As managers of private wealth, our clients leave us in no doubt about what they see as the most vital responsibility we have to them: to ensure the family’s capital can survive the worst that the world economy can throw at them.
When planning an investment strategy with new clients, this kind of stress test can seem slightly academic. Not today. The break-up of the eurozone is seen by many of our clients as inevitable and it consequences as catastrophic. The words ‘apocalypse’ and ‘armageddon’ have also been used.
Threat from debt
If there is indeed a lethal threat to the capitalist system and hence to their welfare, it is more about debt than equity. Debt was the origin of the banking crisis that began in 2008 and is at the heart of the eurozone crisis that it exposed.
It is therefore entirely intuitive that the investment strategies we adopt to preserve real wealth, at any level of risk tolerance, exclude all holdings of conventional bonds, sovereign or corporate.
Our exposure to debt issuers is limited to the UK government in the form of index-linked gilts and inflation-indexed National Savings certificates. The government is effectively also the debtor behind our clients’ insured bank deposits.
Avoiding conventional bonds is intuitive but also perfectly rational. In the particular circumstances the world economy finds itself in, we clearly cannot exclude the possibility of either deflation or high inflation. One of the greatest bond bull markets ever has left conventional bonds extremely vulnerable to both risks.
Governments may not be able to prevent the forced liquidation of excessive levels of debt, causing a vicious cycle of falling prices and incomes that mean debts cannot be serviced or repaid in full.
Ten-year gilt yields of around 2% have almost never been this low. They imply a high probability of this ‘debt deflation’ but the additional 2%-3% yield on the small population of high grade, sterling-denominated corporate bonds is not enough to guard against its consequences.
To the extent that monetary policies aimed at averting debt deflation eventually lead to high inflation and currency collapse, we might even experience both, in sequence.
Volatility versus inflation risk
We do not need to hold bonds or bond funds. The combination of insured deposits and index-linked government securities give us a range of options at all time horizons for matching the purchasing-power outcomes that clients need to guarantee.
Virtually all private client objectives for capital are properly defined in purchasing-power terms, so inflation can be one of the most important sources of risk.
Protecting against both nominal capital risk and inflation is vital both to match our clients’ near-term cash flows (usually ‘draw’ from financial assets to meet spending) and to control the ‘true’ range of possible real outcomes from risky assets.
In practice, hedged client liabilities rarely have a time horizon of longer than 10 years. They currently represent 27% of our total assets under management, but that is by chance the sum of customised allocations, given our client profile, not a target.
The rest is in equities, globally diversified, and so depends on the capitalist system, or ‘market economy’, being able to adapt and survive, given enough time.
Betting on survival has history on its side. The same cannot be said for bonds. Both nominal and inflation losses inflicted on bond holders have often been part of the course of distressed markets that businesses and equity have collectively (at the level of a representative index) successfully adapted to. Shifting losses onto debt holders can even be a necessary condition of the business sector surviving.
However intuitive and rational, managing risks without the use of any conventional bonds flies in the face of the investment industry’s almost universal embrace of ‘balanced management’, which requires conventional bonds to smooth short-term volatility and relies on differential bond weightings to describe a portfolio or fund as lower or higher risk.
This opposition would fall away if managers were to explain to their clients that when reducing short-term volatility risk, they were actually swapping it for inflation risk.
Stuart Fowler in the investment director at Fowler Drew Limited