Fall of the Empire?

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Financial news outlets have no lack of doomsayers. Whether it’s Reddit’s r/superstonk, where investors still talk about an (alleged) market manipulation in Gamestop, slightly more professional but unquestionably biased news sources such as ZeroHedge, or actual hedge fund managers such as Bill Burry (who, to quote someone on Twitter, “successfully predicted 14 of the last 2 crashes”) - someone always expects an imminent market crash.

For a long time, I paid little attention to those crash prophets. As my co-founder Markus likes to say, there’s always a reason not to invest: It’s exactly those looming yet undefined risks that justify long-term equity returns. But recently, I’ve started to think about adverse scenarios: After many years of slow yet economic growth, my home country of Germany is facing the most challenging environment in my lifetime - faced not only with long-term issues such as demographic change and bureaucracy, but also more recent challenges, such as a declining demand for our manufactured goods.

And at this point, I am not the only person to see those issues. Many friends wonder how our societies will continue to function, when many things clearly are not going well (perhaps one way to describe it is hypernormalization). And of course, for the affluent individuals that we work with, the future of Germany and Europe is an even more pressing issue: They wonder how they should address this potential decline to avoid losing the wealth that they have worked so hard to build.

So what scenarios of decline should we consider? And how might we protect ourselves against them?

Scenarios of Decline

Before we can think about what measures might be relevant, we need to discuss what we think this decline could look like. To me, three scenarios are relevant - an economic stagnation, an economic collapse, and some sort of political upheaval.

The economic stagnation is something that I would compare to what we have seen in Japan’s lost decades: After the collapse of the Japanese asset bubble in the 1990s, Japan grew significantly more slowly than the rest of the developed world, even seeing a period of deflation. Despite substantial measures by the Bank of Japan, Japan has so far been unable to return to growth in the conventional sense - going so far as losing its status as third-largest economy to (ironically) Germany amid the significant decline in the value of the yen.

Economic collapse would be a more drastic outcome. It looks a bit like what Argentina has been facing in recent years: Amid challenges such as significant government spending and a struggling economy, Argentina has seen its currency collapse and even defaulted on its government debt multiple times. As a result, assets denominated in Argentine pesos have seen a massive decline in value. (Perhaps Milei’s efforts will reverse this course - time will tell.)

Lastly, political upheaval. Scenarios that come to mind are what has happened in Russia since their attack on Ukraine, with the nation and its citizens being cut off from the Western financial system.  In this category, one could also categorize the fears of some of our clients about a wealth tax, or even confiscations of funds and assets (Enteignungen) in case of the success of a left-wing electoral victory.

So which scenario do I find likely?

If Germany doesn’t find a way to revitalize economic growth, a Japan-like scenario of economic stagnation seems increasingly likely to me. We are already struggling with substantial spend on pensions, and this spend will likely only go up. Given our strong Mittelstand, our economic base will not crumble away from one day to the other - but with no new sources of growth, we might find ourselves in a slow but steady decline. Over the (very)  long term, this might turn into an Argentina-like economic collapse.

Political upheaval, on the other hand, seems less likely to me, even in the (currently) unlikely event of an extremely left-wing government coming to power. For that, the German legal system just seems too unwieldy and powerless, especially against much-better qualified private law firms (see CumEx). What seems more likely is continued action against illegal tax evasion, or some sort of wealth tax.

But you likely don’t want to hear my personal projections - you want to hear how to protect your wealth.

Jurisdiction

Perhaps If I am worried that Germany is approaching its decline and fall, I should simply leave Germany - no longer finding myself exposed to high taxes, demographic challenges, and the theoretical threat of confiscations.

Of course, completely leaving a country is much harder to do than many YouTube videos and whitepapers make it seem. Individuals are subject to so-called exit taxes (Wegzugsbesteuerung), which see the departed jurisdiction levy taxes on all unrealized gains. They also come with tough requirements, i.e. no longer having a permanent residency in the departed country. So while they are creative structuring methods to reduce or avoid said exit tax, only few of the individuals that ask Tamara and I about departing Germany actually do it.

So perhaps it’s more straightforward to stay in Germany, but keep your money elsewhere. Once again, trusting those YouTube videos, perhaps we’d be inclined to set up a foundation in Liechtenstein or a holding company in Dubai. Yet once again, things are more challenging than those videos suggest: In this day and age, most Western nations have protected themselves from the most blatant forms of cross-jurisdictional tax optimization. At least from the taxation angle, such structures are not easy to maintain - one affluent individual we work with already decided to move his holding company out of Dubai.

So when clients ask us what we think actually makes sense, we typically recommend (from a certain asset size) to diversify your custody and jurisdictional exposure. That could indeed mean having your holding company in a jurisdiction the respective investor considers more stable, while perhaps operating it as if it was a German company (i.e. without any major tax optimization). In a more simple manner, it could also be choosing banking relationships in and outside your home country, i.e. neighboring countries such as Luxembourg or Switzerland.

Asset Classes

So you’ve made your jurisdictional optimization, and know where your assets should be custodied around the world. But what assets should you invest in to be decline-protected? 

A client recently sent us a video that drew parallels of the West’s current situation with the fall and decline of the Roman Empire. According to the investor interviewed, Rome declined because their currency was subject to currency debasement (i.e. lowering the intrinsic value of their coins by moving from gold to silver to even less valuable metals) - and that we in the West, driven also by substantial money printing, were subject to the same issue without knowing it. In other words: Slow but steady (hyper)inflation.

That we could understand - but not so much the suggested hedges: Crypto (as a non-regulated, scarce commodity) and technology stocks (due to their ability to scale at essentially no cost).

Starting with the latter, technology stocks. Here, we’d politely disagree: While their ability to scale at little to no cost is indeed a major advantage, it also comes with the challenge of much more rapid disruption (like AI) and a lack of physical, inflation-proof assets. Crypto is a more frequently mentioned example for an inflation hedge: It is indeed scarce (given its limited number) and ideally not centrally controlled. However, it clearly also has disadvantages, such as a lack of physical value, its traceability, and at least some dependence on regulatory recognition.

So with tech stocks and crypto as imperfect means of protection - what other assets come to mind? We’d generally look for assets that see direct or indirect positive benefit from inflation: In terms of direct benefit, there are inflation-indexed instruments such as inflation-linked bonds or infrastructure investments that have inflation adjustments built into their long-term revenue streams. We also think that hard assets are beneficial, i.e. those that can not be immediately replaced and/or have a stable replacement value even in hyperinflation, such as real estate or commodities.

Of course, none of them are a perfect solution. Real estate might be an inflation hedge, but still loses its value if they are based in a declining region or country. Gold has historically retained its value, but might be hard to access in a Swiss bank vault for a German investor based in Berlin in an emergency scenario. So we’d recommend to see it like the jurisdictional matter: Diversify across many such inflation-protected asset classes. Perhaps even by adding a bit of crypto.

Tactical Trades

So you’ve diversified your portfolio and feel protected in the case of an expected downturn. But what if you want to benefit? Perhaps there is a short- or long-term trade that would allow you to profit in such a scenario, seeing yourself make a trade like George Soros’ Sterling Trade? 

First, let’s take a look at the directional, tactical trade. To begin, you need to have an idea: A certain factor that you think will be positively or negatively influenced in one of our scenarios of decline. Secondly, you need to be able to actually trade on that scenario (i.e. no super-niche, illiquid instruments) Lastly, you need to be right: Not just in your timing, but also in the direction of your trade - more than once did I correctly forecast an event, but saw the market or instrument actually move in the other direction from how I had expected.

Attempting such a trade is easily done, and if anything, I’d advise investors to give it a try, if only to educate themselves in the wonderful world of financial markets. However, such trades should clearly be placed in the Aspirational Bucket - making up only a small amount of your portfolio that you can lose without endangering your long-term financial goals.

The alternative is so-called systematic hedging. Instead of trying to time an adverse event, you could position yourself to always be protected from that event. But systematic hedges come at a literal cost, as you might be paying for your protection for a long time until the hedged event actually takes place. You might be able to offset (some of) this cost by adjusting your risk budget: Since your downside should be (partially) protected, you might be willing to increase the risk you take, i.e. through leverage and/or a higher equity allocation. However, once again, be mindful that there is always the risk that like with a tactical trade, your strategy might not work out, or not cover every risk event.

So what makes more sense - tactical trading or systematic hedging?

In our view, investors should think hard about both of them. In most of our client relationships, we see substantial opportunity to de-risk portfolios while maintaining the required target return - often removing the need for additional hedges. Nevertheless, they remain an opportunity for a tactical trade - consider outsourcing it to an external manager, who likely will be better suited at analyzing and implementing such hedging strategies.

The same applies to hedges aimed specifically at the aforementioned ‘Decline’. But I want to leave with a word of advice here - going back to my initial paragraph: Don’t pay too much attention to crash prophets. While as citizens we really should be worried about how the West will deal with the aforementioned challenges, and should urge our representatives to act, we should not forget that things move on long timelines - and luckily, more often than not, end up being solved through action, time, or other factors. 

At best, investors lose out more often by being too pessimistic (i.e. being too cautious in their cash quotas or risk levels) rather than losing money to a Black Swan-like event. At worst, by reading too much into the articles of Zero Hedge or other ‘Doomer’ sources, some investors find themselves changed - from optimistic entrepreneurs to fearful individuals, scared of the prospect of losing their money rather than enjoying their life.

So follow our guidelines: Diversify where your bank accounts are based, diversify your assets, and if you’re bold, maybe put on a tactical trade or two - but don’t lose your optimism: We Germans love to complain, but often have made it work in the end. Hopefully, this time around, it will be the same.

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