4E CIO Letter - Crucial Changes Within Financial Markets – August 2020
The COVID-19 pandemic has not only shaken the world in the short term but is likely to be a key event that will influence the political and financial market environment in the long term. The reactions of central banks and governments remain unprecedented. In a short time, interest rates were adjusted towards zero and quantitative easing (QE) programs resumed. For the first time, the Federal Reserve has committed to buying corporate bonds in the lower quality segment. Governments introduced a range of fiscal measures from direct payments to loan guarantees. In economic terms, this is a (dangerous) merger of monetary and fiscal policy, which will be examined in more detail below.
Thank you for your interest in 4E Capital and enjoy reading our "Crucial Changes Within Financial Markets" letter from the CIO.
Chief Investment Officer (CIO)
Consequences of deficit financing
The purchase of government bonds by central banks due to the coronavirus has been accelerated and facilitated. The debate among experts, whether this is legal, is controversial. However, many countries would no longer be able to finance their accumulated debts if they did not have the support of the federal banks. Central banks will keep their reference interest rates close to zero percent for a long time to avoid governments from collapse under the burden of their interest debts. This threatens a vicious circle with even higher debt levels, which may only be defeated by steadily high inflation rates.
The deflationary trend of recent decades caused, inter alia, by globalization, technological progress, and China's integration into the world trading system will become less pronounced due to current events and will probably come to an end. Inflation depends on money growth and the velocity of circulation. Although central banks have managed to inject liquidity (money growth) into the financial system, the money that has been created has hardly reached the real economy. The outcome has been higher asset prices and debt levels, but it has not yet increased the velocity of circulation and hence inflation rates.
The quantity of money is currently growing worldwide at a strong rate due to direct government intervention in the commercial banking system. By providing credit guarantees to banks, governments allow them to extend credit to businesses and consumers without risk. Politicians have thereby found a powerful tool not only to create money but also to significantly increase the speed of circulation without (apparently) affecting the government’s budget. A very tempting call not only for banks but also for politicians to create inflation and reduce debt in a very cheap way. This is a way of increasing money supply that completely bypasses central banks and is linked to a (self-caused) not negligible loss of power.
Higher inflation figures may reach us faster than expected if the economy normalizes in the coming quarters, and commercial banks increase lending based on credit guarantees.
Implications for investors
The financial system is changing fundamentally with far-reaching consequences for investors. Today more than ever it is important to design a portfolio in an agile and intelligent way, which can overcome costs, current yields close to 0%, and potential inflation.
With "nominal" investments - like bonds - one must be careful and attractive opportunities in the lower quality range, should be actively identified and selectively added. Real estate, precious metals, cryptocurrencies, and instruments that can benefit from increased volatility should be strategically considered. Selectively, equities have also a reasonable chance of profiting from an inflationary environment. While a broad market index might not profit as a whole, a systematically constructed portfolio should be well-positioned to master upcoming challenges.
4E US Equity Selection (blue line): +41.9%
S&P 500 Total Return (grey line): +35.6%
4E Capital has proven from the outset that generating excess returns can be achieved through a structured and disciplined selection process and are convinced that active and forward-looking management will pay off for our clients in the long term.
We remain at your entire disposal for any consultation you may require.
Javier, CIO 4E Capital
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