Prepare for Stagflation...and Boom?

In an Aggressive and Thoughtful Approach to Investing, I outlined the principles used to construct my investment portfolio for maximum capital accumulation. In this post, I describe the current and two most likely macroeconomic environments that I believe investors should prepare themselves for.

I believe that in the 2020s we will either experience the return of stagflation for the first time since the 1970s or the greatest economic boom since the late 19th century. It is even possible that both scenarios could occur within the same decade.

The (Unexpected) Reflation of the 2010s

In 2016, I thought that there would be a recession in the United States within 2 years. I was wrong. Instead, the U.S. economy reaccelerated. In the past 3 years, U.S. real GDP grew at a 2.5% annualized rate, the unemployment rate fell from 5.0% to 3.6%, and the labor force participation rate for prime-age workers rose from 81.5% to 82.8% (FRED).

And although 2019 is not over quite yet, the S&P 500 has grown at a 12.5% annualized rate from the beginning of 2017 to the time of this writing. Technology stocks performed even better; Microsoft grew at a 35% annualized rate, Apple at 34%, Amazon at 31%, and Google at 19%. These 4 companies alone added nearly $2.4 trillion in value, approximately one-quarter of the total increase in U.S. equity market capitalization.

All of this growth occurred in spite of the fact that the Federal Reserve hiked the Federal Funds Rate from 0.75% at the beginning of 2017 to a high of 2.50% in 2018, and the U.S. and China became embroiled in a trade war in mid-2018 with both sides imposing heavy tariffs on each nation’s imported goods over the past year and a half.

Still, not all is well. It is often said that we live in a time of incredible uncertainty. In 2016, I thought there would be a recession in the near future because of the unsustainability of both U.S. monetary and fiscal policy. If anything, U.S. fiscal policy seems more unsustainable than ever before. In 2015, the U.S. federal budget deficit was 2.5% of total GDP. The budget deficit is projected to double to 5.0% of total GDP for 2019. On the other hand, U.S monetary policy looks relatively sane compared to the rest of the world; the U.S. is the only developed country with positive real interest rates. There is now over $15 trillion in government bonds, 25% of the total market, now trading at negative yields.

The Return of Stagflation

The case for stagflation in the next decade is best made by Ray Dalio, billionaire hedge fund manager of Bridgewater Associates in his LinkedIn post, Paradigm Shifts:

“I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly be coming due and won’t be able to be funded with assets. Said differently, I think that the paradigm that we are in will most likely end when a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better and b) simultaneously, the large need for money to fund liabilities will contribute to the “big squeeze.” At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.”

Essentially, Dalio is arguing that the current demographic crisis will lead to a fiscal crisis as well. The aging of the population in the United States, Europe, and Japan will put increasing strain on government budgets as healthcare and pension costs rise. Governments will not respond with the requisite tax increases or budget cuts to fully finance their fiscal deficits and will resort to printing money to cover the shortfalls. Rising inflation will lead to low or negative returns for holders of cash and government debt. He also believes stocks are unlikely to perform much better in this environment because returns have already been pulled forward by the “present value effect”. In other words, the spectacular stock market returns of the 2010s were mostly the result of low-interest rates pulling future returns into the present.

Dalio’s Takeaway: “[Assets] that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold.”

Historically, gold has outperformed as an investment in stagflationary macroeconomic environments characterized by low or negative economic growth coupled with high inflation. In the 1970s, when inflation was extraordinarily high in the United States, gold rose from ~$35/oz in 1970 to a peak of nearly $700/oz while stocks and bonds both fell in value when adjusting for inflation.

I do not own gold in my investment portfolio because Bitcoin is Digital Gold. Bitcoin is superior to gold by nearly every quality of sound money yet the combined market capitalization of Bitcoin is only ~$150 billion compared to gold’s ~$8 trillion. Bitcoin offers a far better risk-reward ratio for investors while also providing a hedge against stagflation. This is why Bitcoin has the largest position size in my portfolio.

The Greatest Boom in Human History

The case for an economic boom unlike anything seen in world history is best made by Catherine Wood, CEO of ARK Invest. ARK has made spectacular returns over the past 3 years by investing in innovation. In particular, ARK is well-known for betting on Bitcoin in early 2015 and being a long-term stockholder of Tesla. I bought my first Tesla shares shortly after ARK published Tesla Valuation Model: Are Investors Stuck in Reverse? in May 2019. Catherine Wood has issued a $4,000 per share 5-year price target for Tesla and even wrote an open letter to Elon Musk urging him not to take Tesla private in late 2018. Here is the performance of ARK’s flagship ETF (ARKK) vs the S&P 500 since 2015:

ARK’s strategy is to invest in publicly traded companies enabling “disruptive innovation”. ARK defines ‘‘disruptive innovation’’ as the introduction of a technologically enabled new product or service that should transform economic activity by creating simplicity and accessibility while driving down costs [About ARK].

ARK’s research shows that disruptive innovation is not consistent throughout time. There are both periods of very high innovation and also extended droughts where very little innovation occurs (see figure from ARK below).

In ARK’s view, the 50 years ended 1929 were the period of greatest innovation in human history with the introduction of three disruptive innovation platforms: the internal combustion engine, the telephone, and electricity. These innovation platforms created a “deflationary boom”, a period of high economic growth coupled with very low inflation. During this period, real GDP grew at an annualized rate of 3.7% while inflation only grew 1.1% per year [ARK - Inverted Yield Cuve].

Catherine Wood now believes that “innovation is picking up at a pace not seen since the turn of the nineteenth century”. Unlike the 19th century when three innovation platforms changed the world, she now believes, based on ARK’s research, that there are five emerging innovation platforms that will power economic growth for decades to come: Artificial Intelligence, Energy Storage, DNA Sequencing, Robotics, and Blockchain Technology.

ARK makes a bold forecast in its Big Ideas 2019 whitepaper:

“According to our estimates, the five technology platforms should generate more than $50 trillion in business value and wealth creation over the next 10-15 years. Today, they account for less than $6 trillion in global equity market capitalization, giving investors an opportunity to capitalize by almost 10-fold if they have positioned their portfolios on the right side of innovation.”

To further put the magnitude of these five innovation platforms into perspective, ARK forecasts their estimated impact on productivity through 2025:

Wood’s Takeaway: “Innovation investors have crowded into the private markets, while at the same time the public markets have increasingly gone passive. Thus, ARK believes innovative public companies with forward looking growth are the most inefficiently priced part of the market.”

In 2016, I would have been deeply skeptical of ARK’s thesis about five disruptive innovation platforms. The United States has been mired in the Great Stagnation since 1973, and we had been undergoing a sluggish recovery after the Great Recession. However, several miraculous technological developments in recent years now lead me to believe their thesis is more likely to be true than not. Tesla and Square are the top two holdings in the ARK Innovation ETF (Yahoo Finance). ARK’s insightful analysis of both Tesla and Square matched with the firm’s “skin in the game” is what convinced me to overweight these two assets in my own portfolio.

Conclusion

If ARK is right, it means that after nearly 50 years, the Great Stagnation will finally come to an end. Tens of trillions in new wealth and equity market capitalization will be created that more than compensate for the creative destruction the coming wave of innovation will unleash. Investors will reap the riches, but only if they bet on innovative companies that grow exponentially.

If Ray Dalio is right, economic growth will disappoint, and inflation will be the result of our debts coming due without the ability to repay them.

I sincerely hope ARK is right and Dalio is wrong, but ultimately investing is about anticipating what is likely to happen in the future, not how you hope it will unfold. I intend to be prepared for whatever investment environment, come whatever may.