Footnotes is a monthly publication which summaries our “First Friday” webinar presentations each month. The goal of the Footnotes publication is to capture our “First Friday” presentation’s most important data points, which will make it easier for The Abernathy Group Family Office members to make intelligent decisions based on facts and data – as opposed to potentially conflicted opinions from the mainstream media.
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As a short reminder to each Family Office member, The Abernathy Group Family Office has now sponsored 20+ “First Friday” webinars. All of them are available on our website and “YouTube” Channel if you would like to go back and see how we have interpreted the economic signals, while doing our best to cancel the noise over the last year plus. Our goal: to help you spend less time making intelligent financial decisions, by focusing on causal, predictive data (signals); and ignoring the clamor of biased, irrelevant data (noise).
Commentary from the October “First-Friday” meeting:
In our last online seminar, we discussed the elephants in the room.
In our discussion today, we are going to discuss several risks everyone is aware of – yet no strategist, portfolio manager, or analyst is actually prepared for.
These risks we are referring to are not new. They are well-known risks standing right in front of us and staring us right in the face. Yet, because these risks have not happened during our lifetimes, very few have prepared their investment portfolios for the possibility that these risks will happen.
We will meet these unfriendly elephants and discuss intelligent investments which can protect us if these scary events take place – yet – will deliver a reasonable return if we are fortunate enough to avoid meeting these elephants face to face.
With that said, let me turn this meeting over to Matt Daley so he can ensure we cover the several incredibly important topics our members have asked us to discuss with you.
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Matt Daley:
Today, we are going to do our best to discuss several uncomfortable topics.
However, like many important activities which involve difficult decisions, discussing uncomfortable topics before they happen is often the difference between making intelligent decisions and making spur of the moment – emotional decisions. It’s often the difference between successful decisions and regrettable decisions.
For most of us on this call, we have worked for decades and achieved a certain level of success in life, which allows us to take care of our families in a manner we have become comfortable with.
One of our Family Office members once commented “I have worked hard, taken calculated risks, and by the grace of God have benefited enough for my family to live comfortably.”
“I just want to make sure that I don’t have to go back and make it all again!”
I don’t know how many of you feel this way, yet if you do, this webinar is for you.
Intelligent investments ALWAYS start with risk analysis.
The reason risk analysis is first is because if you lose the assets you are investing, you lose the ability to invest.
Risk analysis is a first principal concept. It’s a very simple and easy to understand concept, yet the vast number of investors we have spoken with over time do not focus on risk avoidance first.
We understand the reasons most avoid risk analysis. Risk is most often negative, and few of us want to spend the bulk of our lives dealing with negative topics. Discussing and determining how “not to lose money” is not a very motivational topic. After all, it’s much more fun to spend our time on how our investments will deliver profits, and how smart we are going to look and feel when our wishes become reality, and our investment doubles in value!
While the future we envision may well come true, and we hope and plan to do well – there are many outcomes which could become the future, and because most of us are not adept at calculating the future’s probabilities, it is both responsible and intelligent to spend time on the other side of the outcome spectrum.
The question every intelligent investor must ask – after developing their most likely future outcome is “What happens if I am wrong? What are my risks?”
Howard Marks once made the statement when discussing the topic of risk – he said, “you can’t predict, you can prepare.”
He was referring to the fact that there are many more risks which could occur than the risk that actually occurs. And because you can’t know which risk you will confront, you must prepare for them all – or at least you should be aware of them and have a plan in place for each – just in case. This may make the difference between an intelligent decision and an emotional decision.
This is bringing us to today’s topic –
Slide 3
We are going to discuss the big risks which are right in front of us… in fact these risks are so large they are worthy of the “Elephant” moniker. And we are going to do our best to discuss whether the financial markets are adequately pricing in these risks, and if not, why not?
So first we will briefly discuss inflation, and the challenges inflation brings with it.
The capital markets believe inflation is firmly under control. Is this a realistic expectation?
Next, we will discuss the many outcomes surrounding our Presidential election next month. Is there a risk the outcome will take place with acrimony? Is there a real risk there will be some level of conflagration which could lead to an uncomfortable change in command of the most important country on earth? Of course, we hope and pray this does not happen, yet if it does, what risks are most likely? What risks should we expect? How can we prepare?
Next, we will spend a very short time on our deficit spending. We know it’s out of control. We know it’s unsustainable. However, what alternatives are available to us? And again, what risks are most likely?
And lastly, in our estimation, the most serious risk, and the risk that is being least priced into the market – the risk that any small, single war COULD escalate into a global war, which will instantly increase the risk of a nuclear conflagration. This is one of the most difficult risks to plan for. It is categorized as an “outlier,” meaning, it has a very small probability of taking place, yet the outcome could be catastrophic. Are we prepared for this risk?
And finally, we will do our best to discuss the options available to the U.S. Federal Reserve, as the parent in the room in charge of mopping up each of our country’s missteps.
With that said let me turn it over to Steven Abernathy to answer our first topic of the day.
Steven, one of the most active families in our Family Office asked us the following question – and I am paraphrasing – there are so many events which could create a negative outcome to throw us into a dreaded recession, which is the most likely and what could our government do to avoid this?
Slide 4
Matt, thanks for giving us such a complete background on today’s topics.
Clearly there are a number of risks we must be aware of simultaneously.
And I want to be the first to say, this is normal – there are always risks, and there are always activities we don’t believe are risky, yet which turn out to be incredibly risky – the housing crisis in 2007-2010 being a prime example of this statement. The vast majority of the world, including those in charge of predicting these events (the U.S. Federal Reserve comes to mind) completely missed this event, and it led to a near global disaster.
Some quick background if you have forgotten…
Not many investors believed investing in the U.S. housing market could threaten the global financial system; the question I heard so often as to drive me crazy was – wasn’t investing in a house a guaranteed investment? Houses don’t go down in value. How can you lose?
Of course, this was a common assumption to make, yet it was an unintelligent assumption to make. Any asset which appreciates can depreciate. And any asset which has appreciated to an extreme can depreciate to the extreme. And yes, housing values were leveraged to such an extreme that it truly almost brought down the global financial system.
What was the operational variable which created the downfall? There were 3. First – at the cornerstone of almost all negative events is speculation; when investors buy things for a price that makes no sense, financial pain follows. Speculation is a prime villain in almost every serious collapse.
Second, there was leverage. Leverage, like speculation, is almost always at the root of economic destruction. As we have said many times, leverage makes good events great, and bad events disastrous. When leverage is at play, be doubly cautious.
The third variable at play here was the U.S. administration. They convinced everyone that owning a home was an American right. Speculation exaggerated the point. The narrative became that everyone should own a home or two or three. And with this came a level of dishonesty at the lending level which caused over 400 banks in the U.S. to declare bankruptcy.
The reason for this quick historical discussion, of which most of you are well aware? Private credit is starting to look a lot like the housing bubble in 2006-2007. It’s becoming a household phrase with the narrative that banks are not creating enough debt because of regulatory restrictions. Private credit can make loans more efficiently than U.S. banks. The banks are regulated to ensure they have enough capital to repay the loans if they start going bad. Private credit has no regulatory requirements. We hope private credit avoids a similar outcome – yet it is one we are closely watching.
Slide 5
So, to answer your question directly, the risks which are most apparent are the risks we hear about every day.
Inflation is a silent thief, and we do not believe it is going quietly into the night as the market is currently pricing in. Inflation allows the U.S. government to repay debt with inflated dollars. This effectively lowers our debt. The U.S. Federal Reserve has every incentive to inflate our debt away. As a consequence, we believe inflation in the 2-3% level will stay with us for an uncomfortably long time, and if we keep spending more than we are making, economic pain will follow.
However, this is unlikely to be a risk that those participating in this call should fear first and foremost.
Yes. Inflation is an economic structure to be avoided as it’s a silent tax on all consumers – and we are all consumers.
However, there is a good side to inflation for those who are in debt.
Inflation allows borrowers to repay their borrowings with depreciated money. Each year’s inflation decreases the amount borrowed by approximately the same amount.
So, as said above, to some extent, the U.S. Federal Reserve has an incentive to allow inflation to exist at levels which slowly eat away at our incredible levels of debt.
Slide 6
Another topic which is unlikely to become a game changer is the presidential election.
Yes, there is probably a 25% chance that one side or the other will do everything to challenge the other side if the election is close. And yes, the press will get its money’s worth with coverage of one side or the other creating traffic jams and destroying property if some are unhappy with the election’s results.
We hope and pray this doesn’t happen, as this type of outrageous behavior and property destruction is unforgiveable… yet it will most likely not change the way we live. It’s unpleasant, it is reprehensible, yet we will live through it.
Mind you, I am not advocating this, I am just saying our country will likely get over it – with some bumps and bruises along the way.
Our expectation – if this occurs, it will affect the capital markets for a day or week, yet will probably not have a lasting effect – outside of the international reputational damage when most other countries see the U.S. acting very much like a 3rd world country…
Slide 7
When it comes to the next risk – we are elevating our seismometer to earthquake level.
And the analogy does not stop there, as the level of damage our national debt could create is so large as to be almost unthinkable – it’s the kind of risk that could literally change the way we in the U.S. live.
Also – like an earthquake, debt problems are unpredictable with respect to timing. It’s the type of problem intelligent investors can see coming. Unfortunately, the public will see it in hindsight.
The U.S. debt problem is truly one of the living and breathing elephants in the room. It is a risk, and few intelligent investors have allocated for this risk.
The reason our collective debt burden is a well-known risk? Our U.S. debt is publicly available information. It has been creeping up on us for the last 10-15 years. Yet because there have been no consequences, most investors think there will be no consequences – or they may think that when the U.S. debt crisis starts to unfold, they will know what to do and will have time to do it… We do not share that stance and urge all investors to have this conversation with their advisor and their family.
The next risk is in the same category. It is so large, and it’s sitting right in front of us, and I can’t believe that almost everyone I speak with outside of our Family Office has no allocation for this risk to become a reality –
Slide 8
War.
Most of us will agree it’s unpredictable at best. Hot wars are much different than cold wars. While both are incredibly negative, hot wars today are like our debt crisis.
A hot war today, with the amount of nuclear capacity available to most of the countries labeled as superpowers – is beyond scary. It is the definition of a life-threatening risk. It is the type of risk that could change everything – certainly the way we live, our society, and the existence of the earth itself.
This is the type of risk that is often too uncomfortable to think about and plan for – although many of us did this in the 1960s. A global war today, with the abilities each of the world’s superpowers have today, as said earlier, is an “outlier.” Yet, any risk this large demands to be considered. Have you considered the consequences of a global war/conflict?
And even if we evade a hot war, which is the largest elephant in the room, a cold war could tax our economy for years. To note – not much attention is given to a cold war today.
A more likely event given current technology, is a cyber-attack on our U.S. grid. It’s an almost equally frightening event to consider. For anyone living in a city dependent upon electricity for water and food and – without well, everything, a cyber-attack is frightening. How long do you think it would take for your city to become a lawless madhouse of people without water, food, and transportation?
On a parallel narrative, terrorism is a more likely event given the ability of small groups of dissidents to easily negotiate our borders. Strategic terrorism in our major U.S. cities could quickly become an event each of us wish we were prepared for.
We are one of the only firms which has allocated for some level of cold war and a low level of hot war.
If you would like to discuss this matter or any of the risks we have discussed, please feel free to give us a call as these topics are incredibly personal. We don’t have any bias, and this is not political, we just want to help you think about this topic so you have a game plan should the negative future become a reality.
Our next Webinar in November will discuss ideas on how to diversify your portfolio for all but the direst outcomes.
Let’s try to stop here and ask Marissa if we have any questions which have come in since we started our discussion.
Marissa –
We have a question: What will the U.S. Federal Reserve do if a) we enter a recession or b) we get pulled into any of the hot wars brewing abroad?
Slide 9
If Risks become reality, what’s next for the U.S. Federal Reserve?
From an economic perspective, if the U.S. economy enters a recession, we believe the U.S. Federal Reserve will lower interest rates and eventually will do whatever it takes to avoid a recession or make it short and shallow.
The U.S. Federal Reserve will certainly reduce interest rates. It will certainly pump money into the economy – as it has done every time we have had a slight stumble. Why are we so sure?
The reason is because of our debt. The U.S. Federal Reserve knows that if we enter a recession, our deficit spending will increase, AND our income will decrease because jobs will be lost, which means less tax income – history tells us between 4-9% in tax revenue will be lost – which could increase our deficit by another 1-2 trillion.
So, in short, we believe the U.S. Federal Reserve will try its best to ensure we do not enter a recession, and it will do whatever it takes to make sure our job market is not impacted negatively. Lower rates will be first. Quantitative easing will be next and will quickly follow if lower rates prove to inadequately replace lost jobs.
Will the world allow the U.S. to continue printing money? Will the world allow the U.S. to create inflation on a global level?
Inflation is not desirable from the consumer’s standpoint. Yet consumers would probably say inflation is more desirable than unemployment.
From the U.S. Federal Reserve’s perspective, it will always prefer inflation to deflation, as inflation allows them to repay their debt at a discount; it acts to lower our debt. Alternatively, deflation creates an ever-increasing amount of debt as the U.S. Federal Reserve is forced to repay debt with more valuable dollars.
If we get pulled into any of the hot wars – we believe it will be another disaster.
Why? From a personal standpoint, first and foremost, it means loss of life. We believe the U.S. is ill prepared for a global hot war from both a personnel standpoint and from an equipment standpoint.
From a secondary standpoint or an economic standpoint, we will have to produce all types of “war related” armaments, the costs of which will double or triple our deficit spending and will create inflation which we have not seen since the nineteen seventies and early nineteen eighties. Cyber attacks and acts of terrorism will disrupt supply chains. Many countries around the globe will be forced to take sides. U.S. alliances will be tested for certain.
The combination of risks above are truly elephants in the room, yet few are prepared. It seems as if most are hoping for the best – and each of you reading this letter knows what we believe about “hope” as an investment strategy…
As we said, in the next “First Friday” webinar, we will discuss methods of intelligent diversification for a broad swath of “risks” we have discussed today. Thank you for attending, and for sending us your questions!