History Lessons for 21st Century Investment Managers

The United States can be thought of as a strained marriage of democracy and capitalism, with the two often at odds with each other. Interestingly, history has shown that inflection points occur when there is a shift in dominance between democracy and capitalism within our economy. And although managers should not assume that history will repeat itself in exactly the same fashion, they would be wise to use history as a guide in interpreting the secular changes presently occurring within the U.S. economy. The United States can be thought of as a strained marriage of democracy and capitalism, with the two often at odds with each other. Democracy is founded on the principle of “one person, one vote,” which assures that each person (theoretically) has equal influence in the system. Capitalism is founded on the principle of “one dollar, one vote,” which is known as a “cumulative voting system.” Secular changes (or points of inflection) occur when the weights of these two factors in our economy shift. This article describes some recent macroeconomic inflection points as the weights tilted toward government in the 1960s and 1970s, moved back toward capitalism in the 1980s and 1990s, and moved back again toward the public sector as we entered the 21st century. The article also describes what sort of investment management makes sense as the balance of power shifts between democracy and capitalism.The 1960s and 1970s constituted an inflationary period—a bull market in government and a bear market in capitalism. This period ended because the bull market in government eventually created “stagflation,” following which, the electorate decided to shift the weight toward a market-based economy. Strong returns from financial assets in the 1980s and 1990s arose from a bull market in capitalism and falling inflation.Now, the United States is at another inflection point, with the power of government again on the rise. If history is any guide, an expanded role for government means that over the secular horizon, inflation will rise. More inflation holds many implications for investment portfolios. If investment managers take seriously their fiduciary mandate, they will need to realign their portfolios to a mix of public- and private-sector investments that matches the macroeconomic environment. The following are some important recommendations:Overweight tangible assets and TIPS in relation to nominal financial assets. If we are indeed entering a bull market in government and a period of secularly rising inflation, a successful portfolio will need more tangible assets. It will also need Treasury Inflation-Indexed Securities (originally “Treasury Inflation-Protected Securities,” commonly called “TIPS”), which did not even exist in the 1980s. TIPS are T-bonds whose principal value is adjusted to reflect actual inflation, a feature that makes them compare favorably with nominal bonds, whose yields reflect only the market's estimate of inflation. Although TIPS performed well in the past several years as real yields fell, they still offer relatively cheap insurance against inflation. TIPS valuations are supported by the fact that real rates have been lower during reflationary, government-oriented periods than during disinflationary, private sector-dominated times.Balance stocks and bonds. Unfortunately, both stocks and bonds are going to offer lousy returns in the years ahead because rising inflation is both a damper on P/E multiples and a corrosive for total returns on bonds. Stocks and bonds had their glorious two-decade run, but now they face a headwind. If I were forced to choose, I would overweight bonds in relation to stocks, partly because I consider stocks to be a call option on capitalism. And if capitalism checks into the Betty Ford Center for balance sheet rehabilitation, the call option is not worth much.Overweight value in relation to growth. The coming environment is not one in which growth stocks will perform well. They were strong performers in the late 1990s, but that rally was about the nation reembracing the U.S. enterprise as a going concern. Now, we must think in terms of normalized relative valuations and performance, which means a bias toward value.Overweight private-sector obligations. A bull market in government is actually a bull market in credit quality. Current valuations are rich in the corporate bond market, but secularly speaking, investors should shift from government debt to private debt.Overweight nondollar assets in relation to the dollar. In the United States, rising inflation and a more government-controlled economy will weigh heavily on the dollar's value over the secular horizon. What is more, the sheer size of the U.S. current account deficit—an inevitable consequence of “successful” reflation—implies a surplus of dollars globally relative to private global demand.