All we know are the facts...

By: Simon Mikhailovich

Americans of a certain age would recognize the title as a line used by Sgt. Joe Friday of the TV series Dragnet. The competent but humorless Sgt. Friday eschewed idle speculation and always demanded that witnesses stick to the facts. Focusing on the facts rather than speculation is sound advice in the era of "talking head" experts and sophisticated models that have been consistently wrong when it mattered most. They all failed to foresee the .com bust of 2000, the securitization bust of 2008 and, most recently, the outcome of the US Presidential election.  

Up until the evening of November 8, the world was certain that Hillary Clinton would be the next US President. This certainty was lauded by the media and was backed up by the multi-million dollar polling organizations and their fancy models all of which gave Hillary Clinton near 100% odds of beating Donald Trump. And yet, the press, the experts and the models were all proven to have been 100% wrong!  

Similarly, until 8:00 pm of the same day, November 8th, 1.3 billion Indians were 100% certain that their Rupee notes were cold hard cash. Then, at 8:01 pm they were proved 100% wrong as Prime Minister Narendra Modi appeared on TV to announce immediate "demonetization" of the 86% of all Rupee notes in circulation. Mr. Modi said that this way, cash held by the "anti-social elements would just become a worthless piece of paper." He also announced temporary closure of all banks and ATMs and tight limits on cash withdrawals after the reopening. There was also this: those depositing over $3,700 worth of old notes could face questions and a tax audit, i.e. the burden to prove innocence would be on them.

Both developments were met with shock and dismay but neither outcome should have been a surprise. I am not suggesting that the outcomes were easy to predict but that both were realistic possibilities in light of the well-known facts. 

For example, Mr. Trump, an unconventional candidate, had persistently defied expert forecasts by beating 16(!) conventional politicians to win the Republican nomination, despite the strong opposition from his party's establishment. Ms. Clinton, a conventional politician, had full support of her party's establishment but faced a meaningful challenge from Bernie Sanders, an unconventional politician, whose appeal also defied expert forecasts. Based on these facts alone, Trump's victory should not have been a shock, except to those who had not been paying attention. 

The same was true about the Indian war on cash. Mr. Modi came to power promising a fight against corruption and "black cash." Although no one could have predicted when or how he might start that fight, it was reasonable to expect some action. Anyone who had paid attention to Mr. Modi's priorities should not have been caught unprepared. 

What insights are to be gleaned from these unexpected, yet highly consequential events? There are many but the most useful ones are these two:

  1. No one knows the future; the experts least of all.
  2. Ignoring the facts does not mean they do not exist or that they will not have significant consequences.

How does this apply to today's situation? Same as always - all we know are the facts. As the stock market's post-election euphoria induces another round of complacency, here are a few relevant facts, whose implications are worth pondering:

  • The outcome of the election has not changed the deficits or the level of debts.  These were serious problems before the election, and they have not gone away.

  • No one knows whether Mr. Trump's policies will produce enough growth to overcome excessive debts; we do know that more spending and more debt must come first.

  • Since 2007, Federal debt rose from $9T to 19.6T whilst the average interest rate of this debt declined from ~5% to ~2%, keeping the interest costs flat as the debts rose.   

  • A bit of math: if interest costs reverted to the pre-crisis levels, federal interest expenses would go from ~10% of the budget to ~25%, assuming no new debt. Ruinous.

  • Bond yields have been rising since the election. If they continue, the US ability to keep borrowing without limits, which has not be a problem, could very quickly become one.

  • No one knows whether unfunded entitlements will be a big problem but many US pension plans are already in deep trouble; Dallas and Illinois are but two examples. 

  • The rise of populist/nationalist politics and the souring social mood are symptoms of polarization and of the economic disequilibrium, which themselves pose risks.

  • The war on cash is a global phenomenon with growing support in the US, Australia, Sweden, etc. India just put 18% of the world's population under financial martial law overnight. 

These are but a few facts and even if they can be interpreted in different ways, the risk of bad outcomes is material. The same experts and economists who missed the last two crises now argue that systemic risks are not material and will be resolved without adverse consequences. This has been conventional wisdom and is the bet that the vast majority of investors continue to make by holding the bulk of their wealth in financial assets and levered real estate. The bet may be right but it might be wrong, which is why prudent people ought to consider whether they can afford for it to be wrong. 

Which brings us to physical gold - the only liquid hard asset and a store of value that is no one's obligation, does not rely on financial institutions or markets and that governments can not devalue or render worthless, no matter how hard they might try. In fact, the US government did try to devalue gold against the dollar 45 years ago. When Richard Nixon demonetized gold in 1971, experts had predicted that without its official monetary role, gold would trade as a pure commodity and its dollar value would collapse to a fraction of the $35 pre-demonetization price. Experts got it wrong and it was the dollar that has suffered a massive devaluation. At today's gold price of $1,180, the 1971 dollar has lost over 97% of its value in gold terms. 

Those who would rather not take a chance of being "shocked and dismayed" should the experts and conventional wisdom get proved wrong yet again, ought to put in place a sensible Plan B, while it is still possible to do so. Any such plan should include an allocation to physical gold held across diversified jurisdictions and without reliance on financial institutions and markets.