Han Dieperink: Returns vs. capital preservation

October 1, 2024

_{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

Returns and capital preservation seem to be in conflict with each other. After all, if you want to generate more returns, you have to take risks, which puts the objective of capital preservation at risk.

There is also a big difference between short-term capital preservation and long-term capital preservation. In the short term the effect of inflation is not that great, but in the long term inflation is the biggest enemy. Fear of capital loss also plays a major role in capital preservation, while greed is a much stronger emotion in terms of returns. Now a choice for either capital preservation or returns seems subjective, but an important determining variable for preservation or returns is the level of interest. Investors can choose from different assets.

Investing in fear

The ultimate fear investment is gold. Gold is an insurance policy in uncertain times and also beats inflation in the long term, although equities are much better at this. In recent years, gold has lost some of its luster during the period of high inflation, but now that inflation has fallen, the gold price is making up for that this year. The demand for gold largely comes from China, because Chinese investors saw few alternatives where a large part of the savings in the past went to the housing market.

However, since Xi Jinping declared that houses are for living in and not for speculation, people started looking for an alternative. The interest on the savings account was low and was further depressed by the influx. As a result, the interest rate on government bonds is also low. Low interest rates mean that there are few opportunity losses when investing in gold, because gold pays no dividends or interest.

Looking for a safe haven

A historically safe haven for investors seeking capital preservation is the bond market. Long-term US government bonds in particular are the ultimate hedge against uncertain times. For a long time it was even seen as the safest reserve. However, due to rising interest rates, these long-term government bonds have more than halved in a short time. The losses were even greater than anything we've seen in the stock market this century. That is not something that helps with the image of a safe haven.

Moreover, it is not only the rise in interest rates that has not done the image any good. Increasing government debt and interest rates have also risen much faster in recent years than the underlying economy has grown. This applies not only to the US, the UK and France, for example, but to even more developed countries. Furthermore, monetary policymakers have made it clear through reflation or financial repression that asset preservation is not an option for bond investors in the coming years.

Seen in this way, shares are much better suited for preserving wealth in the long term than gold or bonds. This is also because the role of gold seems to have been partly taken over by Bitcoin, the digital version of the fear investment.

The difference between gold and Bitcoin is not that big. Both are worth what the fool pays for them (greater fool), but in international payment transactions Bitcoin is much more efficient than carrying around bars of gold. Bitcoin is also betting much more on the bankruptcy of fiat currencies due to the monetary madness of recent years. The problem remains that the value of such non-productive assets is ultimately determined by the government. After all, he has the monopoly on power. For Bitcoin this is a problem, but perhaps also an opportunity.

Useful versus scarce assets

In addition to scarce assets, such as Bitcoin, gold, art, etc., assets such as shares and bonds are productive. These are productive assets because they can produce scarce assets. Since the industrial revolution, the total value of productive assets has risen sharply, but scarce assets have become cheaper due to strong productivity developments. As long as the value created by productive assets (profits, dividends, interest) exceeds the value of holding scarce assets, there is growth. An important variable is the interest rate. The interest rate includes the risk of time and credit. It is the link between the present and the future.

In the long term, productive assets perform much better than scarce assets, but there are periods in the meantime when scarce assets still perform better. Then it is no longer about the return on capital, but about preserving capital. The classic is the debt deflation a century ago, as so beautifully described by Irving Fisher. This theory states that recessions and depressions result from an overall increase in debt in real value due to deflation, causing people to default on their loans and mortgages. Bank assets then decline due to defaults.

As the value of collateral falls, this leads to an increase in bank failures, a reduction in lending and a reduction in spending. A downward spiral arises that leads to major economic instability. This can only be prevented by stabilizing the economy and that requires authorities to go deep. This was finally prevented in the 1930s by the New Deal and World War II.

In the 1970s, inflation went off the rails and there was another period in which scarce assets outperformed useful assets. After all, recessions in combination with high interest rates create a similar downward spiral, only now under the heading of stagflation. While deflation causes an increase in the (real) value of the debt, the surprisingly high and persistent inflation not only affected the real value of the debt, but also the (real) income of companies and citizens. Again with the risk of a downward economic spiral.

The Great Financial Crisis of 2008 was a classic real estate and banking crisis. Also at that time, the value of scarce assets rose much faster than the value of productive assets. This was helped by central banks that, with the help of unconventional monetary policy (low interest rates, buying up bonds), stimulated the boom in many scarce assets - from classic cars to Japanese whiskeys. This period was less painful than that of the 1930s or the 1970s, but with the consequence that debts (with governments) exploded. Adjustment, but no postponement.

Debt problem solution

The classic solution to a debt problem is reflation, also known as financial repression. Then both short-term and long-term interest rates are structurally below the nominal growth rate of the economy. During such a period, savers (and bond investors) are screwed. Equities are actually performing surprisingly well, also due to (too) low real interest rates. It is also a typical environment for blowing soap bubbles. In such an environment, (real) asset retention is extremely difficult.

However, there is the ultimate outlet of currency. The currencies of countries that have fully participated in the monetary madness are structurally weak, while currencies of countries that have maintained monetary discipline are rapidly gaining in value. After the relative calm on the currency front after the Great Financial Crisis, currencies will play a greater role in terms of returns and therefore also in terms of (real) capital preservation.

More columns by Han Dieperink