Cash, Gold and Private Credit: Are You Actually Protecting Your Purchasing Power?
Cash is King. A Mad King.
It’s a dreary Tuesday morning. A little cold, a little wet, and a little windy. It’s August, and it’s Melbourne, so it isn’t really unusual. You’re trudging into the bank branch to try and find someone to talk to about the cash you have sitting there that makes little to no interest. The Reserve Bank of Australia has recently lifted the cash rate to 4.35%, so you’re reasonably certain you’ll get something decent. We aren’t in Covid anymore, after all, and 4.35% is a long way up from 0.10%.
The teller is chipper. And honest. She cheerfully advises you that you are smart for realising that the 0.25% they are currently paying you for your money against the headline inflation of 3.8% means that in a year’s time, your money can only buy around 96.5% of the stuff it could have bought today.
So you have, indeed, made the right choice in braving the weather. Problematically though, the improvement the teller offers remains fairly undesirable. In her still cheerful tone, she tells you there’s a savings account offering 5% per annum. And it’s all above board. This is no “introductory rate offer”, and there are no hoops to jump through (like leaving the money alone, or consistently adding to the funds) to get that rate each month. No. This is a proper, best of breed, savings account. Your money will earn 5%, a clear 1.2% above the inflation rate.
But you have other income. You pay tax. At 30% on every additional dollar you make. Suddenly your 5% is 3.5%. Suddenly your wealth is going backwards again. Less backwards, but still backwards. This experience is why, even for investors enjoying a period of higher interest rates, you may not be feeling very much richer at all.
So where do you go to protect your purchasing power?
All that glisters is not gold.
Gold has been the supposed store of wealth many look to for the protection of the purchasing power of their otherwise stagnant cash. It is often even regarded as safe, which is a confusion derived from the understanding that gold goes up when stocks go down, which in itself is an overly simplified and often erroneous understanding.
I’m going to do something heinous now. I’m going to cherry pick a time period to demonstrate a point for the sake of the argument. But let me be clear, this is no isolated one-off. The pricing behaviour described here has happened many times for gold and worthy of consideration;
On 5th September 2011, gold hit around $1,895 US dollars. The Australian dollar was fairly strong, so it was $1,795 Australian dollars at the time.
It fell, and was roughly $1,534 (Australian) by June 2015. It wouldn’t fully recover in Australian dollar terms until 2019, finally getting to $2,000 (Australian) in June of that year.
So, over the course of nearly eight years, it had hardly been a smooth ride. But it did protect value eventually, correct? Well, no. The increase in value was around 11%. Inflation in Australia during the same period was a cumulative 16%. And it wasn’t even gold doing the work. In US dollar terms the gold price was still only around $1,400, a loss of 26%. No, for an Australian gold bug, what protected the value of their cash was selling their Australian dollars to buy the US denominated gold, not the gold asset itself. And even then, it would have been better off in that savings account.
Private Credit: Not in one bottom trusted?
So, if it isn’t wise to chase purchasing power preservation through an asset where realisable value relies on someone else paying more for it, and your currency, in the future, how about lending the money to third parties? There are an almost endless number of ways to do this. After the Global Financial Crisis, banks retreated from lending to almost anyone other than home buyers, rates stayed low through a decade of weak growth, and COVID added a fresh wave of cuts and government spending on top, leaving a flood of cheap money looking for somewhere to go. The resulting non-bank lenders and non-bank borrowers make up the majority of the Private Credit market. A mysterious asset class that somehow conjures up images of red velvet sofas and darkened hallways. Private credit can cover all manner of sins. Mortgages, personal loans, car loans, construction loans, corporate loans. Asset-backed or senior secured or subordinated or mezzanine. It’s all very sexy.
Here’s the rub, if you’ll excuse the expression… credit expansion is often the pre-cursor to credit tightening, and indeed since the days of Covid we’ve seen interest rates increase (in response to inflation) at the fastest pace in decades. It’s the increase that can cause issues. When credit (borrowed money) becomes too easily available, those who have a lower likelihood of being able to pay back their debts suddenly look like attractive borrowers to that additional dollar of available funding looking for an interest receipt. And for a while it all works well… until somebody can’t pay. And when that somebody can’t pay, the lender they owe can’t pay the lenders they have borrowed from. And so the snowball rolls. I highly recommend watching “The Big Short” for an entertaining education of the very real horrors of 2008/2009 as the value of credit eroded rapidly (that time mostly through mortgages and their many contrived derivatives).
ASIC recently released a report into the private credit space in Australia, flagging that 22 managers investing $76 billion on behalf of their clients seem, in some cases, to be either underestimating or understating a growing level of risk. Broader market estimates predict the sector will be in excess of $90 billion by 2029. It will likely look attractive throughout that time due to capital values that don’t move and income payments that remain stable and relatively high. That’s the danger here. The volatility of the gold price disappears, and in its place, you receive a monthly stipend. The more attractive the stipend, usually the less reliable the borrowers. If the risks are obvious, they likely haven’t been diversified well enough, which is a risk ASIC highlights directly. If the group of borrowers is broad and well diversified, it can be difficult to identify what the actual aggregated risk might be, which is an equally difficult problem to solve. Because of the opaque nature of this investment type, the stipend is likely to be well in excess of inflation, even after you’ve paid the tax. And it will likely be a smooth ride. And that smooth ride will continue until and unless it doesn’t. And when it doesn’t, it will be called a “Black Swan event” (an event that was completely unforeseeable) and your pound of flesh will be on the line if you’ve placed it all into the one collection of loans that may never be repaid.
We must take the current when it serves
To be frightened of the risks of either of the prior options to the extent they’re dismissed out of hand is not the message you should take from this article. They are illustrations of currently (and periodically) popular investment types that each have merit in their own time and for their own reasons.
But when it comes to hunting for yield, there is a logical framework, which can be phrased as an equation if you’d prefer, to assess whether what you are receiving in return for your investment is worth the risk you are taking. It can be equated to betting on horses, and I will start with that example. If a horse is running at 2:1 odds, it has a roughly 33% chance of winning. If it wins, you receive $2 (interest) plus your $1 (principal) back. If it loses, you receive $0 (like a defaulted loan). A 33% chance of getting $3 against a 67% chance of getting $0 equates to a probability-weighted value of $1, the amount you need to bet. A relatively high chance of winning for a horse race, but alarmingly low chances for an investment.
Chasing yield can be framed with the same probability-weighted equation. What are the odds you win? What do you get if you do? What do you lose if you don’t? The difference between lending money and betting on horses is that often your chances of winning are quite high and your losses if you lose are not total (you can get some or all of your money back by selling the borrower’s security). On the downside, your return for winning isn’t likely to be double your bet.
A real world example might be as follows: through substantial experience and data a private credit manager knows that loans they issue will be repaid properly plus interest 96% of the time (the win). The other 4% of the time (the loss) they recover 85% of what they lent. If they are able to get a return of $1.12 on every dollar when they win (representing the principal and interest payments), and $0.85 on every dollar when they lose, they get a return of ~$1.11 on every dollar they’ve “bet” (calculated as the probability of a win times the return of the win plus the probability of a loss times the return of a loss). This probability-weighted return then needs to be compared against inflation to allow for the impact of time (these things take somewhat longer than a horse race).
Of course, assuming the metrics are correct and the risk can be spread across enough similarly risky loans, the outcome should be relatively predictable. The only (quite major) flaw here is that while the equation is simple, sourcing the information to plug into the equation is not. Nevertheless, it is a useful concept that can be applied in all manner of everyday situations.
Protecting your purchasing power into the future is not something to take lightly. It is unlikely that high-interest savings or term deposits will be adequate (unless you have a marginal tax rate close to nil). Taking risk will be necessary, but it should be measured. The two currently popular flavours identified here, gold and private credit, may be part of the answer, but they most certainly should not be the whole answer. The many varied sizes and shapes of risk found in chasing yield can be used together to build a real return in excess of inflation while standing up to isolated risks. Even with the risks considered, when it comes to yield, it is still certainly better to be the hunter than the hunted.