In case of a haircut of public debt the outcome should be neutral too, but it depends on several circumstances, because in this scenario private debt could be affected too. The debt, public and private is too high, and may be the government could decide to cut the private debt by a percentage too. But this is only a speculation.
In case of monetarisation debt is great, because the inflation will help you too, to diminish your debt as it does with public debt.
In a crash private debt should be erased too, but may be you will have still a small amount. But the government has to restart the system and this will not work with a high private debt.

Conclusion

I showed you in the spreadsheet above, that there is not one single strategy, that is great in all scenarios. Each asset class has its own advantages in some environments and disadvantages in others. Even though this spreadsheet gives you a good overview and estimation, you don’t know which scenario will occur and even worse, you don’t know the correct arrangement.
But on the other hand I hope, that you see clearer what could happen and what investment will be great in which scenario. Your task could be, to check your investment today and compare it with this spreadsheet. Which asset class you don’t have? Then think about it and decide, whether it would be smart to add this asset class to your portfolio or not.

I hope, that you enjoyed my article about wealth strategies today and gained some valuable information. I would be more than happy to read some comments from you.

2 thoughts on “How to build wealth strategies for now

  • 12. May 2016 at 1:28
    Permalink

    This is a very good article Bernd! Nicely done and this is something that everyone should be reading.

    I really like the way you talked about houses. A big thing with real estate is that if we can an inflationary environment you will be able to pay off your house very quickly. Because the mortgage will still be the same but because of inflation you now have more money that you can pay off the mortgage with.

    Gold and silver is probably the easiest way to protect yourself from the coming debt crisis. Like you say they are not as good in stagnation because they wont go up or down and they don’t generate any cashflow.

    I have a hard time seeing that happen though. Our central bankers are so afraid of deflation that they wake up in the middle of the night sweating and screaming. They will do everything they can to not get deflation. Because they see it as a “death spiral” (completely wrong in my view, how can it be bad that your citizens have to pay less for everyday goods and services as food?)

    If we come to a deflation scenario they will ramp up the printing presses just like the always do. And I don’t think we will get a two digit inflation number, we might get even more.

    Because once you have lost control of inflation it can run away very easily. Only thing they could do would be to raise interest rates above the inflation number. But with a 8% interest rate we will get a crash instead.

    Thanks for letting people know that they need to prepare for a enormous shift in wealth. If your not prepared you will get wiped out.

    Marcus

    Reply
    • 12. May 2016 at 16:36
      Permalink

      Hello Marcus,
      thanks a lot for your comment.
      Yes, if inflation increases with a high rate, double digit number or even more, it will be very difficult to stop it again. Someone said: If the ketchup is out of the bottle, it is really difficult to get it back. The same with inflation.
      The problem is to be prepared for different scenarios, because no one knows exactly what will come in future. I hope, that I gave you a good blueprint with the spreadsheet.
      Bernd

      Reply

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