While the media and short-term thinking analysts like to talk about how to position your portfolio for the election, doing so is a crapshoot at best. It’s clear that there are more important and overwhelming forces in play. Particularly, the megatrend related to the decline of the United States world stature and the enormous stress on the dollar carries much more weight. No matter who is elected in November, the dollar destruction script will likely be acted out. The history of great world powers shows that this has decimated other world reserve currencies and their equity markets.
The timing of this megatrend is highly uncertain, but the process is well underway. Smart investors will diversify in new ways (not the 60/40 portfolio). Real assets, including gold, silver and other commodities, and natural resources equities will protect a portfolio. Foreign equities, particularly emerging markets, U.S. value stocks and TIPs, can also provide diversification benefits. The smart money will take the appropriate steps to diversify their assets accordingly – sooner rather than later.
Should You Invest Based on Expected Election Outcomes?
As the election nears, it is interesting to speculate on possible outcomes and investing implications. Barron’s recent cover story, “Three Potential Election Outcomes and What They Could Mean to Investors,” reviewed market history and considered the effects on investing.
The oddsmakers have Biden’s chances of victory around 60%. Based on history, that fact alone would bode well for the market. Ned Davis Research says the Dow has risen faster under Democratic Presidents, with an average gain of 7.8%, versus 3.3% under a Republican White House. But when Democrats control both the White House and Congress, the Dow has gained an average of only 3% per year. Under an all-Republican Presidency and Congress, the Dow gained an average of 7.1% per year.
What about a split outcome? Ned Davis says that under a Democratic President and a split Congress, the Dow gained 8% per year. Barron’s also considered the effects of different election outcomes on small companies, technology, financials, infrastructure, China and other sectors and companies. So, which political scenario should we bet on? Should we adjust our portfolios before or after the election?
First, consider that the Dow returns (7.8%) under Democratic Presidents are nearly identical to the overall returns of 7.75% from 1921 to 2019. These returns are only averages – nothing more. They don’t reflect specific economic or market conditions during a given political regime. Actual return outcomes over a term depend on many variables: economic growth, earnings, taxes, demographics, technology trends, and not the least, investor sentiment. So, it’s hard to glean much insight or draw conclusions from the data.
Second, you can’t accurately predict who will win the Presidency, Senate and House races. Recall the shock when Trump defeated Hillary in 2016, although she held a solid lead in the polls right up until the day of the election.
Third, it is tough to predict specific policy actions by the three branches of government, especially in a dynamic world affected by COVID-19, social unrest, technology advancements and tensions with China. At the micro level, certain policymaker decisions could certainly impact specific industries and stocks. But it’s extremely hard to forecast both the policy decisions and their impact. Predicting who is elected is one thing, but predicting their decisions is like forecasting the weather a month in advance. To sum up, repositioning your portfolio for the election before it happens is like playing the lotto. Doing so after the election might offer better odds, but I would liken it to a crapshoot.
However, there is an overriding macro factor that will dramatically impact the market – and all sectors. And the direction of that macro factor is highly likely, no matter what happens in the election.
What Really Matters – The Destruction of the Dollar
Some optimists believe that the federal government can continue expanding the debt many years into the future with few consequences, thanks to the deep reservoirs of trust the U.S. economy has accumulated in the eyes of investors. Indeed, the proponents of Modern Monetary Theory (MMT) support this. But many economists say this is simply too risky. “The debt doesn’t matter until it does,” says Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget. “By taking advantage of our privileged position in the global economy, we may well lose it.”
Ray Dalio’s insightful series The Changing World Order explores the rise and fall of great empires throughout history. He goes in great depth on the Dutch empire, Great Britain and the United States. He weaves together a brilliant account of the elements that make an empire dominant: education, trade, innovation and technology, competitiveness, role as a financial center, output, military and reserve currency status. He describes the forces, factors and scenarios that have consistently repeated throughout history. Dalio also describes the forces and actions that lead to their decline and describes an archetype that several major empires have followed over the past 500 years. I recommend all serious investors read this. If you don’t want to read all of it and prefer to watch a video, you can find Dalio’s interviews on YouTube.
This provocative series led me to dive deeper into the investment and equity market implications. Below, I recount some key takeaways from Dalio along with my research and conclusions regarding the impact on the dollar, the U.S. market and investing implications.
The Election Won’t Change the Script
It is amazing how major empires have followed the same script throughout history. Here is a general outline of the cycle that Dalio describes:
- Low, productive debt and healthy economic growth and development; use of hard money (backed by gold)
- Rising debt leading to debt crises, defaults and devaluations
- Fiat money printing, extremely low interest rates to fight economic stagnation and deal with crises
- Creation of a wealth gap, fostering civil unrest and major political divisions
- Use of protective measures to fight the decline of world competitiveness due to a rising power (now China challenging the U.S.)
- Transfers of money from those who have plenty to those who have less than they need
- Giving away money and monetizing it via unlimited debt (Modern Monetary Theory)
- A flight back into hard money; restructuring of the monetary system and the loss of reserve currency status
Amazingly, United States actors are carrying out the same historical script, regardless of their political affiliation.
How might the election alter this course of events? Let’s look at the possibilities.
If Trump, the self-proclaimed “King of Debt,” is elected, do you see him implementing fiscal restraint and pleading with the Fed to tighten monetary policy? When Trump campaigned in 2016, he said he would eliminate the federal deficit in eight years. Here is what he has “accomplished” on the fiscal front since he took office less than three years ago during a relatively prosperous economic period:
- Grew the budget deficit from $585 billion under Obama in 2016 to $984 billion in 2019, an increase of 100% in three years.
- Due to COVID-19’s economic impact and fiscal stimulus measures, the deficit this year is projected to be $3.7 trillion, an increase of 630% since Trump took over.
- When you compare the last three years of Obama’s Presidency vs. Trump’s first three years, Trump’s deficits will be almost $1 trillion greater at $2.47 trillion to $1.51 trillion for Obama.
- Trump repeatedly chided the Fed for its “tight money,” even though the Fed modestly raised the Fed funds rate from historic post-Great Recession lows to a peak of only 2.5% in 2019.
- The Fed followed by lowering rates in late 2019 and again after the onset of the pandemic.
What will Trump do if he is re-elected? Statements have been few and sketchy at this point, but here are a few likely elements of his playbook:
- Cut taxes. He signed an emergency executive order for a payroll tax holiday recently and may promote a permanent payroll tax cut.
- Adopt an infrastructure spending bill of over $1 trillion.
- Rebuild the military (aka spend more).
- Get tougher on China; implement more protectionist measures, possibly tariffs (which tend to be inflationary).
- Extend tax cuts set to expire in 2027.
Let’s turn to a Biden and Blue Wave scenario. It’s hardly a picture of fiscal soundness. There would likely be tax increases on the wealthy, but nowhere near enough to offset declining federal revenue from a crippled economy and coming government spending increases.
Biden’s website calls for:
- Additional checks to families, should conditions require (amount unspecified)
- Forgive a minimum of $10,000 per person in federal student loans (that equates to $450 billion)
- Increase monthly Social Security checks by $200 per month (that equates to $153 billion per year)
Biden has also proposed to expand Medicare to those 60 and over, and introduce a new Medicare-like public option. Projected additional costs for this program are $2.25 trillion and would add $800 billion to deficits for a decade, according to an analysis by the Committee for a Responsible Budget.
What about something in between? Say a split congress with either Trump or Biden. That is also likely to result in more spending and ever-expanding deficits. Both Republicans and Democrats agree on more fiscal spending for the unemployed, businesses and infrastructure. It’s only a matter of how many trillions they will agree to spend.
David Stockman quipped that “Republicans and Democrats pretend to disagree,” but they all act alike when it comes to fiscal mismanagement. As an example, in July 2019, congressional leaders from both sides agreed on a two-year budget deal that raised spending by $320 billion, increasing the deficit more rapidly than would have been the case under the status quo. After removing the debt ceiling limitations, House Speaker Nancy Pelosi and Senate Minority Leader Chuck Schumer released a joint statement saying they were pleased the administration “has finally agreed to join Democrats in ending these devastating cuts.”
And all of this will need to be financed somehow. Enter the Fed. Jerome Powell’s May 60 Minutes interview says it all:
“The United States is the world’s reserve currency. The dollar is the world’s reserve currency. And we have the ability to borrow at low rates. We have the ability to service that debt. And I would say this is the time we can use that strength to our longer run benefit. It is true that deficits are going to be big for a couple of years here.”
Excuse me, Mr. Powell, only a couple years?!
Powell continued, “And we’ll have to deal with that. The time to deal with that though is when we’re through this recovery. When it comes to this lending, we’re not going to run out of ammunition. That doesn’t happen.”
This is similar to what the Fed said during the Great Financial Crisis. Twelve years later, we still haven’t normalized rates, nor restored interest rates to normal levels. And that was the case even before the pandemic, during a “healthy” economy. According to Trump, we did that during “perhaps the greatest economy we’ve had in our history.”
Chuck Butler, longtime author with the Daily Pfennig, says: “We’ve moved (the debt level) into 130% of GDP (not using the Covid-19 GDP numbers). And the Bank for International Settlements (BIS) told us many years ago that ‘When government debt exceeds 85% of GDP, economic growth slows.’ Which is something I’ve said for many years now, and that is when the debt level grows too large, the economy has to slow down… And for the last 10 years we’ve only averaged 2.1% GDP growth.”
So, regardless of the election outcome, it’s likely we’ll see a continuation of the historical script adopted by politicians and central bankers throughout history. Now, let’s explore how major empires’ currencies and stock markets fared under those scenarios.
Performance of Major Empires’ Stock Markets During Devaluations
Dalio illustrates in detail how and why major empires have destroyed their reserve currencies over time. He says that of the roughly 750 currencies that existed since 1700, only about 20% are still in existence, and all have been devalued.
Great Britain’s Devaluation
Great Britain was in its heyday as the preeminent world power during the late 1800s and early 1900s. In the early 1900s, the British empire began to lose its status with the rise of the U.S. However, the decline of the British pound occurred in a chronic way over a period of decades. As the chart below indicates, in the first half of the 20th century, British equities exhibited a generally sideways movement with a series of booms and busts.
More importantly, the chart below shows that equities declined in real terms (adjusted for consumer price inflation) from 1900 to 1950 by a whopping 78%! So much for equities serving as an inflation hedge. Those who argue that there is no alternative (TINA) should take note of the erosion of a portfolio dedicated to domestic equities of a declining power that is destroying its currency.
The United States 1930s Devaluation
In 1934, President Roosevelt signed the Gold Reserve Act. It required the transfer of ownership of all monetary gold in the United States to the U.S. Treasury and prohibited the Treasury and financial institutions from redeeming dollars for gold. After confiscation, the government reset the value of the dollar from $20 per ounce to $35 per ounce. Another way to look at that is you need 75% more dollars to achieve the same purchasing power relative to gold. That’s an enormous amount of overnight inflation! So, converting your dollar denominated assets to dollars also buys you a lot less goods and services.
The Dow Jones Industrial Average initially rallied from 219 in January 1934 to a high of 332 in 1937. However, it tanked for the next five years, bottoming at 123 in 1942 for a decline of 44% since the dollar reset. In a broader context, after the 1929 market crash, it took 25 years for the Dow to return to its 1929 peak.
The United States 1970s Devaluation
In August 1971, Nixon removed the dollar from the gold standard. This led to an initial DJIA rally of 14% from 628 to 719 by December 1972. That was followed by an enduring and brutal decline of 61% over 11 years to the bottom of 282 in July 1982. Considering inflation during the 1970s ran at an annual average of 7.25%, real market returns were even more gruesome.
Dalio’s The Big Cycle of the United States and the Dollar noted:
“As a result of going off the gold-linked monetary system that constrained money and credit growth, there was a massive acceleration of money and credit, inflation, oil and commodity prices, and a panic out of bonds and other debt assets that drove interest rates up and caused a run into hard assets like real estate, gold, and collectibles for most of the next 10 years, from 1971 to 1981.”
Paul Volker’s actions to break inflation via tight money combined with the fiscal stimulus of the Reagan administration finally turned the situation around and ignited the bull market of the 1980s and 1990s.
The United States 21st Century Devaluation
Much has been written about the actions of the Fed and the U.S. government to combat COVID-19, as well as the actions in response to the 2008 financial crisis. Rather than rehash what most of you know, here are a few key facts that paint an ugly scenario for the dollar:
- Federal debt has expanded from $10.0 trillion in 2008 to $26.5 trillion today, an increase of 165%.
- The Federal Reserve balance sheet expanded from $4.02 trillion to $7.01 trillion today, an increase of 74% in the past five months.
- The current fiscal year projected Federal budget deficit is more than $3.7 trillion versus $779 billion last fiscal year.
- The M2 money supply has increased at an annualized 22% in the past year.
It might be a surprise to some that gold and silver have substantially outperformed the S&P 500 index, by 4X and 2.5X respectively, since 2000. However, when viewed in the context of currency debasements of other major empires and the data above, it shouldn’t be a surprise. The chart below shows a visual of the cumulative returns:
- Gold: 571%
- Silver: 348%
- Dow Jones Industrial Average: 141%
- S&P 500: 137%
This might explain why Buffett, a long-time critic of gold, now has a $580 million position in Barrick Gold Corp. (GOLD). Dalio’s Bridgewater added more than $400 million in the iShares Gold Trust ETF (IAU) and the SPDR Gold Trust ETF (GLD) in the second quarter.
Oh, and There’s This Little Thing Called Valuations
The chart below from Advisor Perspectives tells the story: the U.S. market is expensive. Even without a dollar debasement, this market is on shaky ground.
Smart Money Will Diversify in New Ways (Not 60/40)
A dollar devaluation – or devastation – will have a profound impact on dollar-denominated assets. I’ve focused here on the impact on equities. But the outcomes for bonds would also be bad. Rising inflation and a declining currency destroy long-duration bonds. For lower-quality bonds in a struggling economy, it will be even worse given the default risk. Dalio warns that cash also carries great risk, with inflation acting as a tax that steadily erodes its purchasing power. The upshot is that the longstanding, “go-to” 60/40 portfolio recommended by conventional advisors won’t work.
So, where will the smart money go? Obviously, gold has broken to new highs, up 25% over the past year. In general, real assets will be beneficiaries: besides gold, look to silver, commodities and natural resources equities. My recent Seeking Alpha article showed how natural resources equities can protect a portfolio from currency declines. REITs have held up well historically in high inflation/dollar debasement periods, but the pandemic has crippled certain sectors, like shopping malls, hotels and restaurant properties. So, investors need to be selective. TIPs can also be useful, although their real yields are negative. A recent survey of advisors found that many are recommending art investments. Aggressive investors might buy the short dollar ETF UDN as recommended by Andrew Hecht.
On the equity front, I believe investors should consider foreign equities, particularly emerging markets. My own portfolio is overweight foreign and emerging markets, as I describe in the article titled “Mean Reversion + Valuation = Portfolio Opportunities.” For those wanting to stay home, U.S. value stocks and MLPs look reasonable. My article titled “Mean Reversion + Valuation = Opportunity” also described these opportunities.
As a macro investor who allocates money to asset classes via indexes, I don’t buy individual stocks. I don’t make sector bets on industries either, with one exception: natural resources equities. The only U.S. equities I own are in value stocks, MLPs, natural resources equities and REITs.
But I recognize I’ve been wrong and can be wrong again. Therefore, I diversify and hold assets that perform well in various scenarios over the long term. I also have some cash and short-term Treasury bonds for portfolio ballast and to protect in the event of a deflation scenario. Nonetheless, my strategic asset allocation is tilted to the inflation/dollar debasement scenario.
Risks and Rebuttals
Near term we could experience deflation. That would strengthen the dollar. Regarding the election, there are some sectors more likely to do well depending on who is elected. An example might be clean energy, favored by Biden and the Democrats. Muni bonds could become more attractive for high income investors if we get a regime that implements higher taxes. Certainly, there is always room for speculators to make sector or individual stock bets that can payoff. But smart and balanced long-term investors won’t put much weight, if any, on the election outcome.
Signposts and Entry Points
When will the dollar decline be in full swing? How long will it take? In absolute terms it has been underway for a long time. The long view shows that the dollar has steadily lost purchasing power since its removal from the gold standard in 1971.
Shorter term, since the flight to safety that occurred in March, the dollar has moved down by about 10%. I’m not a technician. But that might have signaled the beginning of a longer term pronounced trend and an historic inflection point. Seeking Alpha’s Andrew Hecht explains why the path of least resistance is downward. Before the pandemic Lyn Alden wrote an excellent piece that shows why the fundamentals signal a long-term decline.
However, history shows that reserve currencies don’t die easily. The process can take decades. Besides the obvious money supply expansion, here are some signs that suggest the process is accelerating:
Yet, the dollar has proven resilient. Near term, given its recent drop, it may reverse. A 10% drop in only five months is unusual. It hurts exports of U.S. foreign trading partners. Foreign central banks don’t stand by idly when that happens.
A second COVID-19 wave in the fall could cause another major market dislocation and flight to safety. That could present a nice entry point for investors who haven’t yet taken steps to protect their portfolios. Although the dollar could remain in power for years to come, it is likely it will weaken substantially over time. Some say a complete reset could even occur yet this year. Nonetheless, regardless of timing, smart investors will be positioned now.
While some media and short-term thinking analysts like to talk about how to position your portfolio for the election, it’s clear that there are more important and overwhelming forces in play. Particularly, the megatrends related to the decline of the United States’ world stature and the enormous stress on the dollar outweigh. No matter who is elected in November, the dollar destruction script will be acted out.
History shows that this has eventually decimated other world reserve currencies and their equity markets. In some cases, it has also coincided with the creation of a new world order. While the timing for this is usually measured in decades, the process has been underway in the U.S. since the 1970s. The financial crisis of 2008 and now the 2020 pandemic might be moving us towards a major reset sooner rather than later.
Smart money will take the appropriate steps to diversify their assets accordingly.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.