COVID Emergency Funds, the Price of Gold, and the Stock Market

Having one’s cake and not eating it.

When I came to Russia, my first summer was hot and sunny and I took to cycling, exploring the city’s cycle paths, one of my favourites being the one that runs along Bolshaya Nikitskaya up to the Garden Ring. For those unfamiliar, the Garden Ring is a ring road around central Moscow, which carries a good deal of traffic and generally has ten lanes. When the cycle path gets to the ring it ends. Stops. That’s it. No more path, just a highway going across.

When I described my discovery in the office on the following Monday, a Russian colleague, who had lived a long time in the US explained, “Michael, you don’t get it. The order was given for there to be a cycle path. The cycle path exists. That’s it. That’s what it’s for. You expect it to go somewhere. No. You are wrong.

We are in a time of some economic crisis, caused by the horrendous health crisis that engulfs us.  Some countries are spending upwards of 10% of GDP to combat the crisis. Not so Russia. 10% of Russian GDP would be 11.3 trillion rubles. Prime Minister Mishustin says there is 1.4 trillion rubles set aside for this crisis, that is 1% of GDP. After all, 10% of GDP is a lot of money for any country.

However, Russia has 8.249 trillion rubles in its rainy-day fund split between deposits at the Bank of the Russia in rubles and foreign currencies; amounts on deposits with VEB.RF, VTB Bank (Public Joint-Stock Company) and «Gazprombank» (Joint-stock Company); and the value of purchased securities. 

Why is the rainy-day fund not being used? Because then it would not exist. That would be like trying to eat one’s cake and still have it. The rainy-day fund exists. That’s it. That’s what it’s for. You expect it to go somewhere. No. You are wrong.

Even if it’s raining really very hard.

Why is the price of gold rising?

Rather than using its rainy-day fund, Russia is expected to borrow to fund expenditure on the current crisis. Although foreign economic sanctions do not prohibit lending to the Russian government, that is to say investing in Russian sovereign debt, most foreign banks and countries behave as if sanctions did. So, Russia will borrow on the domestic market.

The central bank will place bonds with domestic, commercial banks. Repo operations then allow the domestic banks to borrow overnight from the central bank – by selling these bonds back to the central bank with a guarantee that they will buy them back from the CRB the following day for a pre-agreed price which is higher than the previous days’ selling prices. Clear? 

That’s the same as printing money, effectively. But you cannot be heard to say that anywhere in the world, because that leads to inflation. Inflation is bad, stupid. Modern monetary theory, which is selectively popular, says that inflation won’t happen and that deficits are not a bad thing, austerity is. Clear?

The wonderful thing about this part of economic theory is that the debate about it (not it itself) is a mirror of some kind of hugely complicated extension of differential calculus that gets harder and harder to understand the further away you get from the starting point of the equation. Effectively as one rises higher and higher in the intellectual stratosphere more and more of the world’s greatest brains drop out of the debate for fear of looking stupid. They abdicate responsibility to the ultra-intellects that inhabit the upper atmosphere of economic theory, where the air of common sense is so thin that no living thing can survive, but that’s another secret.

That kind of theorising and moving of money between central banks and commercial banks is a big part of what’s going on globally to keep the economies alive. This is why gold is rising in price at the moment. Because it exists. That’s it. That’s what it’s for.

So, what to do?

It’s worth remembering that the value of a stock is the discounted present value of the future earnings of the company concerned. The discount (i.e. interest rate) is the lowest it’s ever been, which raises valuations. At the same time, the tax deductibility of interest payments on bonds (debt) has become less valuable as rates fall.

Consequently, companies are raising equity at these prices, which causes a downward equilibrium force on equity prices too. In other words, the quantitative easing / money printing that is going on is keeping capital markets working as they should.

Combine that with a reminder that the value of the stock is based on all its future cash flows, not just those from the currently lost year that is unfolding, and you get logic to the valuation we are seeing currently. This article explains current valuations rather well –

Necessity is the mother of invention

At the same, there is a huge rebalancing going on, and so change which was, in some respects, only gently trundling along, is now being rapidly accelerated. The stocks with the highest values (market capitalisation) will be somewhat different, after this pandemic recedes, from those that were higher before.

 “Tech” of course remains the buzzword. But what tech? For now, not all fintech, and not insuretech, as new consumer borrowing is unlikely to be high on the short term agenda, and insurance is likely to see a lot of cash outflows or uncertainty for a while.

 So, in addition to Gold, we look for those asset classes that have either survived the crisis relatively unscathed – food for example, food-tech, and agritech. Also on my lists : genomic research – med-tech, medical devices, healthcare as a whole; real estate – selectively the parts that house and hold the businesses that are successful, or the enduring holders of value, London property for example; e-commerce; home working; logistics, especially last mile distribution and warehousing systems; consumer staples, from toothpaste to pet-food. Look for the Environmental, Social & Governance features that characterise the most successful companies of today

Absent from the list, possibly just for a short period: consumer lending, travel, discretionary consumer purchases that involve borrowing, oil, traditional energy. These could also be described as the bargain basement though – once we know what the post-viral world looks like, will we all be back in our gas-guzzling, single occupier, automobiles?

This has been the most interesting crisis from an investment perspective, because the shock is exogenous; trust had not been eroded in the market, fear does not abound, at least so far, in the economy. Capital markets are liquid. Investment markets are detached from “real life” by time, which is the most important component in any investment equation.  The cynic might say that real life is a poor proxy for investment performance. Thankfully investment performance is a useful tool in helping real life be easier.

Remember that diversification is the way to reduce risk in a portfolio. Diversification is a mathematical science, not a volume game. Diversification is not achieved by investing in as large a group of individual stocks as you can pick. That raises your blood pressure, not your income.