Putting the Puzzle Together

THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.

The puzzle pieces don’t easily fit together, yet the perfect portfolio must do just that.

The big forces are:

a. Tech boom.
b. Erosion of institutional norms.
c. Slowing growth.
d. Monetary easing amid big fiscal deficits.

In more detail:

Tech Boom. Corporate profits are strong—fantastically strong in some cases—and AI creates a strange optionality that hasn’t existed in other productivity booms. A case in point is Meta. They earn about $145 billion (with a “b”) in profit. They produce a service that people are addicted to. When I was in Croatia, I noticed many people take carefully curated selfies destined for Instagram. Meta’s profits equal the GDP of Slovenia, except Slovenia has 2 million people and Meta has 75,000. Meta spends about $50 billion on Capex, mostly for AI. If AI improves their ad service, profits will grow even more. In stock parlance, that’s Return on Invested Capital. But if AI doesn’t pan out, they slash Capex and free cash flow explodes. Typical productivity booms—like building railroads—required huge amounts of borrowed money. This productivity boom doesn’t, leaving the protagonists like Meta oddly immune from many of the forces that usually come into play.

Erosion of institutional norms. While some of it is theater, much of it isn’t. Tariffs are indeed around 18%. The Fed’s independence is under attack. The head of the Bureau of Labor Statistics was replaced by a partisan. Enemies of the White House are being targeted. U.S. military forces are being deployed against the domestic population. Russia is allowed to have its way in Ukraine. Trump has referenced serving a third term. For investors, the question is the degree to which these policies shift cash flows. The answer is that it’s case by case. For Meta, the tariffs probably don’t matter much at all. For foreign investors exposed to fluctuations in the U.S. dollar, these policy shifts likely will matter a lot. Similarly, decisions on military aid to Ukraine are, for some, life and death.

Slowing growth. Growth is spending, and spending rises when money (printing) and credit (borrowing) rise. Due to both past monetary tightening and, now, fiscal tightening in the U.S., growth is slowing. In the U.S., Canada, Germany, China, New Zealand, and elsewhere, unemployment is gradually climbing. Today we found out that Canada’s economy is contracting. All this is forcing a shift in policy, which leads to point 4.

Monetary easing and big fiscal deficits. Pre-Covid, inflation was low, bond yields were low, and government borrowing was modest. During Covid, all of that changed. Governments borrowed heavily, and supply chain disruptions sent inflation soaring. Now inflation is gradually seeping out of the system, and central banks are cutting—but the big fiscal deficits (U.S., France, U.K., Japan, Brazil) remain. Easy monetary policy combined with massive bond issuance is bearish for long-term bonds, particularly in places with significant issuance. The focus of attention this week was France, but the bigger issue is easing, deficits, and the interest rate at which bond issuance clears.

The perfect portfolio captures the nuances of the above dynamic. This means owning companies with strong cash flow that are priced as if their cash flow will be mediocre. It also means owning bonds in countries with rule of law, sound balance sheets, and slowing growth. It means recognizing that the U.S. needs to attract $1 trillion a year to keep the dollar stable—and as U.S. policy becomes more unsettling for foreign investors, this capital flow could slow. There’s a real possibility that one morning we wake up to find the dollar down 5% or 10% overnight, with no clear reason why it happened that particular day. It also means recognizing that the gradual grind higher in long-term bond yields threatens the equity rally.

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The Uncomfortable Truth About Money

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