Who should read this?
You have to put your money somewhere – how do financial advisors providing asset allocation advice for their clients and self-directed investors navigate the road ahead?
We evaluate the success of the 60/40 asset allocation strategy (60% of assets allocated to equities / 40% allocated to fixed income and cash management products) over the past 70 years to assist investors better understand the problems with measuring returns against consumer price inflation (CPI) and consider how to invest during a potentially high-inflation and low-return period in the 2020s.
What are the problems with traditional asset allocation today?
Purchasing Power has been grossly underestimated
Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the amount of goods or services you would be able to purchase.
Purchasing power is measured by consumer price inflation (CPI). It takes into account a constant basket of 500 consumer goods tracking the price changes over time and provides a measure of the change in the cost of living, including food, housing and education.
Numerous changes in the methodology have occurred since the 1980’s which has resulted in a significant underestimation of government reported CPI over the past 40 years. A lower reported CPI heavily influences lower interest rates and lower government bond yields, allowing governments to borrow substantially higher amounts of money at lower interest payments.
This is explained further in our note on CPI here.
Efforts to recalculate the original CPI basket using its original pre-1980’s approach (for example, the Chapwood Index) show that actual CPI has risen by 10% per year since 2015 across most large US cities. These results are also supported by work undertaken by economist John Willams at ShadowStats . By comparison, official US Federal Reserve’s CPI estimates have averaged just 1.5% over the same period. Clearly, something is amiss with government reporting of CPI.
This means CPI on wages and savings has been under-reported
The under-reporting of CPI has had an enormous impact on workers, retirees and investors. Wage and pension payments are tied to CPI increases – the failure of CPI to provide a true measure of the cost of living has resulted in lower wages over the past 40 years, forcing workers to spend their savings before finally turning to government handouts just to survive.
Using the government measure of 1.5% CPI since 2015, the average salary and pension has grown by just 8% over the past 5 years. If we instead use the alternate 10% estimate, wage and pension growth would instead have reached 61% over the same 5-year period, dramatically improving the quality of life and retirement savings for most workers and retirees.
A study undertaken in 2019 reported that 58% of workers across the US have less than $1,000 in savings, providing further evidence that lower CPI estimates have robbed workers of wage increases that meet their actual cost of living increase. This is the primary reason behind the ‘hollowing out of the middle class’ globally over the past five decades.
The 60/40 asset allocation rule analysed
The 60/40 asset allocation rule offers a mix of growth (equities) and safety (bonds), with the purchasing power of investment returns measured by subtracting gold’s performance from annual investment returns.
How has this strategy performed over each decade from 1950 to 2020?
In calculating the performance of $100 invested in 60% equities (SP 500 index) and 40% bonds (US 10-yr treasury), after subtracting gold price returns over each decade from 1950 to 2020, there are two clear periods of decline:
- The strategy was successful for 5 of the 7 decades, with the strongest returns seen over the 1980’s.
- 60/40 asset allocation investors over the 1970’s lost over 80% of their purchasing power value and, again, following the 2001 tech crash, losing 44% of the purchasing power.
- If investors instead moved their assets away from the 60/40 asset allocation during the worst 2 decades and instead moved into inflation-protecting asset classes like gold bullion, they would have generated substantially higher investment returns.
Change in Purchasing Power of $100 invested each decade
Investment performance over the very long-term, with a $100 investment made (again using the 60/40 asset allocation approach and subtracting annual gold returns) at the beginning of each decade and then held over the entire period through to January 1, 2020.
Several additional themes stand out:
- The substantial loss of purchasing power over the 1970’s and 2000’s has a big impact on the total investment return over the long-term.
- Holding the 60/40 asset allocation strategy over the period of 1980 to 2020 had the strongest performance, producing a 10-fold increase in purchasing power, principally due to avoiding the significant loss that occurred over the 1970’s.
- This contrasts with the same strategy over 1970 to 2020, with just $88 of purchasing power created, equivalent to just 1.3% return per year over 50 years.
- We see a similar pattern over the past 20 years. Rising gold prices through the 2000’s in response to rapidly rising government debt produced only $19 of purchasing power growth over 20 years. With gold prices more stable and equity prices strong following the 2008/09 GFC, investor returns were much stronger over the 2010’s.
Why is gold useful to determine real investment performance?
Gold Bullion – a more accurate measure of CPI
An alternative tool to more accurately measure CPI is movements in the price of gold. For the past 5,000 years, gold has remained a constant (it does not erode or decay), providing civilisations with a hard-asset that has been accepted as a global form-of-exchange for trading purposes.
Since the introduction of fiat (paper) money over the past few centuries, investors have used gold to measure changes in the purchasing power of money. As governments increase the volume of currency in circulation (often referred to as “money printing”), there is more currency for each unit of gold, leading to higher prices.
What is the role of gold today?
Gold is one of the most misunderstood financial assets globally. Investors either love it or hate it, including esteemed investors such as Warren Buffett who once referred to it as a “pet rock”. However, as Mr Buffett will understand, a gold pet rock does one thing extremely well – it keeps central banks honest, with the gold prices rising in proportion to accelerated money printing from central banks.
Most investment managers seem to forget this critical point – gold bullion provides investors with a safe haven, particularly during periods of heavy central bank intervention (money printing) when purchasing power of investor savings is under threat. By subtracting annual performance of gold bullion from the investment performance of other asset classes, investors can more accurately measure movements in the purchasing power of their assets.
The chart below shows the history of gold in US Dollars from 1793 to 2020. Through most of this period up till 1971, US and European governments “pegged’ their currencies to gold bullion, which prevented them from running large deficits. Prices remained relatively stable for almost 180 years, rising from $20/oz in 1793 to $40 in 1971. Things suddenly changed in 1971 when the US officially broke away from its gold currency peg and ended US Dollar convertibility. Prices exploded, rising almost 50 times, or 10% per annum over the next 49 years.
US Gold Price from 1793 to 2020
The value of gold responds to rising debt
Gold reflects how much money is in the system. The following chart shows the rising level of global government and private debt that has occurred since 1970. Once the shackles of gold linkage were broken in 1971, total debt rose from US$114T in 1971 to US$260T in 2019.
Global Debt (US$Trillion) from 1970 to 2020
COVID-19 related government and private debt is expected to raise global debt above US$300T or 300% of GDP in 2020. Recent comments from US Federal Reserve Chairman Jerome Powell support many gold investors beliefs that the only tool the Government has at their disposal is to print, print, print and inflate these debts away. Clearly the world has an enormous debt problem. If you would like to know more about the role of gold in the financial system, see our further analysis on this topic here.
What are the risks facing investment performance?
Movements in the price of gold reflect the growth in global monetary supply and provide a more accurate picture of cost of living increases than official CPI figures. Understanding the relationship between money and gold is essential to accurately evaluate investment performance relative to purchasing power.
For example, a $1000 investment into a 10-yr US Treasury Bond paying 1% interest would receive $10 per year for 10 years is a total return of $1,100. By contrast, in a 10% inflation environment, the purchasing power of each year’s payment declines by 10% each year. Over the 10-year period, the final amount is reduced to just $372. An investor buying treasury bonds today for near 0% return may be risking the same extreme loss of purchasing power as real inflation accelerates over the 2020s.
What does this mean for investors today?
Investors are face a mix of the following conditions in 2020 that will influence returns:
- The correlation between the value of gold and rising debt is clear, dangerous global debt levels that are unlikely to ever be repaid will influence stronger gold prices over the next decade.
- The over-leveraged banking system across the globe, forcing central banks to keep interest rates near 0% interest rates for the foreseeable future, will have a knock on effect lowering bond yields.
- Many investors feel compelled to chase riskier assets to generate returns or spend savings.
- COVID-19 has been the catalyst moving the world online and shifting behaviours which is revealing winners and losers among the new world order.
- Central banks are effectively underpinning every asset class – resulting in overvalued asset prices.
- Record equity valuations offer poor risk/reward metrics across almost all sectors outside of the best quality technology companies in the US and China, also resulting in overvalued asset prices.
- Record global unemployment as economies struggle with additional COVID-19 waves. Sentiment will continue to feel highly uncertain as the northern hemisphere moves into winter and the global community still grapples with how to live with a pandemic.
History repeating – 2020 does feel like 1970
Like a hammer that sees everything as a nail, a Central banker’s solution to each of these problems is to print, print, print.
Rising gold prices are signalling that the 2020’s could be a repeat of the destructive investment return period seen in the 1970’s, which wiped out 80% of equity and bond investors purchasing power. It is our view that financial advisors should consider building alternate portfolios to the traditional 60/40 asset allocation approach to better protect their clients purchasing power.