Unconventional wisdom: The Trump threat that investors are ignoring
This week it is Greenland and next week it will be something else – long-term investors should look beyond the headlines.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: The Trump threat that investors are ignoring
“The Federal Reserve... is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up”
William McChesney Martin Jr. (fromer Federal Reserve Chair)
President Trump had regrets less than a year after nominating Jerome Powell for Federal Reserve Chair in 2017. Trump expressed his displeasure bilingually calling the interest rate increase in September 2018 ‘crazy’ and ‘loco’.
In 2019 Trump rhetorically asked if Jerome Powell or Chinese Premier Xi Jinping was the bigger enemy of the United States. Puts my performance review in perspective.
Back in the White House for his second term Trump stepped up the attacks calling Powell a ‘major loser.’ What many consider a politically motivated Department of Justice investigation is now looking at the renovation of the Federal Reserve headquarters.
Trump is not the first political leader to take issue with central bank policy. Treasurer Jim Chalmers was reportedly not pleased with Reserve Bank governor Michelle Bullock’s interest rate policy and characterisation of government spending as a contributor to inflation.
Long after Trump, this inherent conflict will persist between politicians focused on their short-term election prospects and central bankers with a mandate of balancing price stability and employment.
If Powell loses his battle to retain Federal Reserve independence the long-term results are predictable – higher inflation. To see an example of what happens when politicians control interest rate policy we can turn to the UK.
Prior to 1997 the Chancellor of the Exchequer was responsible for setting interest rates. During the 20th century prices increased 3.75 times faster in the UK than in the US and the Pound suffered falling from 4.85 USD to 1.30 USD over the century.
Other factors were certainly at play. But common sense illustrates the impacts of political control of interest rate policy.
If Trump succeeds in breaking the independence of the Federal Reserve there may be little political will to re-establish it no matter which party controls the levers of power in Washington. Broken institutions tend to stay broken.
The battle between Trump and Powell is not the only reason investors should be worried about higher inflation. But first a reminder of how inflation impacts your finances.
The oft ignored impact of inflation
The term millionaire gained prominence in the mid-19th century to describe the beneficiaries of a new era of wealth accumulation in an industrialising world. While still used as a marker of wealth, being a millionaire ain’t what it used to be.
The previous chart shows the purchasing power in 2026 US dollars of $1 million in the stipulated years. I’ve also shown the erosion of purchasing power in each period.
The impact of inflation has accelerated as we’ve progressively moved to more accommodative monetary policies – examples include the end of the gold standard and quantitative easing.
Of note is what has occurred in the six years since Covid. Central banks flooded the economy with liquidity to stem the impact of lockdowns. This was one Powell policy that gained Trump’s approval. Higher inflation followed.
There are many benefits from the evolving monetary approach including less severe economic shocks. However, as investors we can’t lose sight of how this is impacting our own finances. Investment returns are not the only thing that compounds – inflation does as well.
Market commentator Ashley Owen recently demonstrated the impact of inflation by showing that over a typical retirement period of 30 years, purchasing power is reduced by half even if inflation remains within the RBA targets of 2 to 3%. If inflation is 4% a year purchasing power is reduced by about 86%.
When contemplating the risk of inflation you may be picturing the Weimar Republic or some incompetent South American junta. But even slightly higher levels of inflation can meaningfully impact your finances over time. There are several reasons this scenario may occur.
Why we might be headed for higher inflation
The independence of central banks is one factor that impacts inflation levels. However, political leaders can do plenty on their own. The primary examples are fiscal policy which dictates spending levels and taxes and credit policy which regulates the actions of financial intermediaries like banks.
Trump – like any political leader – wants economic growth to accelerate. In his case it may not just be his desire for popularity and to help with the mid-term elections. He might also be trying to outrun the negative economic impacts of tariffs and the mounting US debt.
We will have to wait and see if Trump will get his way with lower interest rates. But on the fiscal front he extended his first term tax breaks and is boosting spending which raised US government debt to 38 trillion USD.
Trump is also rolling back banking regulations imposed after the global financial crisis. This will expand credit from regulated banks in conjunction with the economy being flooded with non-bank lending through private credit.
All of this – tariffs, tax-cuts, government spending, expansion of credit – is inflationary.
Many economists including AMP’s Shane Oliver think higher inflation in the US would lead to higher inflation in Australia. And there is a fear that Australia could follow suit by weakening the independence of the RBA.
Nick McKim the Treasury spokesman for the Greens has repeatedly called for political intervention to force the RBA to cut rates to help homeowners. In a country with heavily indebted homeowners it is not hard to imagine a scenario where populist anger grows if the RBA lifts rates.
The IMF recently called out Australia for persistent inflation in their most recent World Economic Outlook. The chart below shows Australian inflation has again exceeded the RBA’s targer range.
What should investors do?
I believe there is a compelling case that inflation will continue to be higher than the pre-Covid world. But even moderate inflation is something investors should keep front of mind.
The steps I’ve outlined below are not about making some dramatic bet with your portfolio. They are simply prudent reminders for all investors regardless of the degree of future inflation.
Focus on real and not nominal returns
The perception of safety has a cost. In a higher inflation world that cost is higher. Our financial assets are supposed to make our lives better. And holding cash or other defensive assets does provide benefits to your life like peace of mind. Just make sure you are informed about any trade-offs you make.
Virtually all the returns you come across are nominal returns which don’t include inflation. A nominal return of 5% can be good if there is no inflation or it can make you poorer if inflation is 6%. The context matters.
Think about the world in real – or inflation adjusted – terms. Don’t overcomplicate this and just form the habit of reducing any nominal returns you see by 3%. This quick mental trick is eye opening. I ran a screen on fixed interest ETFs from Vanguard and looked at nominal annual returns over the last five years.
It doesn’t take my trick of lowering nominal returns by 3% to see this isn’t a pretty picture. This is no reflection on Vanguard as these are passive ETFs tracking a variety of indexes in a poor environment for bonds.
Yet the fact remains that defensive assets like most bonds and cash do not do well on inflation adjusted returns. Between 1928 and 2021 10-year US treasury bonds have generated annual real returns of 1.8% per year. 3-month US treasury bills which are a proxy for cash had annual real returns of 0.30% a year.
They will likely do worse in higher inflation environments. Now that you’ve reoriented yourself to think of the investment universe in real return terms you can move onto the biggest decision you will make as an investor – the composition of your portfolio.
Focus on your risk capacity and not your risk tolerance
Investors are constantly told to think long-term while simultaneously being told risk is measured in terms of volatility. Volatility is only a risk over the short-term.
If I need cash from my investments tomorrow it is a big problem if the market drops. If I need cash in 10 years current volatility is irrelevant. The primary risk you face as a long-term investor is not earning a high enough real return to achieve your goals.
This argument is far from academic. Many investors are encouraged to put together portfolios by considering their risk tolerance. Investors are infrequently told to consider their risk capacity.
Your risk tolerance is how much volatility you think you can handle. This contrasts with your risk capacity which is the real return needed to achieve your goal. Figure out your risk capacity by calculating your real required rate of return to meet your goal and select an asset allocation accordingly.
This may be more volatility than you would be comfortable taking on in a vacuum. But knowing volatility is the price you pay for earning the return you need to achieve your goal will strengthen your resolve and reduce behavioural risk.
Ultimately it comes down to a simple question – would you rather be anxious at times and achieve your goal or have no chance of living the life you want?
Final thoughts
There is a scene in the movie Dead Poets Society where the character played by Robin Williams gathers his class next to pictures of previous students at their boarding school. He implores the students to listen to the whispers from their long-dead predecessors.
The message to the students is simple – stop getting caught up in the noise of day-to-day life and seize the day to make their lives extraordinary. Time can tick by without us noticing until it is too late.
As investors we often get caught up in the day-to-day noise as well. The drama at the US Federal Reserve has been replaced by Greenland. Next week it will be something else.
Many of these events cause volatility in markets which we’ve been conditioned to equate with risk.
All of this makes investing seem risky while the rhythm of life inures us to the erosion of purchasing power.
Reflexively you may feel the pull to get defensive. Yet there are also whispers for us investors...your dollars are worth less and less.
Don’t let complacency and a misperception of risk distract you from what is really imperiling your future.
Please share your thoughts on the inflation by emailing me at [email protected].
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What I’ve been eating
An Australia Day tribute features a very Aussie meal – a SCG souvlaki at the Ashes. It wasn’t particularly good, it definitely wasn’t cheap, and it only arrived in Australia in the 1950s. But souvlaki has become very Aussie.
The first mention of a souvlaki-like meal was in the Iliad and the name comes from the Greek word for skewer - “souvla.” A souvlaki should not be confused with a gyro where the meat is roasted on a vertical spit although both are served on pita with tzatziki, tomato, onion, and fries.
Traveling across the Aegean it becomes obvious that the Greeks and Turks eat very similar things despite historically not being big fans of each other. In Turkey a shish kebab is cooked on a skewer like a souvlaki and a doner kebab is cooked on a vertical spit like a gyro. You are now thoroughly prepared to have a few too many beers and go searching for something satisfying to eat.
