How detrimental is a falling oil price?
The most likely thing to happen from a falling oil price is a major bankruptcy as there are certainly some corporations who have drilled high-cost wells. When that happens, there will be a mass dumping of oil and a dash for cash.
More important is the effect on countries and deterioration in the solvency of key emerging markets. History suggests, and what we are already seeing, is a general curtailment of external capital flowing into all emerging markets, not just the oil producing ones. Since many governments borrowed in dollars, the higher the dollar exchange rate goes, the more difficult it will be for them to pay back their debt.
Looking at the bigger picture, the oil price is feeding into something that is much greater than just being oil-price specific. This is important for global asset allocation because the last thing that the world needs right now, given anaemic global growth, is another big credit crunch. But that is the trajectory we are on because of a falling oil price and the strong dollar.
There will be a credit crunch somewhere which probably would be manageable if growth was robust and strong globally, but when it is this low it will really bring into question whether central bankers can deliver on their promises of inflation. The current valuation of markets, especially equity, is based on the success of central banks creating inflation and we must look at oil in that bigger context.
Can central bankers reflate the world?
That is a key question and my answer will be no as I envisage deflation. Family offices will predominantly have a mixed balanced portfolio of assets but when inflation is low, ultimately it is going to break out higher or lower and investors need to pick one of these poles. If I am right about the oil price, you pick a deflationary pole and invest accordingly and so I would have allocation to as close to cash as possible. If central bankers create inflation, investors would require a completely different portfolio.
The Federal Reserve’s 2% inflation target is important for investors. If inflation picks up from the current 0%, then equity prices will also rise. But if inflation goes above 2%then equity prices have to come down as central bankers will need to be more aggressive about tackling inflation.
In addition, you have to consider the effect of China devaluing its exchange rate, which it will have to do as domestic capital is flowing out of the country. This will bring into question whether the Fed can succeed in reflating the world if China begins selling its products cheaper in dollar terms. Also, to call the bottom in the oil price before China devalues its exchange rate would not be wise.
What are the prospects for gold?
The first question I am asked at every family office event is my thoughts on gold. The world I envisage should not be good for gold if there is falling inflation and nominal rates close to zero – effectively rising real rates of interest – and a strong dollar.
However, and the single most important thing for family offices to consider, is the next course of government action. Countries are already under severe pressure trying to balance strained budgets and another shock could ultimately result in the implementation of policies that may not be good for return on capital, such as the mansion tax and exchange controls that Cyprus has introduced. In these scenarios, investors would then need a portable form of wealth that is less subject to government manipulation. And gold is one such asset.
My strategy is not to buy any gold until there is a strong dollar, deflation and the gold price starts going up. That will be the tipping point and I would not be surprised if that happened as early as this year. Once we get into that trajectory then gold is the go-to asset for an incredibly long time and I could easily foresee a two-decade bull market. So
it is worth watching, as I think sometime this year prices will start to rise on some very bad news and that will be the time to buy gold.
Gold is also a good hedge for inflation. Bringing down the UK’s high total debt to gross domestic product levels in the least socially painful way is to have high inflation. However, it would take 20 years to accomplish, even with inflation at 5-6%. Gold is going to do very well if you have compounding inflation at 5-6%.
What concerns you about Greece?
In long run, Greece cannot survive inside the euro zone. If Greece does leave the euro, we need to consider whether the free movement of capital within Europe remains intact, as there will be concerns over contagion spreading to Portugal, Italy and Ireland.
Governments could respond with restrictions on the free movement of capital like the Tobin tax or policies that Cyprus has introduced, which in hindsight could be viewed as a precursor for the rest of Europe implementing exchange controls. There is recognition among European states that they cannot afford to bail out the banks again and this has resulted in the bank bail-in legislation. So the next time a bank gets into trouble, it will hit the bond and deposit holders. In the last crisis, everyone was confident deposits were safe; the next European banking crisis will be different and would require governments to introduce much more Draconian measures.
Which investment strategies should family offices consider?
There is good opportunity in Japanese equities which have done well over the past two years and there is still value to be found in the market. When you get into a situation where the central bank is effectively the only funder of the government, then you are going to end up with high inflation. That is the path that Japan is on and a direction that is very beneficial for reasonably priced equities.
It might be boring to say, but holding cash will be a good strategy. Those that lived through 2009 will know what cash can get you and know how impossible it is to borrow money in a distressed market. If debtors do not get bailed out next time, then the value of cash will be the most it has been in the post-World War II era.
