Review Of The Current Investment Landscape - 2021 Edition - Seeking Alpha
Inflation Illustration

lorozco3D/iStock via Getty Images

lorozco3D/iStock via Getty Images
As is typically the case in the world of investment management, 2021 has been an eventful and interesting year. The year started with a substantial pick-up in economic activity worldwide, following the massive blow dealt by the COVID virus to the global economy in 2020. Two main factors contributed to this. First, the pharmaceutical industry was successful in creating a number of vaccines in a record time, which enabled a gradual reduction in restrictive measures imposed by various governments, leading to the ‘re-opening’ of the world economy. Second, monetary and fiscal authorities continued to extensively support financial markets and the global economy via their policies, including an unprecedented amount of fiscal stimulus in many countries.
However, before long, a number of concerns started to surface, in the form of supply chain issues, as well as rising inflation. Central banks were quick to point out that inflation was caused by these temporary disruptions in supply chains and would therefore be transitory. However, as the year progressed, supply chain issues did not ease in any significant way, labor shortages began to materialize, energy prices spiked, and central banks were eventually compelled to adjust their narrative of ‘transitory’ inflation and reevaluate their policies.
Later in the year, China started to come under the spotlight of the global investment community, notably due to an increasing level of government intervention in certain sectors, such as technology and education, as well as uncertainty about the foreign listing of Chinese companies. A more fundamental cause for concern was the fact that economic activity in China started to slow down rapidly in the second half of the year, for a number of reasons. First, similarly to most advanced economies in recent decades, China is starting to experience demographic pressures, including a slower growth in its workforce (or even a shrinking workforce), as well as the overall aging of its population. Second, as part of its effort to rebalance growth from exports and infrastructure/real estate investments towards domestic consumption and the production of higher value-added goods, the government has aimed to constrain the growth of private sector debt in 2021. This soon became problematic, particularly for the real estate market, as evidenced by the recent struggles of Evergrande and numerous other Chinese property developers.
Moreover, the COVID virus continued to be a challenge throughout the year, with the emergence of a number of variants, including the highly infectious Omicron variant, and an increase in the number of hospitalizations in several countries towards the end of the year. Thus far, this hasn’t led to the kind of highly restrictive measures we saw in the spring of 2020, apart from a few places in China. Still, pandemic-related restrictions would likely coincide with disappointing economic data in the quarters to come, should they materialize.
Overall, financial markets finished the year at or near an all-time high, and seemed little concerned about the ongoing COVID situation, the rising threat of inflation, China’s economic slowdown, or the prospect of policy normalization by monetary, and perhaps even fiscal, authorities. Seemingly, all is for the best in the best of all possible worlds.
Perhaps the most discussed topic in 2021 was inflation, so let’s spend some time discussing that topic, and its impact on asset allocation.
Inflation is on the move. 2021 saw a clear inflection point in the rate of inflation, to levels unseen in nearly four decades. Unseen, in fact, by the large majority of investment managers practicing today.

Inflation is the talk of the town

U.S. Bureau of Labor Statistics, Fred.org

U.S. Bureau of Labor Statistics, Fred.org
So what is inflation? It is commonly understood as the rate of increase in the price of goods and services. A perhaps more appropriate way to think of inflation is the decrease in the purchasing power of money, which manifests itself by an increase in the general price level. And if inflation is about the purchasing power of money, then it stands to reason that it is essentially a monetary phenomenon, ‘always and everywhere’, as Milton Friedman once famously stated.
Specifically, inflation occurs when the quantity of money increases at a faster rate than the output of goods and services in the economy. The evidence for this is quite compelling. Throughout history and across countries, there’s never been an inflation that wasn’t accompanied by an extremely rapid increase in the quantity of money. And there’s rarely ever been an extremely rapid increase in the quantity of money that didn’t result in inflation.
So why does this occur? Is it necessary, is it desirable?
In the first place, it is important to recognize where money creation occurs: at the level of central banks and commercial banks. Central banks create ‘base’ money by creating bank reserves, and through open market operations (i.e. purchasing securities in the market using new money). Commercial banks in turn also create money by lending out these deposits in the form of loans, via the fractional reserve banking system. Commercial banks are responsible for the vast majority of overall money creation, and clearly they’ve been at the center of many of the monetary booms and busts throughout history, the latest example of which being the financial crisis of 07/08. This paved the way for our current predicament, which has more to do with fiscal spending and money creation by central banks, rather than commercial banks, so let us focus on that side of the equation.
One of the main reasons why central banks create money is to finance government spending. Simply put, it enables governments to spend more than they raise in taxes. And yet, it is crucial to understand that whatever deficit exists, it is ultimately paid by us as citizens, via the accumulation of debt, and via inflation. There is no getting around this. Whatever the government spends, we unavoidably have to pay for in full. As we’ve stated in the past, debt accumulation, especially when used to finance present consumption, fundamentally amounts to borrowing from the future. Inflation, on the other hand, can be seen as a hidden form of taxation, and it’s easy to see why politicians see it as a wonderful way to finance government deficit spending. Money printing requires no vote, it comes very close to the notion of ‘taxation without representation’, and it is a concept that is obscure enough for the broader public not to recognize it as such, until it takes on such proportions that typically create massive social, economic, and political upheaval. Crucially, inflation also reduces the real value of debts accumulated over time, so one can clearly see how debt and inflation go hand in hand in reinforcing governments’ capacity to finance deficits.
But it would be narrow-minded to lay the entirety of the blame on elected officials. Arguably, we as voters are also complicit in this. That is certainly the case, when we ask our representatives to continue to increase government spending, without increasing taxes to pay for it. In other words, when we demand the ‘best of both worlds’ from them, as is quite common nowadays.
Is inflation necessary, is it desirable?
The economics discipline, in its current state, arguably misrepresents inflation by largely ignoring a key determinant that is the quantity of money, and by suggesting that its main drivers are increasing input costs (i.e. cost-push) or thriving demand (i.e. demand-pull). It also endorses the questionable notion that inflation is desirable, as evidenced by many central banks’ mandate to achieve ‘price stability’, or an inflation rate of 2% p.a.. But clearly, if one takes a moment to think it through, it’s easy to see that in the bigger picture, rising input costs and higher consumer demand can also be side-effects of money creation, rather than root causes of inflation themselves. Relating this back to the present day: are supply chain issues causing inflation, or is inflation causing supply chain issues? It’s certainly not as straightforward as central banks would have us believe.
As for whether inflation is desirable, we’re told that a little bit of inflation is a good thing. It stimulates spending, which is a crucial component of overall economic growth, by preventing consumers from being thrifty, and waiting for lower prices. And for most producers, moderate inflation is also seen as desirable, as they can typically increase prices faster than costs rise, which enhances their profitability. That is certainly the case if there’s hardly any competition.
All of these assertions are not unreasonable. But what’s the overall cost/benefit analysis? What are dangers of inflation? We’ve already mentioned that inflation can be considered a hidden tax that is largely outside the scope of democratic accountability. Another argument against inflation is that it incentivizes consumers and debtors at the expense of savers and lenders. And this has important implications in terms of savings, capital formation, investments in productive assets, productivity growth, and therefore overall long-term economic performance.
Inflation also has a highly disruptive impact on economic harmonies. It is a major contributing factor to rising inequalities, in that money creation does not impact all economic agents simultaneously. This is the central insight of what’s known as the ‘Cantillion effect’: that the closer one is to the emission of new money, the more one benefits from its emission before the unavoidable manifestation of higher prices. And in a world in which the economy has become increasingly financialized, this effect can result in massive increases in the price of financial assets, resulting in growing wealth inequalities. Moreover, lower-income households suffer disproportionally from inflation, as consumption of basic necessities represents a higher share of their total income. For these reasons, inflation, when left unchecked and once it reaches very high levels, will frequently lead to great social tensions and political upheaval.
Let’s also briefly discuss the manner in which inflation is measured, which may point to the fact that judging by official numbers, common citizens are not being helped in taking the full measure of the phenomenon. Focusing on the U.S., inflation is typically measured by the Consumer Price Index (CPI).
Simply put, the main issue with the CPI is that it is a measure we employ to try and gauge three different things: prices, the cost of living, and living standards. Now while all of these are clearly interconnected, it is important to understand that they are still different, and that it can be quite misleading to try and measure all of them with a single metric.
Take the example of housing, which obviously represents a large portion of one’s expenses. In most countries across the world, house prices and rents have risen significantly faster than wages, making housing increasingly expensive and less affordable. However, this is not fully captured by the CPI, which does not use house prices or rents in its calculation, but rather focuses on interest payments for home owners, and the concept of ‘owner-equivalent rent’ for tenants (introduced in 1983).
We can also point out that in an effort to have the CPI measure not just simply prices, but also the cost of living, the calculation methodology began using a geometric mean, rather than an arithmetic one previously, in 1999. This, together with the introduction of the ‘chained’ CPI in 2002, aims to reflect the changes in consumption patterns that consumers make in response to changes in relative prices, or the so-called ‘substitution bias’. For example, if the price of beef goes up, people might switch to a different kind of meat. Fair enough. Although it literally becomes an apples-to-oranges comparison, making the argument rather unconvincing, and it implies that such a switch is neutral in terms of satisfaction, which is hardly ever the case. Last, from a purely mathematically standpoint, it is important to note that a geometric average is always lower than an arithmetic one. Ok, maybe just a coincidence…
Finally, in an attempt to have the CPI place a larger emphasis on living standards, and not simply prices and cost of living, so-called ‘hedonic quality adjustments’ were introduced in the early 2000s. This method aims to remove any price differential attributed to a change in quality by adding or subtracting the estimated value of that change from the price of the old item. While it is commendable to try and estimate the enjoyment, usefulness, and quality of life that goods offer in comparing prices over time, it seems clear that this is a task that comes close to being impossible. How does one separate utility, or quality, from all of the other considerations that influence prices? And isn’t utility a value judgment that is largely subjective, rather than objectively quantifiable for all persons collectively? At any rate, hedonic adjustments indisputably contribute to the incoherence and dangers of trying to have a single measure appraise the change in prices, cost of living, and living standard all at once.
Cui bono? Who benefits? Well, readers will no doubt have noticed that all of the adjustments made to the calculation methodology over the years have had the effect of reducing, rather than raising, the CPI. Again, maybe just a coincidence… But when you relate this back to what we previously discussed regarding government deficit spending, and the impact of inflation on the ‘soft defaulting’ of debt, it isn’t hard to see that the incentives are there for perpetual monetary expansion and inflation. It certainly seems beneficial for governments to generate moderate inflation, all the while preventing it from going out of control and becoming an economic or social issue. And considering the psychological component of inflation, underreporting it in official metrics such as the CPI makes quite some sense. Furthermore, it is important to note that many mandatory expenditures, such as social security, are directly linked to inflation, providing another strong incentive to keep that measurement artificially low. For those that prefer to refer to hard figures rather than theoretical arguments, suffice it to say that the latest reading for U.S. inflation stood at 7.0% for 2021. Using the calculation methodology of 1990, that number is currently above 10%. And using the methodology prior to 1980 would bring it up closer to 15%.

Consumer Inflation 1980-based

Shadowstats

Shadowstats
Fiscal deficits of historic proportions financed by central bank money printing, pandemics, supply chain shocks, energy transitions, mountains of debt, demographic shifts, faltering globalization and numerous other challenges define the current investment landscape and have culminated in levels of inflation last seen when Paul Adolph Volcker Jr. was the Chair of the Federal Reserve – a period of great structural shifts in the world economy.
Let us now tie all of this back to the practice of investment management and make a transition to asset allocation.
Demanding that governments should run ever-growing deficits on our behalf, and never raise taxes or cut spending, is a dangerous strategy. It may very well result in the debasement of the currency, and mounting inflationary pressures, which, for all of the reasons we’ve described, has more costs and dangers than benefits. Unmistakably, the return of a higher rate of inflation has been one of the most significant developments of 2021. It is something that investors need to reckon with, as is a certain probability that it may continue to accelerate or remain at currently elevated levels for a period of time. This marks a substantial departure from the type of investment environment that has been prevalent for the last 40 years, characterized by a declining rate of inflation and falling bond yields. As a result, investors may be well-advised to reconsider whether typical asset allocation frameworks for exposure to fixed income securities and public equities remain appropriate.
But that is not to say that inflation is now the only thing we need to worry about. For years, central banks have been fighting against an inflation rate that they deem to be too low, which – while it may not be the worst thing in the world for consumers and overall economic prosperity – is clearly not in their interest. And there are some strong deflationary drivers out there. Technological progress is most often cited these days. It is also important to recognize that monetary expansion and debt accumulation, in itself, also ultimately becomes a strong deflationary force. This occurs because the accumulation of incremental debt has a diminishing marginal productivity. So, while the amount of debts outstanding increases alongside monetary expansion, inflation rates increase and nominal prices rise, but real output does not grow as fast. And this growing gap creates an increasingly strong deflationary force. As a result, more often than not, inflation ultimately ends up in economic recession or depression, a process through which the liquidation of unproductive debts/credits results in lower prices.
So it’s not as simple as saying we just need to worry about inflation from now on, and invest accordingly. Certainly not for longer-term capital allocators. For us at Oyat, the developments that occurred in 2021 change surprisingly little in the manner in which we’re positioned across asset classes. In a world of monetary abundance, we want to mainly focus on owning scarce and/or productive assets, as well as maintain some level of optionality by holding liquid reserves. In that sense, we’ve long been positioned in a way which adequately reflected the anticipation of a return to a higher rate of inflation. But we’ve also been strong advocates of a balanced positioning, that accounts for the possibility of various outcomes, including a deflationary recession/depression. Ultimately, we recognize that various outcomes are possible, and therefore aim to maximize the chances of satisfactory results irrespective of how the investment landscape develops from here. After all, being the culmination of so many complicated inputs, inflation is notoriously difficult to predict. We feel comfortable that such a balanced approach is coherent with our investment objectives and overall level of risk tolerance, which each investor will have to evaluate for their unique situation – please remember that when viewing our asset allocation and notes below.
The following graphs highlight our asset allocation as of December 31st 2021. The first graph (left) displays our total asset allocation, including assets held in escrows from former divestitures. The second graph (right) focuses on our liquid assets, and thus excludes real estate, private equity, private loans, and escrows.

Asset allocation

Oyat

Oyat
Non-U.S. stocks to U.S. stocks relative performance (1970-2021)

US / Non-US stocks performance

First Eagle

First Eagle
Relative valuation of ‘Growth’ to ‘Value’ stocks in the U.S.

Relative valuation of Growth to Value stocks in the U.S.

First Eagle

First Eagle
We also provide a peek into our equity allocation with the top-ten positions in our global equity fund below. The fund aims to achieve long-term appreciation of capital with minimal risk of permanent capital loss, while providing a certain level of current income.

global equity fund Top-10 companies

Oyat

Oyat
Overall, our asset allocation remains very prudent, which we believe is warranted given the overall market environment, including high valuation levels, accelerating inflation, and a number of significant economic, financial, and geopolitical risks. As far as liquid assets are concerned, each portion of our allocation serves a specific purpose. Our exposure to equities aims to provide us with capital growth, and some level of liquid income. Precious metals and alternative investments represent the ‘anti-fragile’ portion of our allocation, which should serve us well in case of pronounced market turmoil, whether characterized by inflation or deflation. And finally, our cash reserves give us some level of flexibility and option value to acquire assets whenever attractive prices present themselves.
Ultimately, the investment landscape remains complicated and hard to predict, especially with inflation potentially heralding a structural change in the overall investment backdrop that most of us are familiar with from the last four decades. True diversification seems the best strategy for now.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of FNV, GDX, GDXJ, BRK.B, RHHBY, ENB, UL, MPGPF, NVS, HRB, OMC, NVO, RDEIF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article should not be considered as investment advice. While we hope you find this article informative, please do your own research – or speak to a financial adviser – before making any investment decisions.

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