How To Value Modern Assets

Why Understanding The Inflation Regime is Crucial

Asset allocation is often done in a vacuum with little regard to the monetary regime that investors will face. The standard approach is to build a portfolio benchmarked to a 60:40 mix between equities (risk assets) and high quality bonds (safe assets). The justifcation is that these two asset classes are negatively correlated much of the time, especially during major recessions.

Although this thinking forms the bedrock of modern wealth management in practice it only applies at certain times and under special circumstances. These times have spanned the period from the early 1980s through to the 2008/09 GFC. They did not apply in the 1970s and arguably do not apply today.

The key to understanding wealth management and, hence, asset valuation is inflation. In short, although we all plainly want to become wealthier, our main preoccupation is to at least maintain our levels of real wealth. Assets should not be valued against each other e.g. bonds Vs equities, but against inflation.

Inflation may be a tricky concept to measure, but for ease of illustration assume it represents the loss of purchasing power of paper money. This can arise through both monetary inflation, i.e. ‘printing money’ and cost inflation, e.g. higher oil prices and falls in productivity.

The diagram below shows how inflation affects the valuation of different asset classes. The chart is schematic, but it is straightforward to construct empirically using, say, the long-run data published by academic Robert Shiller on his website. We show our version further below using data from 1880. The humped curve has been fitted using a polynomial regression.

High quality bonds, e.g. US Treasuries, reveal a monotonic relationship, with their valuations falling (yields rising) as inflation accelerates, and rising (yields falling) as deflation beckons. This trade-off is recognised by textbooks. Real assets (not shown), such as residential real estate, land, gold and arguably Bitcoin, tread the exact opposite path. They enjoy high and rising valuations and prices as inflation accelerates higher.

Equities in contrast have a more complex and non-linear relationship with inflation. This does not appear in finance textbooks. Either side of a 2-3% inflation ‘sweet-spot’ where P/E valuations peak, higher and lower inflation rates mean falling ratings. In other words, to the left of this valuation peak, equities and bonds negatively correlate (the ‘risk parity’ zone) and to the right they positively correlate. Shifts in the patterns of correlation demand big changes in portfolio construction.

Much of our investment experience since the 1980s has been in the ‘low’ inflation zone around and mostly to the left of this peak valuation point. This not only strongly favours a large allocation to equities, but small perturbations to the inflation rate justify holding bonds because they negatively correlate with equities. [ Note the equity and bond valuation lines diverge.] This especially true as economies weaken and even test deflation. Japan has historically proved a good example of what happens to stock and bond valuations in this ‘very low’ inflation zone.

But this was not a feature of the inflationary 1970s. Then, real assets were in vogue and financial assets seriously underperformed. The rationale can be seen using the same diagram. To the right of the peak valuation point, i.e. circa 2-3% inflation and above, both equity and bond valuations fall. What’s more, they fall in tandem. This correlation weakens the case for holding both assets together in a portfolio. In fact, the opposite and positive performance of real assets versus inflation strengthens their case for inclusion.

Rising Monetary Inflation

Much of our research has lately been devoted to the gathering risks of monetary inflation, namely to the deliberate devaluation of paper money by governments. [We are equivocal about cost inflation.] The diagram includes a right-ways facing directional arrow as a reminder. In other words, the 60:40 asset allocation (or ‘risk parity’ approach) is under serious threat. Looking ahead, this is what investors should be thinking about now: fewer bonds and more real assets.

Admittedly, we have drawn the chart showing the right tail of the bell curve for equity valuation falling below the bond valuation line. This, of course, may not always be the case. Unlike bond coupons, equity earnings and dividends likely move higher with inflation. Valuations across equities will move differently because some equities are better inflation hedges than others and so their valuations may stay relatively more elevated. On the other hand, many businesses will struggle to remain profitable in a high inflation environment. However, we are discussing generalities, not specifics here.

World bond yields are progressively rising. This is being driven more by increasing term premia, rather than higher policy rates. This suggests that the increase may be jointly caused by rising inflation uncertainty and a concern that high levels of government spending will lead to ever larger supplies of coupon securities.

Looking across the markets, it seems to us that the US currently faces the greater inflation uncertainty both because of a large fiscal deficit and the prospective increase in ‘sales taxes’ from the imposition of tariffs. What’s more, the fiscal deficit is being increasingly funded by short-dated securities, which increases the risks of monetary inflation.

Japan has lately been experiencing a step-up in inflation, notably from higher wage costs, but this comes after decades of disinflation and, at times, deflation. In other words, putting Japan on the above diagram shows her equity valuations potentially rising towards the ‘sweet-spot’ of 2-3% inflation. Plainly, at current low levels, JGB yields of 1.5% do not look attractive in real terms.

China, which is currently in deflation following the ‘tariff shock’, may be at an earlier stage than Japan. Chinese equity valuations are low, but further monetary stimulus and a firmer economy could easily swing investor sentiment back towards stocks.

Meanwhile, European stocks, on this inflation criterion, are close to the favoured ‘sweet-spot’ but they fall between the US and Asian markets. In other words, if inflation continues to pick up (we believe in a stagflationary World), then there is more chance of European equity valuations following the US and being progressively derated.

Asset Allocation Conclusions

The 60:40 or ‘risk parity’ model beloved for decades by wealth managers face serious questions in a monetary inflation. We favour reducing bond allocations or at least switching some towards index-linked bonds (TIPS).

Asset mixes should be bespoke for investors, but taking the 60:40 benchmark for financial assets for illustration, a strategic change towards a 60:10:10:10:10 mix makes more sense to us. Here, 10% might be allocated to TIPS; 10% held in cash; 10% added to gold and precious metals, and 10% to Bitcoin. We have excluded dedicated real assets, like prime residential real estate and land, not because they are unattractive, but simply because they are less liquid and anyway are often a permanent and non-tradable component of investors’ wealth.

Moderately rising inflation may be good news for equities overall. We have depicted the notional positions of different markets on the above diagram. Arguably, Wall Street is ‘past its peak’ because the US economy has an inflation problem. Europe still enjoys moderate inflation, while both China and Japan are emerging from deflation/ low inflation regimes which has favoured bonds, not equities. It may be worth diversifying into these Asian markets, open-eyed to their greater geo-political risks.