Confronted with the possibility that the endgame of the present experiment in extreme monetary accommodation may be higher inflation and even currency disaster, many private investors and portfolio managers respond that they should be okay, since their wealth is protected through allocations to equities and real estate. In contrast to cash and fixed income securities, which are certain to get obliterated in an inflationary environment, equities and real estate are considered some form of ‘hard’ or ‘real’ asset, not just nominal paper promises. “Why should I own gold? A well-diversified portfolio of top international companies should give me good protection against any major disaster,” a senior portfolio manager told me. “I don’t know about gold. What’s so special about it? But I own real estate. If we enter a high inflation scenario, real estate will maintain its value”, a private investor said. But how probable is it that those strategies are going to work?
The Wages of Fear
Let us consider the overall backdrop first. Most experiments with unconstrained paper money in history ended in hyperinflation and currency collapse. Those that didn’t were terminated by a political decision to return to commodity-linked, inelastic money voluntarily, a move that required a combination of economic literacy and political backbone that I will leave to the reader to assess if it can be found in sufficient measure among today’s political and bureaucratic elite. Our present fiat money experiment is close to 43 years old and showing signs of serious strain: For a number of years now central banks have been maneuvering themselves into a corner where they must keep rates at zero and keep propping up certain asset prices through targeted money printing operations to maintain the mirage of the system’s solvency, and there are little signs that any of them is going to find a way out anytime soon.
I know, I know, there are two alternative memes making the rounds presently. One maintains that a deflationary correction is more likely than inflation. The other that a recovery is on track and that this will allow central banks to pull back. The former is not entirely silly. One of the side-effects of relentless bubble blowing is indeed that Mr. Market will occasionally insist on deflating the bubbles. But then the global monetary politburo that holds the keys to the printing presses knows better what the world needs and won’t let Mr. Market do his work. Thus, money-printing will continue. Remember Mr. Bernanke and his apodictic declaration that a ‘determined’ government can always create higher inflation. The second meme is popular but silly, and not the topic of this essay.
The first thing to say is that the idea of equities being a good protector against monetary disaster sounds too good to be true. Here is an asset class that benefits immensely from the current policy of “quantitative easing” and interest rate repression, as even the most hardened believers in equity-markets as disinterested and trustworthy barometers of economic health will find it hard to argue that present valuations purely reflect solid company fundamentals, yet equities should also do well when the recovery finally enters self-sustainable speed and the central bankers exit, and even offer protection for when central bankers don’t exit and we finally go into inflationary meltdown. – Wow! Stop the presses! Here is an asset class that you cannot lose with. (Well, maybe with the exception of the deflationary collapse.)
We should maybe get a tad suspicious if an asset class claims to be the winner in all seasons. Maybe the explanation is psychological. People like to own assets that are sufficiently mainstream, which means they have done well in the past, and assets that offer an income stream (dividends or interest payments), because even if they attach (as I do) a meaningful probability to high inflation and even to currency disaster, the timing of it all is difficult and waiting is so much easier when you are sitting on an income stream. I suspect that there could be an element of wishful thinking at work when investors argue that equities offer disaster protection as well. Like most other people I, too, want to have it all but I believe the universe was not quite so kind to us and arranged things differently. Usually, life requires harsher trade-offs. So at present, the returns from rising equity markets and the paltry returns from fixed income are the ‘wages of fear’ that investors get paid for driving nitroglycerin-filled trucks through the financial jungle, just as in Henri-George Clouzot’s eponymous 1953-classic. Remember: the way to hell is paved with positive carry!
Equities versus Gold
I am not denying that equities do have, in principle, the potential to offer some degree of protection against inflation and other financial calamities imposed by government. A reader from Germany recently wrote to me how his father had managed to protect large chunks of his personal wealth through World War II and subsequent currency reform by holding shares in some of Germany’s top companies (and diligently avoided bonds – in particular government bonds!). There can be little doubt that owning claims to the capital of well-established productive concerns is superior to owning securitized promises of politicians. But what about equities versus gold? In my view, gold is still the essential self-defense asset against fiat money disaster, certainly in case of hyperinflation but probably even in a deflationary calamity.
If you own gold you own a universal monetary asset, a global, inelastic and apolitical form of money. Its value is not derived from any specific enterprise, any industry or nation, or any issuing authority. It is nation-less, boundary-less, completely global in its appeal – an international and for all I can say ‘eternal’ form of money. (I like Bitcoin but I don’t think it is quite up there yet.) If you own equities instead you hold claims on the future income stream of specific and hopefully continuously productive enterprises. Shares are not just claims on any “hard” assets that a company may own, such as land or factory buildings but constitute claims on the future profitability of particular business models. But inflations are macro-economic fiascoes. They are disasters, and disasters of a peculiar kind. Some firms may indeed benefit, at least initially, from rising and even high inflation but for many companies inflation will create severe problems. Many companies will indeed go under.
One of the many problems with inflation is that it greatly complicates economic calculation (to the point of making it almost impossible), and that it encourages entrepreneurial error. It can, of course, be said that encouraging entrepreneurial error is the very modus operandi of any policy of easy money: artificially low interest rates ‘work’ by creating an illusion of high savings availability, of a low time preference of the public that should enhance the feasibility of long term investment projects. Via low interest rates entrepreneurs are lured into investment projects that are bound to lack, in the long run, the necessary support from the public’s true voluntary savings. ‘Easy money’ encourages investment always and everywhere under false pretenses. But the point here is that, once inflation really kicks in, the errors are likely to compound.
A common problem of calculation under inflation is that many companies will report ‘phantom’ or ‘apparent’ profits, which result from rising sales revenue being booked as income while the also rapidly rising replacement costs for machinery or semi-finished goods are often not fully reflected in depreciation charges, and often remain difficult to ascertain anyway as high inflation is also volatile inflation. Some of what is shown as profit will ultimately simply constitute ‘eating into capital’. Long term planning and economic calculation are greatly disrupted by inflation. In any case, inflation will create some winners but also many losers, even to the point of company failures. High inflation economies are sick economies and usually not a good place to invest.
Historical Example: Germany 1918-1923
In 1931 the Italian economist and statistician Costantino Bresciani-Turroni published a study of Weimar Germany’s descent into hyperinflation under the title Le Vicende del Marco Tedesco, which was translated into English under the title The Economics of Inflation, and published in 1937. Among many other things, Bresciani-Turroni also looked at how equities fared: in rapidly depreciating paper money terms, in dollar terms (which means versus gold), and relative to the wholesale price index.
Such studies must always be taken with a generous helping of salt, for a number of reasons. First, history can tell us what happened (in specific and always unique instances) but not what must happen (as a general rule). The social sciences know no laboratory experiments. The next inflationary meltdown may look different from this one. There is no reason to believe that what was observed in Germany at the time must be prototypical for all currency collapses going forward. Second, any study that uses historical data, meaning statistics, is potentially subject to challenges on account of the methodologies used and the accuracy of the underlying data, and this is the case many times over when data series are of such staggering volatility and even somewhat dubious reliability as they are in the case of Germany’s quick descent into monetary chaos. Be that as it may, the study is still very interesting.
Sensibly, Bresciani-Turroni starts his account in the summer of 1914, when Germany left the international gold standard to allow for inflationary war financing. As almost always in the history of money, the state decreed to get rid of the gold anchor so that it could fund itself by printing money freely, and not, as the fairy tales that modern macroeconomists tell themselves will have it, because the gold standard was oh so inflexible and deflationary, which it was, of course, but that was a good thing.
Bresciani-Turroni takes the average of an official German stock index for the year 1913, the last gold standard year, as the base and sets it at 100. He then charts the index in paper mark prices through to 1923, and also calculates the index adjusted for the mark’s steep depreciation versus the dollar, and adjusted according to the index of wholesale prices.
I give you the conclusion right away: If you had held paper marks throughout you would have lost everything. Paper marks became worthless by the end of 1923. Equities did much better but over the whole period underperformed the dollar (and thus gold) and the wholesale price index. By the end of 1923, the stock index that was on average 100 in 1913 stood at 26.80 if adjusted for the dollar exchange rate, according to Bresciani-Turroni’s calculation. In gold-terms you had thus lost more than 70 percent of your purchasing power by staying invested in German equities. Adjusted for wholesale price inflation, the index stood at 21.27. Yes, you avoided total annihilation of your wealth but you were still almost 80 percent poorer measured in the real prices of goods and services and also about 70 percent poorer in gold terms.
What is also fascinating is the sheer volatility of the stock market throughout that period. In 1918, the year of the armistice, the index dropped 30 percent in nominal terms, more than 50 percent in dollar terms, and more than 40 percent when adjusted for inflation. In nominal terms, the index reached a low of 88 in late 1918 (remember: the average of 1913 = 100) and never looked back. It rose to 127 by the end of 1919, 274 by the end of 1920, 731 by the end of 1921, 8,981 by the end of 1922, and it finally reached 26,890,000,000,000 (that is 26.89 trillion) by the end of 1923. Yet, it still underperformed gold and wholesale prices.
In 1919 the nominal index rose 30 percent, yet in gold/dollar terms German equities lost more than 70 percent that year. The years 1920 and 1921 are of particular interest. Inflation had set off a speculative frenzy in Germany. “Playing” the stock market had suddenly become a national obsession. Over those two years the nominal stock index did indeed keep pace with the ongoing destruction of the German Mark. By the end of 1921, you would have even come out slightly ahead of gold and overall prices when compared to early 1920 as a starting point. However, this changed again dramatically in 1922 when the German public shifted its focus to foreign exchange and gold as protectors of their real wealth. Although the nominal stock index grew more than tenfold in 1922, German equities lost 70 percent of their value in gold terms and in wholesale items. The public turned their back on stocks as they sensed that Germany was heading for economic ruin. In October 1922 stock prices were in fact so depressed that some truly bizarre situations occurred:
“…all the share capital of a great company, the Daimler, was , according to the Bourse quotations, scarcely worth 980 million paper marks. Now, since a motor-car made by that company cost at that time on an average three million marks, it follows that ‘the Bourse attributed a value of 327 cars to the Daimler capital, with the three great works, the extensive area of land, its reserves and its liquid capital and its commercial organization developed in Germany and abroad.’”
In 1923, stocks did again remarkably well. In what looks like a classic “crack-up boom”, in which everybody desperately tries to get out of paper currency and rushes to buy just anything, the equity index did outperform gold, dollar, and wholesale prices. Despite this impressive sprint, equities were still, over the entire period, a suboptimal tool for wealth protection.
Some Observations on Real Estate
Interestingly, owning real estate proved disastrous for many people in Weimar Germany. There is no detailed analysis in Bresciani-Turroni’s study but the anecdotal references are hardly encouraging. Rents were regulated by law and in the rapid inflation of 1922 and 1923 could apparently not be adjusted quickly enough. Real estate became a zero-yielding asset while maintenance costs exploded:
“In 1922 and 1923, because of the rapid depreciation of the mark, the old house-rents became ridiculous. Consequently the value of houses fell considerably. Many landlords, for whom houses were now valueless because the rents did not cover maintenance expenses, were forced to sell them.”
Germany’s hyperinflation was an economic, social and political disaster. It impoverished large sections of the German middle class, in particular those who were conservative with their finances, who saved and who entrusted their savings to the state-sponsored financial infrastructure: banks, insurance companies, government bonds, mortgage bonds. Real estate investments offered poor protection and even equities were suboptimal. Having gold bars stored in a Swiss safe deposit (or even a German one) would have done the trick.
Again, history does not – usually – repeat itself. Next time things may unfold differently. Yet, gold certainly remains my favorite asset.
[Must Listen: Steve Hanke on the Characteristics of Hyperinflation]