Reader Q&A - your questions answered
AI, crypto, inflation-linked bonds, currency risks and individual stocks
The following is for educational and informational purposes only, and is not a recommendation to buy or sell shares or other investments. When buying or selling investments, investors should do their own research and seek independent financial advice if necessary.
In this update:
Questions on AI, inflation-linked bonds, currency risk, crypto ETFs (free to all)
Questions on individual stocks (paid readers only)
It’s time for some reader questions and my answers.
In some cases, I've clipped and edited the original texts sent to me. That's because it's always a challenge to keep the length of these missives under control. I hope those of you that contacted me understand.
In the meantime, keep your comments and questions coming. I answer all emails.
Emails should be sent to ofwealth@substack.com
So let's get into it...
Artificial? Yes. Intelligent? Not so much.
QUESTION: I have been following the investment press on an issue where I would appreciate your view . AI and its use in the investment space. I believe there is a lot of BS about it but fundamentally the logic seems to stack up in some circumstances when you are looking at shorter timescales than you/we are pursuing as our investment strategy. I would appreciate a discussion and your views if at all possible.
...and...
COMMENT: I am writing regarding your comments at the end about the markets and the possible impact of AI (note: see here - paid only). I have a maths/science background so have always been comfortable with technology and innovations in this area. However, AI from the beginning always struck me as being dangerous. It is producing output without direct human input or intervention and people seem willing to accept everything it says without question. In the year or so since it hit the headlines, your comments are the first I have seen which have shown any concerns.
Please continue this dialogue in future updates, there could be fireworks ahead!
ANSWER: I'm no expert on AI, and its influence on financial markets is something I need to research further if possible. As I wrote recently, the use of AI for trading algorithms may explain some large and erroneous price moves in markets these days.
Speaking in more general terms, I have some concerns about AI.
Not least since one of the last major public pronouncements made by the famous professor Stephen Hawking was about the potential threat of AI to humanity. Given who he was - i.e. a physics brainiac, and neither a politician nor professional luddite - this is certainly enough to signal that caution is required.
I studied Physics, Chemistry and double Mathematics at A-level, so in a sense I have a distant maths / science background, although I switched direction at university (mainly Psychology and Philosophy). I try to take a balanced view on new technologies. I look for the positives but don't blindly ignore the negatives, or believe the absurd hype that's usually spewed from the cake holes of tech sector promoters.
For example, the internet has obviously brought wonderful benefits, but there are clear downsides too. In the meantime, the fully-automated, self-driving cars that we were promised quite a few years ago still don't exist, and maybe never will outside of easy roads.
Anyone that drives on narrow two-way city streets full of parked cars, through ancient and irregular towns, on single-track country lanes, or in any developing country will understand why. It was always obvious that the real world is actually a complex place, and reality wouldn't live up to the hype of car automation. Even Apple Inc. just announced that's it's given up in this area, after wasting many years and billions of dollars.
New tech rarely lives up to the hype, at least not in the supposed time frames of a few years. If it works out, it usually takes many years, or even decades, to really have an impact.
In the meantime, I expect you will have read about Alphabet/Google's recent "problems" (by design?) with its Gemini AI chat thingummy. It treated people to "historical" images of black Nazis, Vikings and the like, while refusing to produce any images of white people in any context.
This should give pause to anyone tempted to let automated AI systems run their investment portfolios. The tech can't even get basic historical facts right.
Index-linked bonds
QUESTION: What are your views on index-linked bonds which both the UK and US governments offer. Practically zero real income but keeping your powder dry ready for possible opportunities in shares. I really enjoy your reasoning.
ANSWER: In short, index/inflation-linked bonds are complex beasts that are often misunderstood and riskier than many believe. In the UK they are called index-linked gilts ("linkers"), and in the US treasury inflation-protected securities ("TIPS").
They do well if inflation between issuance and maturity exceeds the rate anticipated in the bond market, which is known as the "breakeven rate". That's because the amount of principal paid back at maturity increases with inflation. In the meantime, they pay a small interest coupon, which is a fixed percentage of the inflation-adjusted principal value along the way.
As such, if you buy a new linker/TIP when issued, you will beat inflation if you hold it to maturity. When it matures and you're paid back, the amount invested will have increased with inflation. That makes you even in real terms. The coupon interest received along the way gives you your real, above-inflation return.
The problem is what happens in between. If fixed-income (i.e. normal) bond prices fall, meaning yields rise, then that puts downwards pressure on linker/TIP prices as well.
If inflation turns out lower than initially expected, then you would have been better off buying the fixed-rate bonds and holding to maturity, as you would benefit from the higher coupon interest since the start (which would have been the combination of linker/TIP real yield plus the higher expected inflation at the time, or breakeven rate).
And if market real yields increase, being effectively the required coupon rates on new issues of linkers/TIPS, then the prices of already-issued linkers/TIPS will fall to compensate (although the end result is unaffected if you hold from issuance to maturity).
As inflation took off, a lot of people were seduced by linkers/TIPS. After all, their names imply that they should protect investors from inflation. Could the issuing governments be accused of "miss selling"? For sure a lot of people were confused. I suspect even a lot of financial advisors got this wrong.
But look at what happened to TIPS prices as both nominal and real yields rose. Carnage.
iShares TIPS Bond ETF (NYSE:TIP) - past 10 years
Source: Stocks (and app)
From its 2021 peak to its 2023 trough, that particular fund lost about 22%. That's during a period of rocketing inflation. The reason was that both nominal and real bond yields were absurdly low in 2021, and both rose sharply, which pushed down TIPS prices. Real yields were actually negative for much of 2020 and part of 2021, which was one sign of an absurd bond bubble.
For those interested, there was something written recently on the topic in the Financial Times, in their free AV section (see this link).
Personally, I think it's highly likely that inflation rates will come down sharply in the coming months, both in the US and UK (and eurozone). That's because the money supply is falling, which is also likely to provoke sharper than expected recessions.
Put another way, for all intents and purposes, the excess money printed during covid - which caused the later inflationary spike - has mostly been used up, and is back in line with where you'd expect it to be relative to nominal GDP.
In which case - on a tactical basis over, say, 9 to 18 months - it could pay off to own standard, long-dated (10+ years), fixed-coupon bonds (e.g. US treasuries or UK gilts). I'm personally toying with the idea, as an alternative to cash. I also recently increased my gold allocation, since that could also benefit in the same circumstances (falling interest rates).
TIPS might also do okay, driven by falling nominal bond yields and despite falling inflation. But they would be likely to underperform their fixed-coupon bond counterparts in such circumstances (in the same way that they didn't fall as hard as fixed-coupon bonds when inflation expectations and yields went up).
But I still don't like government bonds over the long run, of any kind. That's because of the dire state of government finances.
Currency risks clarified
QUESTION: Just a quick note to say thanks for the update and I totally agree with your position on fully evaluating ALL potential opportunities before giving us your analysis rather than the usual “must have a few buys to recommend - that one will do” that other newsletters seem to employ!
I have put some money into your recent new potential investments and although I've bought them in GBP and hence have an exchange risk to consider I am quite relaxed and they are doing well. I also have some gold bullion in my portfolio and also from time to time buy the GDGB ETF if it looks appealing but currently am out of that so I am extremely interested in your forthcoming stock analyses.
ANSWER: It's interesting that you highlight currency risk, which is clearly a relevant concern but also often misunderstood.
For example, if you buy gold it doesn't matter if you pay for it in dollars, pounds or anything else. You'll still get the same end result in whatever currency you use to count your wealth.
Let's say you have pounds and count profits in pounds. But the gold price is quoted (most usually) in dollars. You can buy a gold-backed ETF priced in pounds (or pence) and the end result will be a function of changes to the dollar gold price and changes to the pound/dollar exchange rate.
Alternatively, you could convert pounds to dollars and buy a gold-backed ETF priced in dollars. The end dollar result will be a function of changes in the dollar gold price. But once you sell it for dollars and convert back to pounds again, at the later exchange rate, you'll still get back the same amount of pounds as the first example.
Of course, there may be costs to consider, such as FX spreads or brokerage commissions for different markets. But the underlying performance is the same.
Here's another example in the stock market: a British investor could buy shares of Unilever priced in either pounds or euros. Is there more currency risk with the latter? Logically no, there's just a currency conversion when bought (and later sold).
What's more, a major multi-national like Unilever has underlying sales and expenses in multiple currencies, so there is always currency risk.
Even a business with 100% of sales in one country, but input costs from overseas (e.g. a US re-seller of manufactured goods from China), has currency risk. If the dollar fell relative to the Chinese renminbi yuan then that company would either have to take the hit to profits, from higher import costs, or raise dollar product prices to compensate (itself likely to weigh on sales volumes).
Put another way, it's a rare stock that doesn't have embedded currency risk. But if the rest of the investment case is compelling then it may not be a major concern.
The only things truly without currency risk are domestic currency cash deposits and local currency bonds, the latter of which have interest rate risk instead. Both have inflation risk, in terms of eventual real returns.
Bitcoin, and crypto ETFs
QUESTION: I enjoy your global insights and musings from Argentina and am glad to see you will publish more. I missed your posts when they ended.
Since you mentioned gold, I wonder if you’ve studied the new, highly successful Bitcoin spot ETFs? Even a safe 2%, annually-rebalanced allocation over any 4 year period to date has shown remarkable results.
Personally, I have conviction and have accumulated an 11% position to good result. It’s only a $1 trillion asset class and poorly understood by most still, but the BlackRocks and Fidelities of the ETF world likely are attracted to the only investible asset whose supply issuance is unrelated to demand. It is profound and uncorrelated in that way. The current supply issuance of about 900 Bitcoin per day will be cut in half in April, according to its code, making it even more scarce and, eventually, finite. There’s nothing else like it.
I know people have unpredictable reactions to the topic so I won’t pester you about Bitcoin unless you ask.
ANSWER: On crypto / bitcoin I like it, but I also have some reservations. I have modest portfolio exposure to crypto of less than 4%, which is up a lot recently given the latest crypto price surges.
Everyone will have their own comfort level with crypto, ranging from 0% of their portfolio to something very substantial. My 4% is fine for me. It could potentially result in gains that are big enough to make a difference. But if it implodes then it won't hurt too badly. It certainly can't wipe me out.
Overall I take a balanced view and try to stay level headed - neither wildly optimistic nor overly dismissive. I have absolutely zero respect for the opinions of one-sided crypto cheerleaders who can't see any potential problems, and often have conflicts of interest. At the same time, I don't agree with those that say crypto is all bad, or even toxic.
For me, it's an interesting new asset class. Apart from the obviously (still) huge price volatility, the main risk that remains is that it could be made illegal by more governments in future. Even if they can't confiscate crypto holdings, that would cause prices to plunge.
That's because owning crypto or using it would then become (by definition) 100% criminal, restricting it to a narrow niche of society. Obviously, in such a scenario, all legal businesses and regulated institutional investors would dump their holdings (if still possible), regulated ETFs would cease to exist, and crypto exchanges would be shut down.
Trading volumes would collapse and crypto prices would plunge, given lack of buying interest. There would be no legal way to make exchanges between transactional fiat currencies and crypto assets.
That may seem like an extreme scenario. But I'm thinking in the big picture context of basically bankrupt developed country governments. Sooner or later, when sovereign crises strike, they are likely to impose capital controls to restrict currency dumping. Banning crypto would be an easy target.
In the meantime, I'm happy to hear crypto ideas, especially if they involve stocks of good businesses that operate in the sector, and trading at decent prices. If I like what I see then potentially I can share it with other readers.
I'm particularly interested in "picks and shovels" type listed companies that help to provide investor access to crypto. These include crypto fund managers, wholesale traders, brokers, venture capital investors and the like.
Personally, I'm not especially interested in crypto miners or companies that just own a load of crypto, when I can just buy it directly (unless, of course, they are trading at a substantial discount to their net asset values... and as long as management looks credible).
Crypto ETFs are potentially interesting too, for those that have access to them. (As far as I know, they aren't permitted via investment accounts held in the UK and EU.)
For those interested, and not suffering such restrictions (such as US-based investors), one potentially interesting ETF that owns bitcoin and ether is the Valkyrie Bitcoin and Ether Strategy ETF (NASDAQ:BTF).
The next section, which covers issues related to individual stocks, is for paid readers only...