- Central banks’ balance sheets have quadrupled in the last decade.
- Balance sheets will continue to balloon as there isn’t another option for economic growth in developed countries.
- You should start to think about protecting yourself from inflationary pressures now, when such fears seem distant and unlikely. It’s the cheapest time to do it.
Yesterday we discussed the three drivers that could push markets higher if all other factors like interest rates, risk perceptions, and global political issues stay as they are now. However, we didn’t discuss what happens if the underlying pillars that have been holding up global financial markets since the Great Recession change. Today we’ll discuss what could change and how to properly diversify.
Never Take Things For Granted In Financial Markets
Two things that many take for granted are low inflation and low interest rates. However, central banks’ balance sheets have quadrupled in the last 10 years. This has influenced financial markets in a very positive way through low interest rates, however, we don’t know when and if things will start to change.
Figure 1: Central Banks balance sheets. Source: National Inflation Association.
The biggest change from the current situation should be higher global inflation. Quadrupling assets without quadrupling economies has to lead to higher inflation, eventually. The issue is that for now, everyone regards these inflated balance sheets as normal and not a threat because inflationary pressures are low.
Low inflation is just central bankers getting lucky. It isn’t a result of them doing a great job, but more the result of the changes in the global economies, technology enabling unlimited supply and thus lowering production costs, low commodity prices as a consequence of increased investments due to low interest rates, etc.
Figure 2: Global inflation in the last 30 years. Source: World Bank.
Thinking that things will remain the same in the future could be the correct way of thinking, but it’s also potentially very dangerous if such assumptions fail to hold. We’re in a moment when everything seems excellent, the economy is doing well, employment is low, and there are more jobs. However, few understand that this is the consequence of seven years of near zero interest rates. With inflation starting to pick up, the FED will be forced to raise interest rates which could lead toward a recession that will push the FED into balance sheet expansion, again.
It’s a vicious circle we have entered, one where no one dares push on the brakes because they understand the terrible consequences it would have. Sooner than later we will see more easing and ballooning of central banks’ balance sheets.
Looking For Protection
You can protect yourself from higher inflation and ballooning balance sheets with investment vehicles that, in theory, should increase in nominal value alongside inflation. Those investment vehicles are the ones in relatively fixed amounts such as gold and land.
We showed above that central banks’ balance sheets have increased four times in the last 10 years, which is close to what happened with gold. If we take an average price of $500 per ounce from the beginning of the century and the high gold reached of almost $2,000, it’s close to the four-fold increase. Gold has dropped as the financial community took the low interest rates and low inflation as granted. If that changes, gold should surge again.
Figure 3: Gold price in the last 20-years. Source: Macrotrends.
Other precious metals like silver, or other commodities, should also do the trick.
The issue is that we can’t know if gold will go from the current $1,160 per ounce to $800 or $500 before surging to above $2,000, but as the above trends clearly show that money is and will be worth less and less, it’s a good time to start thinking about dollar cost averaging.
Dollar cost averaging implies putting equal amounts into a certain investment through a longer period of time. In that way, you minimize volatility and as long as things go well with the economy, interest rates increase you have a longer period of time to do so.
The question now is how much of your portfolio should you put into gold in the next year or two. Ray Dalio says that:
“If you don’t own gold, you know neither history nor economics.”
You can read more about Ray Dalio’s approach to investing and his all-weather strategy in our article available here. In that article, we discuss his strategy of having 25% of your portfolio risk in assets that do well in rising inflation. That’s 25% of your portfolio risk, not your portfolio. There is an important difference there and you should hold assets that protect you from inflation, like inflation linked bonds and commodities.
The next question is, how can you invest in gold? You can invest directly or through miners. Be aware that miners are far more volatile and such investments carry much more risk as the end result could be zero. A good compromise could be an ETF like the iShares MSCI Global Gold Miners ETF (NYSEArca: RING).