Steen's Chronicle: Beware the implications of the K-shaped future

Macro

Steen Jakobsen

Chief Investment Officer

Summary:  Why the letter K defines society, economics, politics and markets - plus how this new macro model impact the construction of your portfolio going forward.


I have been quiet for a long, long time as I have mostly been busy behind the scenes in developing own extension of Christopher Cole of Artemis Capital Management’s 100-year portfolio, which I believe is the best, “most innovative” work I have seen in Portfolio Management in decades. Citation marks only because Chris’ work really merely crystallizes wisdom that old macro guys like me have seen before, believing and implementing “true diversification” as best mean to improve overall performance.

The seeming death of these good old principles started 22 years ago when Maestro Greenspan bailed out Long Term Credit Management Hedge Fund in 1998 and into 1999. With the bailout came the advent of “non-accountable” markets via the infamous “Fed put”. Greenspan and his successors remain the worst thing ever to happen to free markets and price discovery. End of story.

Since 1998, the presence and belief in the Fed put has meant that financial institutions could take infinite risk, reaping all of the potential rewards while avoiding any downside with the knowledge that the bailout is always there to safeguard the downside risk. But that paradigm will soon be history because the latest super-sized version of the Fed put to deal with the Covid-19 crisis is breaking our society in two – literally, in the so-called K-shaped recovery.

The K-shape defines the world now in economics, politics, markets, and even society.

Source: US Chamber of Commerce

((My K is of course incomplete…..))

I think we are living in K-shaped world in general, not just in economic recovery terms, which means K-shaped also is the model to explain politics, market, and social tensions.

Across our society, the K-shaped world means that a smaller and smaller group is taking an ever bigger share of the pie than ever before in history, leaving a growing percentage of the former middle of society, to find itself left behind. If Karl Marx lived today, he surely would feel vindicated. This however is not to say Karl Marx was right – his descriptions were actually quite accurate even if his prescriptions were horrifically misguided. Rather, the point is to declare that if market based economies (a vastly preferable term to the loaded “capitalist” descriptor) are to survive, it is time right now to stand up and take action.

Covid-19 has accelerated trends already in place: anti-globalisation, the break -own of international cooperation and multilateral institutions, increased nationalism, lack of privacy, anti-constitutional curfews and rising inequality to name a few. What COVID19 also did through this acceleration was to leave a huge number of people, organisations, small- and medium companies, and whole categories of businesses dead forever. I don’t think it has dawned on policy makers or even strategists that the question we need to raise is not when economy and world will be back to pre Covid-19, but rather:

How do we create a new system based on price discovery and free markets, one that better allocates resources and the marginal use of money and most importantly one that improves overall fairness?

Remember fairness is what drives our cooperation with the society’s laws and norms. Laws and behavioural norms are only respected if they are seen as fair and unbiased over time. If fairness goes out the window, social unrest spikes in response. Individuals should absolutely have the right to be rich, but a society has an obligation to educate and create equal rights and opportunities for anyone in society independent of race, sex, and belief. Furthermore, what globalisation failed to do was to mitigate the fall-out from the economic gains for the few from the “division of labour”. The new late information age “platform model” of the economy in which companies create monopolistic structures have created a winner-take-all and too-bad-so-sad for the rest fallout, which locks out huge swathes of the population from upward mobility or enjoying even basic participation in real per capita GDP growth. Tech is making whole classes of jobs obsolete and re-education is deficient or even impossible for some workers. The modus operandi has been to “keep jobs” rather than “create jobs”.

So, how will the K-shaped narrative shape markets and change portfolio priorities?

Volatility will stay high and go higher. Entropy means a “system” has constant potential energy. It may look stable from the outside, but on the inside energy will shift and ultimately our system will release energy in the form of political upsets, unpredictable rule changes, increased regulation (when government extends lending, favours, or support it will always comes with condition. Condition = regulation) and a less certain future. Change the rules of the game and you get volatility.

Inflation. Consumer pricing indices haven’t rebounded with much vigour, but have you noticed that your local delivery service is now pricier than pre Covid-19, that you have paid through the nose for sanitizers and health. That your government wants to “strategically” contain risk of being short masks, sanitizer, technology, hospital beds, etc… all of them well thought out, but all of them also more expensive – and marginally massively more expensive. Add to this the break-down in China vs. US, monetization by governments through central banks, future supply shocks in energy because current low prices are drying up investment in future capacity, and we may eventually have a perfect storm for inflation.

The basic bond-stock portfolio allocation models are dead. Trillions of dollars are invested in the 60% stocks and 40% bonds model (or today more like 80-20) model that has prevailed since, you guess it, 1998. Why do these portfolios face their imminent demise?  Fixed income has reached somewhere close to “absolute zero” in terms of yields, which means it offers no diversification and little upside and risks correlating positively with all risk-on assets, offering zero protection for your portfolio. The only asset left with inverse correlation? Correct, net long volatility! Whether I am right or not on inflation, the important thing is to consider is that inflation is driven by expectations, not realised inflation. And any significant exit of funds from the endlessly deep pools of fixed income will flow to much, much, much smaller buckets of risk in assets like inflation linked treasuries, gold and silver and volatility! Yes, I am sorry, size does matter in finance!

In closing, some thoughts on the investment environment here and positioning:

  • The 60-40 portfolio will have a negative expected real return due to the drag from fixed income over the next ten years and only a marginal positive real return from equities
  • Your return will come from increased volatility
  • US Dollar weakness is a key component of global investment, so beware exposures in your portfolio lower dollar exchange rate translation
  • You need to add long volatility and inflation-linked assets to your portfolio now (when no one believes in inflation!)
  • Beware the risk that the spectacular returns for the monopoly technology platforms, the biggest winners in market history, risk getting reigned in by the authorities.

If you run a real business:

  • Price in price inflation for medium- and long-term budgets
  • Expect to pay marginally much more for new employees. The labour market has seen “weak jobs disappear” – the people left with skills have higher bargain power = unit labour costs set to rise
  • Educate, educate, and take on apprentices. The global labour force in advanced economies is shrinking – especially at the younger end of the spectrum.
  • Prepare for political backlash if your business or products are not Green certified. Governments, customers, and equity market pricing will continue to increase the hurdle rate.
  • Know that the present model of a just-in-time, globalized model is stone cold dead. The new model must align with a green transformation, better quality, and better margins.
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