Five years on from the first pandemic in more than a century it is salutary to recall how working habits were upended, leisure was curtailed and family relations severed because of the Covid-19 lockdown — except, of course, in Boris Johnson’s riotous entourage in Downing Street.
Likewise, now that restaurants, theatres and holiday travel are vibrant again, to appreciate how the investment landscape has been radically transformed, leaving us with important questions about how we manage our money.
In pre-pandemic days there was little volatility in output and inflation. But everything changed with the Covid-19 lockdown. While central bankers have done well to bring down the ensuing inflationary surge without inflicting big increases in unemployment, inflation is proving difficult to return to target levels. At the same time, higher volatility has become endemic in the markets.
Much of that reflects chaotic policymaking by the new Trump administration in Washington, most notably in relation to on-off proposals to impose 1930s-style tariffs on the US’s friends and foes alike. As Steven Blitz, chief US economist at TS Lombard, remarks: “The sum of Trump’s actions can yet skew the economy in any which way, including an implosion of capital spending.”
Notwithstanding Donald Trump, and his capacity for economic self-harm, there is no escaping the reality that geopolitics poses a much increased challenge to investors, with Russia’s invasion of Ukraine and an evermore aggressive China combining to raise volatility. Yet one immense benefit of the Trump administration’s wavering commitment to Nato is that it has caused a dramatic policy shift in Europe, especially in Germany. Friedrich Merz, winner of the German election last month, has pledged to retreat from his country’s long-standing fiscal conservatism and aversion to defence spending by amending Germany’s constitutional debt brake.
This is a remarkable watershed and is part of a wider recognition in Europe that military and infrastructure spending has to be increased significantly. A postwar settlement whereby Europeans enjoyed a peace dividend that helped finance generous welfare systems while defence spending declined under the protection of a US security guarantee has been reversed.
After years of economic stagnation in the Eurozone, this sea change holds out the hope that fiscally expansionary rearmament will put Europe back in business. And after years of low European stock valuations relative to the US, surging share prices, led by the European defence sector, suggest that global capital is reappraising European prospects.
That said, an important factor weighing on markets is the debt legacy of the pandemic and the earlier period of ultra-low interest rates. Across the developed world public debt is now at record levels.
Government budgets will be further stretched by the need to support health spending and pensions for ageing populations along with higher defence and climate-related spending. With interest rates having normalised since the inflation rise, borrowing costs on all this debt have risen and will cause pain and mounting defaults as debt is refinanced over time.
The good news around this interest rate normalisation is that defined contribution pension scheme members can now earn respectable returns as they de-risk their pension pots by shifting from equities into bonds and cash before retirement. This is in contrast to the pre-pandemic period when bonds — supposedly safer investments than equities — were seriously overvalued.
The bad news is that these levels of debt could be financially destabilising. In the judgment of William White, former economic adviser at the Bank for International Settlements, continuing inflationary pressures and higher real interest rates are likely to endure for much longer than most people currently envisage. Thus, he says, a serious global debt crisis seems likely.
He also observes that the three recessions preceding the pandemic were all triggered by financial disturbances, each following a long period in which debt was rising faster than GDP and asset prices were also rising rapidly. This is a salutary reminder of how finance has become the Achilles heel of the real economy.
Another striking change in the investment landscape over the past five years is the outright victory of passive funds over actively managed funds in terms of market share. This has been a boon for private investors because the very low fees on indexed funds ensure enhanced returns over the long run relative to higher charging active funds which have on average underperformed the indices in recent years.
A further advantage of passive investing is that with most defined contribution pension funds investing substantially in benchmarked global equity portfolios, home bias — investors’ preference for assets in their own domestic markets — is eliminated. That tends to enhance performance, although there is growing political concern about pension funds’ neglect of UK equities.
Yet with indexing there is a new risk of investment concentration. The percentage of US stocks in the MSCI and MSCI All Country World indices has long been at all-time highs. This partly reflects the enormous market capitalisations of big US tech stocks, notably the so-called “Magnificent Seven”: Nvidia, Apple, Amazon, Alphabet, Meta, Microsoft and Tesla. It follows that markets are vulnerable to the performance of just a handful of corporate giants. This also raises questions about systemic risk.
Note here in addition that Elroy Dimson, Paul Marsh and Mike Staunton in the UBS Global Investment Returns Yearbooks have established that over more than a century investors have placed too high an initial value on new technologies, overvaluing the new and undervaluing the old. Also worth noting is that while US equities outpaced European markets from 2010 to 2020 US performance was worse in the decade before, because of the bursting of the dot.com bubble and the subprime mortgage crisis.
In sum, we are in a new world of geopolitical friction, increased volatility, greater vulnerability to inflation, excessive debt and heady equity valuations. How should investors respond to this toxic mix?
The first priority has to be diversification and a more defensive portfolio stance. Modern portfolio theory (MPT) tells us that if investors add non-correlated assets to their portfolio they can enhance returns and reduce risk. This, according to the late Harry Markowitz, the pioneer of MPT, is the only free lunch in investing.
The snag is that even a very diversified portfolio cannot make money in a steep market decline. In a market crash equities and bonds tend to move in lockstep. They cease to be negatively correlated.
This makes the case today for an asset that was anathema in the pre-pandemic period, namely cash. Back then the return on cash was dismal. And over the long run cash underperforms equities and bonds. But in periods of extreme volatility it offers genuine diversification against bonds and equities. And in periods of low inflation it is a solid store of value. For private investors, cash is thus a vital portfolio hedge in current circumstances.
Another obvious hedge against the plethora of post-pandemic risks is gold. The yellow metal is, in one sense, a paradoxical safe haven. It yields no income and is thus a purely speculative asset. As the great investment sage Warren Buffett once remarked, “Gold gets dug out of the ground in Africa, or some place. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Well, yes. But gold has form going back to the ancient Greeks who associated it with the gods. And, as the economist Willem Buiter has pointed out, gold has had a positive value for nigh on 6,000 years, making it the longest lasting bubble in human history. That pedigree means it is a genuine hedge in the present financial turbulence against future inflation and geopolitical risks.
The trouble is that the gold price keeps hitting new peaks, despite the fact that the opportunity cost of holding a non-income producing asset has greatly increased with the normalisation of interest rates.
This is probably not the time to head for the exit, not least because central bank reserve managers around the world are seeking alternatives to the world’s fiscally challenged reserve currency, the dollar. But investors should recognise that the gold price tends to overshoot both upwards and downwards over long periods. Those who bought at the peak of the 1971-81 bull market in the metal saw a loss on their investment in real terms of much more than half over the next 20 years.
What, then, of the qualities of crypto as a portfolio hedge? The key point is that there is even less underlying value than in gold. Saul Eslake and John Llewellyn of Independent Economics point out that these instruments neither represent a claim on assets (unlike shares or mortgages), nor have they any alternative use (unlike gold, other commodities and property). Their primary uses, they add, appear to be to enable payments by criminals and to scammers, and to provide speculators with more fodder. They are only worth what people in their collective wisdom think they are worth.
Meantime, Maurice Obstfeld, former chief economist of the IMF, argues that a fundamental problem with most cryptocurrencies, aside from stablecoins, are that they are disconnected from the real economy and operate beyond the reach of public policy. They thus introduce significant uncertainty into financial transactions, making them an unreliable foundation for economic decisions. Even stablecoins, he adds, are only as good as the assets backing them.
So this, compared with gold, is a very immature, low-quality bubble. But judgments about it are complicated by Trump’s declaration that he wants the US to be the “crypto capital of the planet”. This is accompanied by much talk about the creation of a bitcoin reserve to purchase US government debt. Once again, investors and speculators are hostage to potentially chaotic policymaking. Be well advised to leave this minefield to criminals and credulous retail investors taking time off from punting in frothy meme stocks.
Is my advocacy of essentially defensive portfolio positioning unduly cautious, you might ask. Good reasons to raise this question include the prospect of almost certainly unsustainable debt-driven expansion in the US under Trump and, in the light of Europe’s shift to a defence build-up, a fiscal lift across Europe. Equally important, we live in a world of asymmetric monetary policy where central banks rush to put a safety net under markets and banks when they collapse, but impose no caps on soaring asset prices. This is potentially a general anaesthetic for permabears.
Yet the level of debt in the developed world is extraordinarily high. According to the Institute of International Finance, a bankers’ trade body, global debt hit a record high in 2024 of $318tn. The implication is that bond vigilantes may be due to make a comeback. If this is right, as the British experience of the short lived Liz Truss government suggests, we are heading for an era of greater interest rate instability and potential financial shocks.
In this new world, value no longer looks a disaster relative to growth. Government bonds, offering positive real yields, are no longer the pre-pandemic graveyard they used to be. Boring equities look modestly interesting relative to whizzy tech stocks. But in the face of unusually high uncertainty, the mantra has to be diversification. For many private investors, it has been a wild, lucrative five years; now cash should definitely be back on the agenda
