Jolted by weaker than expected economic data and compounded by a surprise Japanese rate hike, equity markets began falling. This led to a sudden rise in volatility which then fed back into further falls in risk assets creating an ugly spiral that culminated in one of the largest ever single day declines.

The volatility index, pictured below, spiked to 53 which, to be put in perspective, can be compared to previous spikes in March 2020 (65) and October 2008 (79).

The US markets have been priced close to perfection for some time, giving market participants a good excuse to take some risk off the table.

The first warnings came from disappointing labour market data in the US. Whilst one can sometimes shrug off macro data as backward looking, the stark reality hit home with Intel’s announcement that they would be slashing 15% of their workforce. Amazon’s quarterly reporting miss added to concerns, with the third warning bell ringing when Warren Buffet announced over the weekend the sale of half his Apple stake.

The natural question is why the prospect of falling interest rates would not be good for equity valuations if the market is, as suggested by Benjamin Graham, a weighing machine? After all, lower bond yields should improve expected corporate cash flows by lowering future expected interest costs. Also, discounting expected cash flows of equity back to today’s value (as a dollar in ten years is worth less than a dollar today), using lower bond yields (part of the rate we use for discounting) increases equity prices today.

Therefore, the fall in the 10yr bond yield (from 4.2% to 3.8%) in just a couple of trading sessions will have been supportive of equity prices.

However, this event did not happen in isolation. In fact, this was overshadowed by (i) the reality of interest rates remaining high in absolute terms and (ii) questions arising around the relative valuation being ascribed to markets as expectations of future economic growth moderate.

To understand the former, we may need some broader context. The US 10-year yield has moved from 0.5% at the end of 2020 to a high of 5% in October 2023 and is currently just below 4%, so still well above 0.5%. This dramatic move in rates was the Federal Reserve’s long overdue assault on inflation and caused havoc for traditional 60 / 40 portfolios in 2022 (covered extensively in our prior Investor Letters). Thus, even with a 25bp, 50bp or perhaps 100bp cut, the discount rate (or future interest costs) remains high.

With a Bloomberg squawk-box blaring in the background, it is difficult to sometimes put these big moves in perspective. While US markets have indeed come under pressure in August (S&P is down 3%, Nasdaq down 4.5% - at the peak down 8.5%), it is small relative to from where they have come.

Consider that the S&P 500’s cyclically adjusted price / earnings (CAPE) ratio is around 35x, with the long -term average roughly half of this value. What could explain these valuations? Currently AI carries the bulk of investor’s optimism and is upheld as the catalyst which will unleash productivity and boost earnings growth by more than any innovation made over the past century. If indeed real, this boost is expected to more than offset the increased discount rates. Any challenge to this narrative is damaging to current markets.

Queue the magnificent seven – Nvidia, Microsoft, Meta, Alphabet, Apple, Amazon and Tesla – which combined account for the lion’s share of the rerating over the past 18 months, boosting the S&P 500 (and with it, the MSCI World Index) to multiple new highs. The reliance on a handful of companies to sustain equities is apparent, and when faced with risk-off situations, investors start questioning their growth assumptions.

The move in bond yields imply that the Federal Reserve will cut rates – at a faster pace and to a greater extent than was previously being priced in. The prevailing view is that recent poor economic data points to increased risk of recession because of rates being held high for too long, despite sticky core inflation. The Fed was slow to react to inflation and could potentially be too slow to react should they be faced with recession.

There is nothing stopping the Fed implementing an emergency rate cut prior to its scheduled meetings (the next one being in September) as opposed to waiting for the meeting and delivering the telegraphed 25bps cut.

The fly in the ointment is that the Fed’ s mandate is to pursue the goals of maximum employment and price stability – not to protect equity markets. However, this perceived risk mitigation for investors has arisen as the Greenspan / Bernanke Put created the expectation that the Fed would protect equity markets given the policy decisions since the Global Financial Crisis and during the COVID lockdowns. However, this is clearly an unhealthy moral hazard and is, incorrectly, being relied upon today by many investors.

Our thoughts at this current stage are that the Fed will be disinclined to react dramatically to one lousy jobs report or volatile stock markets. However, who knows, so be prepared either way. There is also the small matter of the upcoming election, where each candidate appears happy for the Fed to move to their own benefit and very unhappy if it moves to the benefit of the other candidate (which puts significant stress on the Fed’s independence).

Their record-high debt levels combined with their obsession with deflation risk have kept Japanese interest rates low despite the rising interest rates across the globe and have created the ‘carry trade’ – the process of borrowing in Yen and investing the proceeds in risk assets.

This has created a spiral of weakening Yen and more demand for the carry trade, placing the market at increasing risk of reversal. The surprise 25bps hike closed the gap (albeit only slightly for now even when considering the expectation of US rate cuts) which initiated a reversal of the carry trade. Illustrating just how sensitive the market is to this reversal, the Yen spiked nearly 10%, and equity tanked, wiping USD1.1 trillion of value from the TOPIX in one day as investors were left trying to make sense of the moves. We are left to imagine what could happen if the interest rate differential closes further. We think the Yen has further strength in it and while we have profited from the recent move, we continue to hold the position for now.

In line with our mandate of capital preservation, we are continuously assessing our portfolio and remain well positioned to protect capital via our significant levels of diversification as well as many of the tactical tilts we have in place.

We continue to monitor closely and will act if a good opportunity presents itself. The most important thing in markets like these are portfolio diversification and calm heads. Our balanced stance towards asset allocation, particularly a well-considered weighting towards gold, bonds and tail risk, positions well for such stormy seas.

The preservation and long-term growth of our investors’ portfolios in real terms remains our overriding objective in everything we do.

Loved by movie gangsters and millions of ordinary Americans. So much so that they devour over 550 million of these nutritional gems each year – making this staple as iconic as ‘good old’ apple pie.

So it’s more than just irritating when labour shortages and increasing meat and transportation costs force management to continuously increase prices. First by 6% in 2021, then an additional 8% in 2022 and a series of further increases in 2023. While management may seek some operational improvements to offset rising costs in the hope of protecting margins, the increases just keep on coming. Day-to-day life in America continues to be more expensive with food prices having increased by an average of roughly 25% between 2019 and 2023.

The increased cost of that burger meal and other less essential daily items unfortunately started depleting the excess savings many Americans built up during the pandemic. Credit card balances are now over a trillion dollars at the end of March, hovering near record highs once more. And with interest rates having spiked, delinquency rates are rising above pre-pandemic levels.

Economist warned that consumers would be forced to cut their spending in response to the nasty combination of higher prices and interest rates. And here it is. Major retailers and fast-food providers, including Starbucks, Target, Home Depot and Yum Brands have all reported a decline in sales as consumers are forced to cut back on luxuries and travel and generally start trading down. Walmart is back in vogue.

Here’s the rub. This nasty bout of inflation just won’t go away. This, despite Central Banks shifting from treating inflation as a temporary phenomenon – it’s “transitory” - to recognizing it as a more entrenched issue, requiring significant monetary policy interventions to address it. In fact, they can be commended for throwing all but the kitchen sink at the problem in an effort to sustain economic growth while minimizing unemployment.

However, the headwinds persist. Increased fiscal spending, driven by geopolitical tensions, climate change mitigation, and re-shoring of strategic manufacturing, is sustaining higher inflation levels, reducing the flexibility for central banks to start lowering interest rates. All this when US national debt has already reached USD 35 trillion. These secular forces, coupled with demographic shifts and labour market dynamics, point to a prolonged period of elevated inflation, posing significant implications for future fiscal policy and economic health.

As it stands, the Fed's "wait-and-see" data driven approach suggests that long-term interest rates may remain at current levels or possibly even rise to combat inflation effectively. The stickiness of US inflation has broader implications. Other central banks, such as the European Central Bank and Bank of England, may be forced to cut rates ahead of the Federal Reserve to mitigate the recessionary impacts of high rates on their economies, despite causing downward pressures on their currencies.

The interplay between inflation, interest rates, and market performance is complex. US bond yields have surged, reflecting the ongoing struggle to curb inflation. Strangely, given that consumer spending accounts for about two-thirds of America’s GDP, the markets have been relaxed about increasingly stretched consumers. The S&P 500, a broad US equity Index, continues to hit fresh highs largely on the back of the AI tech rally. It’s easy for investors to be overcome by FOMO and pile into the momentum trade – with very few looking under the hood just as a precautionary check to see how much of all this is actually real and sustainable. It certainly feels as if the common view is to hover close to the “buy” button any time there is a sell-off of any type, with no clear strategy of when to push the “sell” button.

Many companies that fixed their debt at historically low rates will have to refinance in the coming years. If 5 to 10-year interest rates remain above 2 to 3% (they are currently around 5%), there will be tremendous pressures on corporate cashflows. In the face of this risk, the 10 trillion dollar US corporate bond market is alarmingly festive, with credit spreads (a measure of risk appetite) at their lowest levels in almost two decades. This suggests that while investors are bracing for a prolonged battle against inflation, they remain perversely optimistic about the US economy's strength. We believe this confidence is fragile and largely based on very recent positive US economic surprises – the biggest being the avoidance of a recession in 2023 despite this being forecast by over 90% of economists polled by Bloomberg. However, the risk of recession remains clearly on the horizon.

At a macro level, “higher for longer” interest rates cannot be ignored and are important given their real impact on both consumers and savers – meaning you and your investment portfolio. We haven’t seen this environment for some time. In fact, for most of us, we have never had to navigate through this, meaning most portfolios have, over time, become more and more exposed to a market of higher and/or volatile inflation and interest rates. This has been the case across most developed markets since the early 1980s – a period which has justifiably been exceptional for both equities and real estate – with interim growth shocks being easily offset by nominal bonds. A sustained period of stagflation (lower than expected growth and higher than expected inflation) will be disastrous for the commonly held 60 / 40 stock-and-bond-focused portfolios. High inflation means the fixed interest payments from bonds can fall behind inflation, providing losses in real terms, and companies’ earnings disappoint as they deal with slower sales and a higher cost of capital.

Over the past few years, we have been somewhat contrarian in that we have been in the “higher for longer” camp, believing that the risk of inflation remining higher than the market has forecast to be uncomfortably high. As our core philosophy is to protect our investors capital, we have positioned our portfolios to address this risk by diversifying across both growth and defensive asset classes with the objective of reducing volatility without compromising on the longer term growth of assets in real terms. While being contrarian is not a naturally comfortable place to be in the face of a US equity surge, we continue to advise our investors to hold a portfolio slanted towards more defensive assets. These assets are ones that tend to perform best when growth assets are at their worst, making them ideal candidates for rebalancing as part of a holistic portfolio. While gold is a good starting point, we believe that other defensive assets can be included to improve the diversification and protection of the overall portfolio. These include an allocation to a selection of strategies including Long Volatility, Tail Risk, Commodities and Trend Following. Together, this defensive group of assets now make up 40% of our core portfolio, excluding our tilt from nominal bonds towards inflation linked bonds.

To solve for the fact that their clients did not need loans, SVB channelled their deposits towards long-dated Treasuries, residential mortgage-backed securities, and corporate and foreign bonds. One might argue that this was a very sensible approach – investing deposits into safe assets that could be easily liquidated. But as every Cluedo player knows, there is always a “however” that comes along with the murder weapon. And in this instance, the “however” is that, as interest rates went up, the market value of Treasuries, mortgage-backed securities, and bonds went down.

Eventually, the situation became intolerable for SVB. To meet its obligations, the bank was forced to sell a USD21 billion portfolio with a 1.79% yield into a market where 10-year Treasury yields hovered near four percent and mortgage-backed security yields reached 4.75%, up from 2.47% a year ago. To say 2020-21 was an inopportune time for a four-fold increase in holdings of these securities is an understatement. And, as the saying goes, the rest is history.

In selling its bond book, SVB realized a USD1.6 billion loss, with the intention being that it would make up the difference with a capital-raising exercise. But it did not happen that way; the word got out, and depositors rushed to the bank to withdraw their money in favour of deposits with larger multinational banks, short-term US Treasuries and/or money market funds. As Ernest Hemingway’s bankrupt war veteran, Mike Campbell, noted, the way that you go bankrupt is slowly, then suddenly. This is exactly the case of SVB. In a classic bank run, the Wile E Coyote moment arrived, and it was the end for the bank.

But banks bring with them another risk – and that is the risk of contagion. They seldom fail alone. And the collapse of SBV was joined by the collapse of Signature Bank. In response to recent crises, policymakers have implemented numerous measures to bolster the banking system. These include increased capital requirements, stricter regulations on risk-taking, and enhanced supervisory frameworks. While these measures have undoubtedly improved the system's resilience, they also underscore the inherent fragility of the banking sector which remains vulnerable to shocks, despite a decade of post-global financial crisis reforms.

Given the contagion risk, policymakers moved swiftly over the weekend to reassure depositors and markets. This included the US Federal Reserve (Fed) announcing emergency measures to backstop banks facing short-term liquidity pressures. Banking regulators also said they would protect all SVB depositors, including those above the USD250,000 deposit insurance limit provided by the Federal Deposit Insurance Corporation (FDIC). In this, the Fed stressed that the system had been protected “for the good of the economy” and, also, that we should rest assured that the shareholders, bondholders, directors, and executives of the failed institutions will suffer severe financial consequences. We leave the latter point for another discussion.

For now, it is important to recognize that the policy steps and regulatory pronouncements have not stopped the rumbling. In the aftermath of SVB, other regional banks, including First Republic Bank and Western Alliance Bancorporation, have come under pressure. The prices of these banks’ shares fell 70% and 50%, respectively, over a few days. And, at the time of writing, the anxiety has spilled to European Banks, with the price of global investment bank Credit Suisse Group falling by a third over a few days.

According to Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru, the cause for concern about system-wide risk is well placed. Their paper, Monetary Tightening and US Bank Fragility in 2023, was published with immaculate timing, arriving in inboxes on Friday of last week. Their work analyses US banks’ exposure to recent rises in interest rates and explores the implications for financial stability. Amongst other things, the researchers observe that accounting for loan portfolios held to maturity, the US banking system’s market value of assets is USD2 trillion lower than suggested by their book value of assets; marked-to-market assets have declined by an average of 10% across all banks, with the bottom fifth percentile experiencing a decline of 20%; and if uninsured deposit withdrawals cause even “small fire sales,” there is substantial risk baked into the banking system.

This leads the researchers to conclude that the US banking system is a lot more fragile than commonly assumed. Before the interest rate increases of 2022, all US banks had positive bank capitalisations, compared to 2,315 banks, accounting for USD11 trillion of aggregate assets, that now have negative capitalisations. This significantly heightens the fragility of the US banking system to uninsured depositor runs and is cause for real concern.

Beyond the first-order risks of bank runs, there are myriad second-order risks that come with banking crises. At least one worth flagging in this episode are risks faced by owners of so-called structured products, which have become extremely popular under the guise that they offer ‘guaranteed’ returns, downside protection, upside ownership, and all other types of free lunches that generally do not exist in investments. The specific risks that come with these investment products include index market risk, which refers to the performance of a reference index; illiquidity, which relates to the ability of the investor to sell their investment prior to maturity; and counterparty credit risk, which usually comes in the form of a bank bond that is meant to provide a level of capital protection to the owner of the structured product. The last of these three risks is especially material in the case of SVB, where administration officials have said the regulatory intervention does not constitute a bailout because stockholders and bondholders would not be protected. As a result, structured products underpinned by SVB bonds would be at risk of 100% capital losses. This should be pause for thought for owners of structured products everywhere. And while this risk always appears remote at the outset, as can be seen in the SVB case, the risk materialises quickly and unpredictably with potentially devastating impacts on owners of these investments.

The collapse of SVB, Signature Bank, and subsequent rumblings would not be the first rodeo for many investors. Every Fed hiking cycle has usually ended up causing some sort of turmoil, with the saying going that in every cycle, the Fed hikes until “something breaks”. Are SBV and Signature Bank the “thing that is breaking”, or are they the canaries in the coal mine? Under either scenario, this begs the further questions: “What are the implications for policy; and what are the implications for investors?”

In 2018, at the end of the hiking cycle, there was a big market sell-off late in the year, which was followed quickly by a pivot away from rate hikes. The US housing collapse followed a series of rate hikes over 2004-06, and the bursting of the dot.com bubble followed a series of rate hikes over 1999-2000.

At this point, it is not altogether clear if the failure of SVB and Signature Bank are the extent of the financial rumble, or that the swift policy action has cut financial sector contagion off at the pass. As suggested above, there is good reason to suspect this is the first – and not the last – rumbling, and even if it is no more than a storm in a teacup, it equips us to be alive to the prospect of substantially greater risk and system-wide impacts that could permanently damage investors’ capital.

What SVB shows is that higher interest rates hurt. And, importantly, they are meant to; that is the point of monetary tightening – to take the froth and foam out of the system and to return asset prices to sane territory without breaking the economy. However, what SVB has underscored is the high interconnectedness and fragility of the banking system.

These recent events also question the extent to which the Fed will stay the course in fighting inflation. At least one view is that the tightening in financial conditions caused by market reactions over the last few days may have done what, just one week ago, was the Fed’s unfinished business. In the aftermath of SVB, investors have rapidly priced out the chances of aggressive rate hikes from the Fed this year, with the futures-implied rate for the December 2023 Fed meeting down by more than 100 basis points (one percent) since the SVB episode began.

Even more than that, a 2023 rate cut is now expected. This is remarkable because consumer price inflation – one of the slower but surer destroyers of wealth – continues to run hot, coming in at 6.0% year-on-year in February. While this recent inflation number matched expectations, the New York Fed’s Underlying Inflation Gauge was still running at 5.1% in January – a long way above the Fed’s target.

On this point, the Federal Funds rate has not yet exceeded the rate of inflation in this tightening cycle. In every other tightening cycle in recent decades, the Fed has not stopped hiking until they have passed that point and taken the policy rate into positive territory in real terms. If the uncertainty surrounding the financial system led the Fed to opt for an easier interest rate stance, rather than going bankrupt quickly, some investors may find their wealth slowly confiscated by the stealth of stubbornly high inflation.

Given the strong economic data over February, there had been growing hopes that a US recession in 2023 could be avoided, even though it was the consensus forecast among economists. But after the SVB collapse, those recession risks are higher, even if the Fed stops hiking. Keep in mind that the Fed has never tightened this much this quickly without a recession happening, so avoiding one would require several historical precedents to be overturned in order that “this time is different.”

This puts three risks squarely on the table: the fragility of the financial system; the corrosive force of inflation; and the threat to earnings, incomes, and valuations that are brought by recession. Whether these risks materialise quickly, or slowly, we have our eyes on all three, and our portfolios continue to hold assets designed to protect against these risks.

In 2022, Hindsight Capital’s managers made some exceptional calls in January, including that Vladimir Putin really would invade Ukraine; China's economy would take strain from the omicron variant; inflation would not be transitory, and instead would entrench itself; and interest rates would hike far quicker and further than markets expected, putting pressure on security valuations around the world. As John Authers notes the potential gains for someone with this ability are infinite. Shorting Tesla Inc., FTX Tokens, and the ARK Innovation ETF would have delivered gains of 69%, 98%, and 68%, respectively. After the returns experienced around the world in 2022, most investors would grab these types of results with both hands if Hindsight Capital really existed.

But Authers suggests that identifying names with this type of razor-sharp vision makes the exercise a little unfair. Instead, he proposes that Hindsight Capital should be limited to identify broad themes. With this constraint in place, Hindsight Capital’s team bought US defence contractors and went short Ukrainian stocks (+244%); and they also went long the S&P 500 energy sector and short S&P 500 automakers (+354%). In a contrarian bet on autocrats, they went long Recep Tayyip Erdoğan and short Putin by buying Turkish firms and selling Russian equities (+234%). Hindsight Capital also invested in integrated oil and gas firms, which they funded by shorting global wind energy (+101%). As with every other year on record, seeing backwards delivered another set of fantastic returns for Hindsight Capital. While it's a fun exercise, there is a serious undertone to this thought experiment. All of Hindsight Capital’s calls were contrarian, at odds with market consensus. Individually, each of the ideas would have looked foolish based on the mood at the start of 2022. And if presented as a strategy, at best, the ideas would have been regarded as folly, and more likely lunacy. This is an important point to make at the start of each year where there is a penchant for identifying the big drivers of the year ahead – as if markets are somehow calendarized – and then positioning portfolios for those themes.

Whilst anecdotal, the annual quiz exercise, and the Hindsight Capital though experiment, show just how hard it is to peer into the murky distance. And these anecdotes are supported by rafts of empirical evidence that reach cross time, asset classes, and countries that show almost no relationship between forecasts and outcomes. Yet, the temptation to forecast persists, because the world is complex, and we are human. But we are bad at forecasting for the same reasons: the world is complex, and we are human. Put simply, the temptation to forecast is ever-present, powerful, and seductive. But this is a dangerous investment habit, and one that should be broken quicker than any other New Year's resolution.

Bob Newhart’s skit, where he acts as the therapist, Dr Switzer, to his patient, Katherine Bigmans, gives us all the guidance we need when it comes to the habit of forecasting. Newhart tells his patient that there are just two words that she needs to remember when it comes to changing her behaviour, and that he finds “… most people can remember them.” Bob Newhart goes on: “Here they are: Stop it!”

If you want to do your investments a big favour in 2023, here’s the resolution when it comes to forecasting: “Stop it.” This leaves us with the question of what we should do in the place of trying to see around corners. Thankfully, there is an excellent substitute.

With the benefit of hindsight, many of the greatest investors have three permanent features in their portfolios. They own good assets, at good prices, and they diversify to manage risk. And many – not all – add a good dose of patience. This might mean that at the start of the new year you own some high quality emerging market equity which looks extremely attractively priced; inflation-linked bonds to deal with not-so-transitory inflation; fewer dollars, which are expensive, and more South Korean won, which look cheap; some physical gold, which is a powerful diversifier; and perhaps TSMC, a shunned Taiwanese semiconductor manufacturing firm trading on 13 times earnings. And if you’re wondering what the event of 2023 will mean for these investments, stop it. This is a diversified portfolio of good assets, owned at good prices, which gives us the single best investment approach across all times and all markets. And while we wait for foresight to become hindsight, I wish you a wonderful 2023.

Investment Specialist, Genera Capital & Professor in Finance, GIBS

In four short words: this argument is wrong. Amid furious finger pointing, the argument ignores the actual star of the show – the wild printing of money by many of the world’s central banks, and especially the US Federal Reserve (the Fed).

Inflation has rattled people to such an extent that the release of US inflation data in the second week of September saw stock markets falling by the most since the early months of the pandemic. The price of sub-investment grade bonds dropped. Short-dated US Treasury yields spiked. Yet, strip out food and energy prices, and inflation is still roaring. Core inflation in the US rose at an annualised rate of 7.4% in August, exceeding economists’ forecasts and well above the Fed’s target for overall inflation of 2%. Yet, over the course of 2022, the US dollar has surged, gaining 25% against the Japanese yen, and achieving parity with the euro. Over the last part of September moves against sterling became even more pronounced as a statement by Kwasi Kwarteng, which was meant to usher in an era of economic growth, instead triggered a crisis. In a somewhat ironic twist, just as the Bank of England had started to get serious about taming inflation, Britain’s central bank has been forced to announce that it was ready to buy unlimited quantities of long-dated bonds to restore order to financial markets – simply a variant on quantitative easing. Earlier, the pound had crashed to its lowest level ever against the dollar. In all of this, the irony is that investors seeking protection from inflation are embracing the very thing that caused it: the US dollar. Something akin to a global Stockholm syndrome appears to be playing out.

Human beings have short memories, which may be partly to blame for this psychological bond to the greenback. Plus, it may be easier and more politically expedient for some to trot out the “Putin’s war” soundbite rather than reflecting on the sheer volume of money that has been put into the system by central banks. Europe’s money supply has grown by about 20%, or €2.5 trillion over the past two years – a robust expansion by any measure. But this is a far cry from the Fed’s actions, which have grown the country’s money supply by 38% since early 2020. To give the US figure some colour, the US$5.9 trillion created by the Fed since the start of the pandemic is equivalent to printing the economies of Mexico, Switzerland, and Spain out of thin air – twice.

This lens provides a different perspective to the consensus view on the origins of inflation and leads fund manager Tim Price to wonder if “… everything we are told about inflation is a lie.” Perhaps Putin triggered inflation. But if money causes inflation, it is hard – maybe impossible – to escape the argument that the root cause of our current global conundrum is the wild printing of money, and specifically printing of the US dollar by the Fed.

If Putin catalysed inflation, rather than caused it, then a second-order consequence is that that the world’s most loved currency might not be coated with as much Teflon as euro parity suggests. The criteria for sound money are that a currency is trusted, regarded as a store of value, widely accepted as a medium of exchange, and considered to be a stable unit of account. In addition, the monetary authority behind the currency must be seen to manage it prudently.

To clarify, in this case ‘prudent’ speaks to growing money supply in line with – or perhaps modestly ahead of – the growth structure of the economy. This means growing money supply at a rate that is a composite of growth in productivity and growth in population. With the US population growing by 0.5% per annum, and US productivity growth running at about 1.0% per year, the pace at which money supply should be growing is about 1.5% per year. Actual growth in money supply is about 10 times this rate. In which case, perhaps it is galloping money supply growth – and not gallons of fuel – that is causing runaway inflation.

More than this, even if the Fed was overly zealous during the pandemic, their job is ultimately to set interest rates so that inflation reaches its target. This is the very definition of prudent policy that underpins sound money. With the US economy still strident, and inflation running far ahead of the targeted 2%, The Economist has come to the conclusion that the Fed is producing “almost the opposite of what good monetary policy is supposed to achieve”.

All of this said, while abundant printing of money is now a well-established pattern in the US, it needs to be acknowledged that this happened at a time of severe economic stress – in the US and globally – where money was created to fund government deficits as part of important social spending programmes. It then this begs another question: could those funding programmes actually justify the printing of money? Could printing money be an acceptable, ‘necessary evil’ and an alternative to borrowing if a government is running a large budget deficit and building up debt? If the action doesn’t provoke inflation, then, yes, you could call this defensible and level-headed funding. Unfortunately, there are two problems with this approach, specifically when it comes to the greenback.

The first problem is that to support strong structural growth, you need a high investment rate. Yet, gross fixed capital formation in the US averages five percentage points below the world average of 25% over the past decade. This suggests that the printing of money has facilitated consumption, not investment. The second point is that printing money has happened alongside a steady ramp up in debt-to-GDP ratios. The US debt-to-GDP ratio stands at 124%, which is way beyond the safety lines. As the seminal work of American economists Carmen Reinhart and Kenneth Rogoff attests, the orange warning light turns on at a 60% debt-to-GDP ratio, and the red light goes on at 100%.

This puts the US situation into stark perspective. When you put all this together, it exposes the greenback, which for so long has been favoured for its believed ability to protect against inflation. Rather than being the protector, the US dollar might be the prime suspect in the cause of inflation. What sits behind this problem is the debasement of money due to prolific printing which, to a large extent, has been used to fund deficit spending and consumption. It is a toxic cocktail.

The extent to which the dollar is coveted – and high reliance on the greenback – adds a further dimension of risk to capital markets and the world economy. Maurice Obstfeld, former chief economist of the International Monetary Fund, notes, dollar strength tends to impose contractionary pressure on the world economy. This is because the roles of US capital markets and the dollar are far bigger than the relative size of the US economy. While the US accounts for one-fifth of world GDP and one-tenth of world trade, the US dollar stands behind 90 percent of world forex transactions, two-thirds of official foreign exchange reserves, and half of all cross-border loans. US capital markets are those of the world and the dollar is the world’s safe haven. Yet, if you consider the criteria for sound money in the cold light of day, the US dollar fails on most of the metrics. This suggests – at the very least – a case for looking beyond the greenback as a default currency; and perhaps considering other options, even if only as part of currency exposure to get all investment eggs out of the dollar basket.

It would be bold to suggest that the US dollar will fall from its established place as the world’s reserve currency. There is some talk of co-ordinated currency intervention, as happened in the 1980s, with the Plaza and then Louvre accords, first to weaken the dollar and then to stabilise it. The difference is that the Plaza accord, in particular, suited what the US wanted at the time. This made intervention credibly consistent with its domestic goals. As Martin Wolf, a Financial Times columnist, notes, until the Fed is content with where inflation is going, that cannot be the case this time. Currency intervention aimed at weakening the dollar by just one or even several countries is unlikely to achieve that much. If in doubt, just ask the European Central Bank or Bank of Japan. To boot, even in the face of co-ordinated policy amongst major central banks, forecasting currencies is folly. If in doubt on this score, it is worth revisiting forecasts on the British pound made at the start of the year.

With these circumstances and challenges, arguably, a more considered approach for responding to the current conundrum might be to recognise the faults in the US dollar and look for the merit in other currencies. These could include the less widely held – but structurally stronger – South Korean won, and Singaporean dollar. And alongside these holdings, physical gold.

Sentiment should play no part in this determination, after all the greenback would not be the first dominant global currency whose number was eventually up. Just ask Britain which, for 100 years (1815-1920), held the world’s reserve currency – or, before that, France (1720-1815) or the Netherlands (1640-1720). We also need to consider that if diversification is the only free lunch in investing, then the principle should apply as much to currencies as it does to other denominations of investing, including asset classes and industries.

It is a rare circumstance when economists agree. When it comes to the waves of inflation that are washing over the world, it would be a coincidence inside a coincidence if, in agreeing, economists were also right. Since the 1980s Professor Steven Wilkinson has been suggesting that the world is playing a double-or-quits game. He may be right. Perhaps we are close to peak US dollar. Perhaps the buck stops here.

This bird’s-eye view affords us an elevated perspective that makes it evident that, since the 1980s, we’ve been living through a becalmed period of US domination, globalisation, minimal geopolitical tension, and a surge in technology and innovation which, together, have translated into a long period of capital market strength that has been largely devoid of price inflation. This cocktail of factors has combined to dampen investment risk and has produced a welcomed – but unusual – period of enormous prosperity and low volatility for investors. But the world doesn’t always look like this, and you don’t have to go too far back in history to be reminded of the other side of the coin.

Without being congratulatory of our position and critical of all other stances, it would be difficult not to acknowledge that the writing has been on the wall around current market challenges for some time. Unfortunately, not all managers of wealth have been paying attention to the warning signs, possibly because their primary motivation is based on growing assets under management by showcasing recent performance and not accepting the challenge of the primary mandate of investment, which starts with the long-term protection of capital as the foundation for growing capital. This requires independent thought and the conviction to stand apart from the madding crowd – no matter the shorter-term consequences.

In this instance, it didn’t take much for us to start beating the drum about the risk of unexpectedly high inflation all the way back in 2020 when inflation averaged just 1.2% in the US, but the monetary taps were gushing. Then, our alarm bells began ringing especially shrilly when it became apparent that the US Federal Reserve’s (Fed’s) policy was increasingly lagging the data – with the result that a widening gap, caused by providing liquidity irrespective of bulging debt levels, would require an almost impossible balancing act to close. Central banks appeared confident that they could repeat the “rabbit out of the hat” trick that was implemented post the global financial crisis of 2008. And while the initial market reaction agreed, the chickens are now coming home to roost.

As Milton Friedman famously observed: “Inflation is always and everywhere a monetary phenomenon.” With central banks pumping money into capital markets and governments spending wildly, it was only a matter of “when” inflation would arrive, and in “what size” – which is entirely at odds with the market story of the past two years that inflation would be “transitory”.

As is now well documented, consumer price inflation in the US and in other developed economies is at its highest levels in 40 years. And the Fed is increasing interest rates at an accelerated rate to try to keep these pressures in check. However, rising interest rates, elevated inflation, and high levels of debt are a toxic mix, slowing down economies and potentially pushing them into recession. The risk of stagflation – a cocktail of economic stagnation and high inflation – as experienced in the 1970s, is once more uncomfortably high and will leave vast parts of the asset management industry vulnerable to significant real capital losses.

World equity markets have lost in the order of US$25 trillion year to date, with global equity market capitalisation falling from US$121 trillion at the start of the year to US$96 trillion at the end of June – a loss of 20% in nominal terms. Bonds, which are supposed to defend portfolios in times of stress, have come under similar pressure, with the world bond market shedding US$19 trillion in value since January 2022 – a loss of 15% in nominal terms. This is a spectacular collapse in wealth by any measure, with traditionally decorrelated asset classes shedding value at the same time.

As history teaches us, stagflationary periods are a particularly challenging environment in which to protect capital. As the recent market experience shows, traditional investment approaches of long-only equity and the widely used “60/40” approach, comprising 60% equities and 40% bonds, are poorly suited to the current environment. As we have long argued, this approach is based on a limited view of the last 40 years and will be inadequate to protect and grow capital in a world with materially different economic drivers and changed market circumstance.

The problem with not learning the lessons of the longer-term past is that fundamentals can become detached from reality for long periods of time, and this can create the false impression that the investment world has entered a “new normal”. In this instance, the inevitable pain must arise from the reversal of decades of the “Greenspan put”, the buoying up of the system by central banks through quantitative easing and the creation of money, as well as abundant debt creation and fiscal stimulus packages. From elevated points, small ruptures can have amplified consequences. This period of deleveraging is particularly painful for speculators who find themselves adrift as they cling to shattered models. At the more extreme level, it is difficult and painful to witness the implosion of intangible assets such as cryptocurrencies and various mystifying derivatives. As easy money evaporates, so do past returns.

A well-structured portfolio in today’s market must include alternatives to the 60/40 model, such as inflation-linked bonds; precious metals, including gold; and commodities – all of which have performed a shock-absorber role during more turbulent inflationary periods, including the past 12 months. Our exposure to portfolio protection through longvolatility and other tail-risk positions is another increasingly important way of providing a convex return stream to offset the losses being recorded by growth assets. These positions have served us well, and we believe our core thesis remains set to play out further with hard yards still ahead for capital markets, central bankers, and investors.

Without putting too dramatic a point on it, we could be witnessing a decoupling of the world as we’ve known it. The last 40 years have rewarded “economic growth risk” but become complacent to “inflation risk”. Now we face a stark reality where the reward might be taken off the table, leaving only the risk. As a fundamental case in point, “safe haven” counter-cyclical bonds do not offer protection in the face of elevated inflation and rising yields – in real terms they are down the better part of 25% this year.

While it is impossible to predict the future, we do know that it’s mathematically foolish to expect returns to mirror those of the past 40 years. We also know that 80% of the volatility in a portfolio can be explained by asset classes. Therefore, for investors seeking to protect capital and dampen volatility, the only free lunch remains embracing a strategy of true diversification.

This is where patient money comes into its own, by recognising that an effectively diversified portfolio holding truly offsetting asset classes may lag during halcyon days. But when cycles turn – which they ultimately always do – this portfolio comes into its own. Our approach has highlighted three key takeaways. For significantly less risk, you can still achieve an equity-like return. Investment success is tipped in favour of patient capital. And wealth will continue to whisper while the world rages.

One of Genera Capital's key focus areas is helping its investors avoid the so-called "third-generation curse", the oft-quoted aphorism that wealthy families typically lose their wealth within three generations. A study of 3,200 families by US wealth consultancy Williams Group found that 70% of high-net-worth families lose their wealth by the second generation and 90% lose it by the third.

Gold’s name has common roots with the Afrikaans and German geld (money), and Dutch gulden (currency), which reveals something about gold’s attribute as a monetary asset. However, gold differs from printable currency (“paper money”) in that it cannot be created by fiat but must be mined from the earth. Gold has a fixed supply compared to easily printable fiat currency. To the extent that there is a demand for gold as a hard backing for money, the limited supply will ensure its price is well supported, at least far better than that of overprinted fiat.

Physical gold hedges the exposure that other assets have to monetary inflations, which are not limited to price inflation, and include supply disruptions because an unstable medium of exchange makes it harder to do business. The extent of gold’s power is evidence by central banks holding the precious metal to back their currency, discipline their ability to print money and, in so doing, serve as a hedge against deteriorating monetary conditions.

This summarises the conceptual case for gold: it is not necessarily a sure thing, but a “maybe” thing that may be just about the only thing – alongside inflation-linked bonds – that can protect against a serious bout of stagflation.

Here, however, challenges quickly emerge, with one of the most common being to compare gold’s returns to realised inflation. A regression of monthly gold returns on consumer price inflation for the United States (US) over 25 years shows virtually no relation. This readily supports the complaint that gold is a feeble inflation hedge.

The first impression is that gold is a poor inflation hedge. Grander versions of this faulty analysis, including more elaborate statistical methods, level the same complaint against gold being a poor hedge. But this conclusion misses a key point. If we apply the same method to US inflation-linked bonds over the same period, we are led to the same strange conclusion: even though inflation-linked bond coupons are directly linked to inflation, they have no relation to inflation. This sounds wrong because it is wrong!

A different – and corrected view – of gold and inflation-linked bonds is that they help manage the risk of changes to inflation and economic growth expectations going forward, and not backwardlooking realised results. That is because markets price assets based on expectations. From this, one would expect gold and inflation-linked bonds to at least have some (even if imperfect) similarity to one another. This is exactly the case, as shown over the past 20 years. Even more important, and returning to the diversification point, they behave different to US equities (S&P500) and produce a better return over the measured period. This is the free lunch of diversification which is earned by viewing gold’s relationship with inflation through the correct lens.

The real glory of stagflation assets – such as gold – is how they can be combined with disinflationary boom assets – like equities – to create a risk balanced portfolio that is better than either asset class in isolation. This is evidenced by the zig-zag pattern between equities and gold is caused by the fundamentally juxtaposed exposures to monetary and real economic supply and demand conditions (consider the early 2000s or 2015 to present). When held together in a diversified portfolio, the basket produces growth that is more reliable, just as rapid and with much lower real risk of loss. This is the power of diversification.

The above shows what is possible with two fundamentally different exposures that are risk balanced with one another. More can and should be done (by including more asset classes across a greater spread of geographic-economic blocs) to not place at needless risk the wealth saved up today, to meet the needs of the future to the extent that they can attained with financial wealth. Gold is not perfect, but that is the wrong standard anyway. The important point is that a portfolio is radically improved by including some of it, and that is the pragmatic, even central, point to take away. Some call it portfolio construction, Harry Markowitz called it a free lunch.

One of Genera Capital's key focus areas is helping its investors avoid the so-called "third-generation curse", the oft-quoted aphorism that wealthy families typically lose their wealth within three generations. A study of 3,200 families by US wealth consultancy Williams Group found that 70% of high-net-worth families lose their wealth by the second generation and 90% lose it by the third.

While that's often due to poor stewardship, it's also a symptom of protecting wealth from the impact of seminal historical events being no easy feat. From the French Revolution to Weimar Germany, wealth has ebbed and flowed with the shifting tides of socioeconomic and political history.

Goss cites the example of Zimbabwe and recalls the comment of someone whose wealth was affected by the country's economic collapse in the wake of its disastrous land seizures in the early 2000s.

To illustrate his point, Goss reveals a diagram on risk-balanced asset allocation across four quadrants depicting various combinations of future economic growth and inflation surprises (see diagram). The top left quadrant indicates stagflation, the uncomfortable mix of high inflation and low economic growth. The lower left quadrant shows the recessionary conditions of lower growth and lower inflation, while higher inflation and higher growth are characteristic of a boom. Benign economic conditions are marked by higher growth and lower than-expected inflation.

Goss says that's where careful asset allocation and diversification become critical to wealth preservation, a strategy he says must go beyond the typical split of 70% equity positioning with the remaining 30% of portfolios allocated to real estate, credit, bonds and cash. To protect against stagflation or hyperinflation, one has to incorporate meaningful allocations to assets like physical gold, commodities and real return hedges such as inflation-linked bonds.

Saville has been a successful entrepreneur and investment manager in the financial services sector for over 25 years. His passion for financial markets and the development of people, as demonstrated by his professorship at the Gordon Institute of Business Science, are well placed to make him an integral part of the Genera Capital team. He has been a positive voice for development in South Africa which is evident in his media activity, research and engagement in public policy.

During her career, Kathleen has gained significant global alternative investment experience. Kathleen will deliver and monitor suitable alternative investments and separately managed accounts for the families we partner. This is a natural continuation of our holistic investment offering where we have successfully provided access to several select opportunities alongside our risk-balanced portfolios. We believe that the targeted alpha from these opportunities offers a valuable uncorrelated return stream. As always, the careful selection of the right opportunities requires focus and a depth of expertise and plays perfectly to Kathleen’s experience in this regard.