In a new column for Irish Medical Times, financial guru Eddie Hobbs says that many pension funds — including the GMS pension fund — haven’t allowed for double-digit inflation, which is likely in the coming years. What can you do to protect yourself from asset destruction?
It’s hard to get your head around what’s happening in the global economy, such is the blizzard of events over the past year – whatever about interpreting what it means to you and what actions you should be taking to better position yourself for what’s to come. But it is necessary if you are to avoid real losses in balance-sheet value as we enter a new economic age and not a return to the old one with just less wealth!
A few years back I set out to disprove a contrarian theory gathering momentum among geologists, engineers and certain economists. This was that the world, based on access to cheap oil for over 100 years, was facing into depletion as red hot demand from non-OECD economies was outstripping production, a by-product of adding an extra two billion new consumers to the three billion that already made up global consumer markets. Put it this way, you can’t increase the Chinese and Indian car fleet by 25 per cent each year without facing intense competition for limited natural resources like copper, aluminium, silver and, the king commodity, oil.
The beginning of the Age of Scarcity
Fast forward to today and we now have the results from the International Energy Agency’s audit of the world endowment of oil, published last October but lost in the melee over Lehmann Brothers and near collapse of the global banking market. Long a sceptic on peak oil, the IEA report validated much of the peakers assumptions; the depletion rate at 6.7 per cent per year is twice what we’d thought — which means jumbo oil fields like Ghawar are close to exhaustion — and to meet demand, six new Saudi Arabia’s have to be discovered over the next twenty years.
The IEA is praying that a ‘Goldilocks’ solution can be found involving the release of huge amounts of oil from Canadian oil sands, a rapid growth in Natural Gas Liquids (NGLs) and a €26 trillion investment over 15 years in oil and gas infrastructure — half of it needed to make up for a deficit in refurbishing existing assets.
The problem is that Canada can’t become the world’s second largest oil producer without burning up vast amounts of gas reserves needed to heat the sand to release bitumen, there’s been zero growth in NGLs for several years and the infrastructure investment is very iffy as national oil companies focus on feeding domestic demand first before exporting. Internal demand within oil-producing nations is accelerating to a point where shortly, combined, they will exceed the USA as the world’s largest consumer. It’s just a question of when the oil available for export begins to shrink as domestic demand is given priority.
A noted expert, Jeff Rubin, former CEO and Chief Economist of CIBC, a Canadian bank, reckons that crude oil has flat-lined since 2005. All that’s increased in the oil production numbers is propane and butane, by-products of maturing oil fields.
Robert Hirsch, reporting to the US Dept of Energy in 2005,stated bluntly that if action isn’t taken until peak oil is upon us, we face twenty years of severe disruption in global energy markets. This recession and four of the last five years coincided with price peaks in oil. US inflation in 2007 ran up to 6 per cent and was inevitably chased by interest rates, bursting the credit bubble the following year.
So it’s the story of our time — a time of substantial opportunities too if you’re on the right and not the wrong side of this mega-trend — arguably the biggest economic shift since steam technology came together with the printing press to trigger the Industrial Revolution. This time around it’s energy production technologies – clean tech and energy efficiency coming together with a global communications network and the common problem to grow economies sustainably and to do so by using less conventional fossil fuel sources.
What happens when a high inflation cycle arrives?
For starters, many of the assets upon which we’ve relied over the past 30 years of low inflation are at peril in the coming age of scarcity. During the last high inflation decade (1973 to 1983) caused by the OPEC embargo on US oil exports, cash deposits fell against general inflation by 3 per cent per year for 10 years. Common or garden variety bonds declined by 5 per cent yearly, which has implications for the GMS pension fund since it partially relies upon bonds — accounting for about a sixth of its assets.
The trustees need to move quickly into index-linked European Government bonds if they wish to avoid insolvency in the years to come, especially as the huge cohort aged over 55 head towards drawing income from the fund. The problem is that the pensions industry is about the sleepiest bunny around, is the last to innovate and is addicted to high fees and an easy life.
So what about shares? Equities, which account for the lion’s share of the GMS scheme, and the common managed fund just crabbed sideways during the last long-term high inflation cycle giving very modest 2 per cent p.a. real growth because many companies merely increased prices rather than real profits over the period, such was their exposure to high energy input costs.
But this masked huge losses as certain sectors like airlines and pharma stocks took an almighty hammering. So relying on general equity strategies and index-tracking funds isn’t a bright idea.
But the huge transfers of wealth that occurred as oil prices acted like a tax on economies guaranteed spectacular returns for energy titans, meanwhile gold grew 35 per cent p.a. above inflation.
Ideally the Trustees of the GMS pension scheme should be running ‘what if’ scenarios on the model to examine the impact that will occur if inflation hits very high levels. The scheme, which has adopted actuarial smoothing of the downturn to spread out the recent slump in value, is starting from a point of four years of negative bonuses. It could get worse, not better, if the wrong assets are held in the belief that inflation is not a threat because of a consensus within the somniferous Irish pensions industry.
What can you do to prepare?
So what does this mean for you and your money? An era of high inflation, in my view, is inevitable. The huge expansion in global money supply created by vast government borrowing programmes is itself inherently inflationary. The only thing slowing it from hitting us like a train is the tepid speed at which money is circulating, and that will change as the banking system and global economy recovers. But the long-term kicker is a return to a long and volatile commodity bull market. Oil, remember, kicked up fivefold in price from 2001 to $147 a barrel before the demand destruction from the recession.
It’s back hovering at $70 and it’s going to go much higher next time. The IEA itself is predicting a five-year oil crunch even if everything goes well. Meanwhile back at the ranch most investment funds and pension schemes, suffering as they do from mimicry, are steadfastly tied to assets that won’t perform and collectively have just about an 8 per cent exposure to commodities and energy simply to reflect the value of these sectors in global markets.
Here’s the thing the financial industry doesn’t want you to know – 90 percent of the return you make on investment is down to the asset allocation decision and not fancy fund performance. In other words the squillions spent convincing you that fund manager A is better than fund manager B, is bull.
The key decision is yours — whether you put your money into property, cash, bonds, equities or commodities: that’s the driver. Look at it this way, it didn’t matter which three-bed semi-d you’d bought in Dublin as an investment when the crash came, they all got marked down 50 per cent and the same in the rising market. It wasn’t the individual property selection that drove the return but the decision on the first day to invest in Irish property.
During the Tiger, I didn’t invest a cent of client money in Irish assets, and that has nothing to do with patriotism but everything to do with a basic tenet of investment – concentrate on your profession or business, but diversify your assets. With Ireland increasingly acting like a big property hedge fund, diversifying investment abroad made a heap of sense, otherwise you risk income destruction and asset destruction if, as has happened, 1 per cent of the European economy goes off the rails. So what are my top tips moving forward?
l Have a bridge to retreat over if the public finances aren’t repaired, Ireland gets marked down further, and another bank run begins despite the Government guarantee. Set up an on-line demand account with Rabo — one of a handful of banks worldwide with an AAA rating. That gives you same day transfer capability and keeps you out of the queues in the unlikely event of another run.
l Put 15 per cent of your long-term cash reserve and other liquid assets into gold. You can invest in gold these days in a variety of ways, each with their own strengths and weaknesses – Exchange Traded funds, Zurich Life fund or Perth Mint Certificates. Gold is the ultimate reserve currency and responds strongly to high inflation, rising oil prices and a declining dollar.
l Redirect your personal pension portfolio, putting at least one-third of it into energy-related themes like oil and gas, metals, food, water and green energy, and watch out for the inevitable development of energy efficiency and clean tech funds. There are a growing number of these now within fund ranges and switches can be organised free of cost.
l Increase your exposure to faster growing economic regions. Most of the economic growth on the planet is likely to take place in non-OECD countries over the next 20 years, so up your investment in Pacific funds that cover China, India, South East Asia, Australia and New Zealand.
l For older investors seeking to protect rather than grow assets, switch out of ordinary bond funds into indexed Eurobond funds. These are available within a few life office ranges. Lobby the trustees of the GMS scheme to strengthen the board with non-Mercer professionals, and to run studies on what would happen if inflation ran at double digits for several years.
l High inflation, if you can maintain your earnings in real terms, has a positively wonderful effect on borrowings by destroying the real value of outstanding debt — which is why the US is likely to follow a policy of inflating its way out of its vast debt burden. So don’t fret about high leverage, provided you’re making repayments, but don’t hang about: fix your interest rates for as long as you can — even out to ten years. We’re at a historical interest rate lows right now, but as the language of inflation becomes common currency, long-term rates will rise sharply even if short term rates remain flat for the next year. You could be dining out on long-term fixes at 5 per cent with inflation running twice as high in coming years. That’s known as negative real interest rates -getting paid to borrow money is the nirvana of positioning.
l Steer clear of most US assets and same for the GMS pension scheme. The dollar is back to its long-term trend of decline against other currencies, and the fall in its value may destroy any growth in the value of assets held in the US unless these are in really fast-growing sectors like alternative energy and in sector-dominant companies with lots of non-OECD growth exposure. Expect tepid growth from the debt-ridden US economy for many years.
www.eddiehobbs.com
Eddie Hobbs private practice, FDM ltd provides strategic financial advice to professionals and business owners.
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