Investing in the Age of Financial Repression
July 27, 2020

Authored by Beacon Pointe Advisors Chief Investment Officer, Michael G. Dow, CFA, CPA

 

“We know that advanced economies with stable governments that borrow in their own currency are capable of running up very high levels of debt without crisis.”
– Paul Krugman
*  *  *
“…financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.”
– Carmen Reinhart 

 

Clients are asking, “What are the long-term effects of all the debt issuance and money printing in response to the ‘Great Lockdown?’ What does it mean for investing?”

To be sure, the investment outlook remains quite uncertain. The massive fiscal and monetary response since March is unprecedented, but the macro results are not. When thinking about the future, we are not in completely uncharted territory. In this piece, we describe the current environment and what it means for investing. Our view? The government will support and implement policies collectively known as “financial repression” – the capping of nominal interest rates. In addition, a relaxation of strict policy rules will allow for higher inflation. The goal? To keep annual government debt service manageable and to “liquidate” the mountain of debt created in the aftermath of COVID-19 via negative real interest rates. The process will take time to reduce debt levels. In the meantime, we face a highly unusual investing environment, but not one without precedent. The implications for investment are already being priced into gold, the U.S. dollar, and inflation protection bonds, but it is still early days. But if we are right, the landscape will remain “repressed” for many years to come.

Before we can make predictions about the future, we must level set – that is, summarize and agree on the important features of the current environment. In the United States, the federal government has unleashed an unprecedented fiscal stimulus response designed to protect households and businesses from worst-case economic outcomes, by replacing incomes lost in the Great Lockdown.  The scope of the stimulus is breathtaking – even more measures will be forthcoming as the economic fallout evolves.

The quantity of federal government spending on income replacement is greater than current tax revenues – significant budget deficits are the result. A budget deficit requires debt issuance to plug the gap, and this additional borrowing adds to the national debt. Hence, the national debt will grow as a function of deficit spending (and debt service costs). Given the scope of the stimulus required to bridge the gap, the national debt is expected to grow at an alarming rate, to record levels of Debt/GDP.  As a result, government interest payments on the mountain of debt will become an increasingly burdensome line item in the federal budget, eventually crowding out other priorities such as healthcare, education and defense. This problem becomes acute if interest rates rise and the government’s funding costs increases as a result. This is the backdrop that motivates today’s piece.

Keeping debt service manageable and reducing the national debt will be top of mind at the U.S. Treasury Department (responsible for funding the budget deficit) and the Federal Reserve (responsible for a stable macro environment, and directly and indirectly, market interest rates). There are several ways to reduce the mountain of debt: growth, fiscal adjustment, default, inflation – and financial repression. Typically, a cocktail of these policy prescriptions is applied. We expect financial repression to take the starring role given our views on the other alternatives. If we are correct, certain monetary and macro-prudential policies will be implemented by policymakers and the outlook for investing and capital markets becomes a little less uncertain. Not certain, just less uncertain if history is any guide.  But first, how much debt is too much? What are the limits to debt capacity in the United States?

The Limits to Debt Capacity

It is an observable bond market fact that some governments can borrow substantial sums in international markets in their own currency to fund their budget deficits, and other countries find it more difficult to do so. Developed versus emerging economies is the general line of demarcation, using some measure of national income per resident. The World Bank uses per capita GNI [1] to make the distinction. For our purposes, it is enough to know that, generally speaking, developed countries can issue debt in local currency in size, and emerging markets have less capacity to do so. If you cannot issue in local currency and you need access to capital, foreign currency debt is your only option. As a result, a country compelled to issue in foreign currency will have constrained debt capacity – debt in foreign currency contributes to currency mismatches that increase vulnerability to external shocks. See the Latin American debt crisis of the early 1980s for the textbook example of the “original sin” of foreign currency debt issuance, as defined by Eichengreen and Hausmann in 1999.[2]

The so-called hard currency countries – the Eurozone, the United Kingdom, Switzerland, Japan, the United States – and a few others do not suffer from “original sin.” They are recognized as developed economies with stable governments and institutions and therefore do not face the same level of currency vulnerability as say Brazil or Turkey. Hard currency-countries can issue high levels of debt without facing a crisis. “High levels” is not defined – there is no generally acknowledged maximum sovereign debt load that any one country can maintain.  The limit is a function of a country’s specific credit risk and is determined by the market in real time. It is not static and fluctuates with circumstance.

Country credit risk is generally analyzed based on four major dimensions: economic data, financial factors, political factors, and liquidity. In practice, evaluating the government Debt/GDP ratio, budget deficit, potential GDP growth, private sector debt growth, interest burden, political stability measures, and current account are the primary tools of the sovereign credit analyst. Taken together these factors paint a picture of credit risk that, coupled with the more ephemeral confidence factor, ultimately determine the debt capacity of any country. Japan scores high on primarily institutional factors – stable government, monetary and fiscal institutions, rule of law, etc. Therefore, Japan can issue massive quantities of debt in Yen – in Japan the gross Debt/GDP ratio was almost 240% as of year-end 2019.[3] The Japanese case is extreme. In the United States, Debt/GDP was 109% as of December 2019. That was then.

Circumstances have changed radically since the end of 2019. The stimulus has created massive budget deficits and debt issuance. The U.S. Debt/GDP ratio is headed to 141% by year end and perhaps to 160% in coming years. We should be able to issue debt to cover the budget gap given our reserve currency status and very low sovereign credit risk. We have issued large amounts of debt in the past to fund budget deficits. An illustrative example is the period from 1941 to 1946 – budget deficits averaged greater than 15% of GDP. Debt/GDP grew rapidly during this period.

See Chart 1 below for U.S. Debt to GDP; the record level was 119% in the immediate aftermath of World War II. We are starting at a much higher level of debt as a result of the budget deficits incurred during the Great Recession (they averaged 8.3% from 2009 to 2012). We will easily exceed the prior record in 2020 when the budget deficit is expected to be over 18% of GDP.[4] It’s a two-peaked “debt mountain,” then and now.

The rest of this paper is the story of how the debt mountain created during the war years was reduced from 1946 to the early 1980s, and how we are likely to repeat that exercise in the years to come.

U.S. Debt to GDP
Is the Debt Mountain Really a Problem?

In a crisis the government should address the current economic situation with aggressive deficit spending today and worry about paying for it later – the debt mountain is not a current problem. While new debt increases debt servicing costs, the problem is contained with interest rates at historic lows. For countries that issue debt in local currency there is no theoretical reason to ever default – you can print more money to make the scheduled coupon and principal payments. The U.S. issues ALL its debt in local currency and owns the dollar printing press.

In practice, outright default rarely occurs in developed markets. That is not say that developed sovereign debt is risk free – investors care about the purchasing power of their investments as well as credit risk. Unexpected inflation erodes the real value of debt and is a very nuanced form of debt restructuring. More on this later.

Emerging market government, quasi-sovereign and corporate debt is a well-established bond market of about $10.6 trillion, most of it is denominated in foreign currency such as the U.S. dollar (USD).  Default occurs with some regularity in emerging markets, generally as a result of some financial imbalance that results in a currency crisis. Venezuela, Argentina, Lebanon and Ecuador are recent examples of countries experiencing debt problems due to their foreign currency debt. Again, typically not a problem for developed markets in general.

Debt and currency issues are even less of an issue in the United States given the USD’s status as the world’s reserve currency. Given the depth of transaction volume, rule of law, and other institutional safeguards, the U.S. is a very desirable place for foreign investors. We are the safe haven investment destination when risk aversion rises. Our solid monetary and fiscal framework reduce the likelihood of uncontrolled inflation or a balance of payments crisis – the U.S. is a low credit risk country. Furthermore, most global transactions are denominated in USD, requiring the sale of local currency (and the purchase of USD) on both sides of any transaction, even those not involving the U.S., creating additional demand for dollars. Greater debt capacity in the United States is the result.

Even with these built-in advantages, it would be a mistake to say our debt capacity is limitless. It is also a mistake to try and pinpoint exactly what that debt limit is. We will know we have reached it only when borrowing costs increase dramatically with a concurrent reduction in foreign demand for USD-denominated investments – including U.S. Treasury securities. There is an optimal non-zero level of debt, we do not know what it is, and it changes all the time. This uncertainty argues for remaining well below the perceived theoretical maximum Debt/GDP just in case things go south and the denominator (growth) falls precipitously, or a substantial increase in debt issuance (the numerator) is required. Just like now.

High debt levels limit a country’s ability to maneuver when faced with crisis – they have also historically been associated with periods of lower growth, reducing the capacity to service debt. The Bank for International Settlements suggest that “high levels of debt” means, on average, Debt/GDP of 85%.[5] The U.S. is currently at 109% and headed much higher – given this, it seems reasonable to consider possible negative implications for growth. If economic growth is impaired, risks to debt service increase all else equal.  Conclusion? We should attempt to reduce (or restructure) this mountain of debt, to promote higher levels of growth and reduce risk.

Reducing Government Debt Levels

There are several ways to reduce debt:

1) GROWTH: pay down debt through normal debt service. In the country example, this means increasing economic growth in order to increase tax revenues. Specifically, economic growth must be greater as a percent of GDP than nominal debt service cost. Consider: If the average cost of sovereign debt is more than your economic growth rate, and assuming Debt/GDP is > 100%, then you are adding to debt every year instead of reducing it all else equal. Growing your way out of debt is the best-case scenario for bondholders – it becomes more difficult to accomplish as debt levels grow.

2) ADJUSTMENT: fiscal adjustment, or a reduction in the primary budget deficit. This can be done by either raising taxes or reducing government expenditures, or a combination of the two. Neither policy is easily sold to the electorate, and hence elected officials will avoid running on a platform of fiscal adjustment. It may be the responsible thing to do, but no one gets elected by raising taxes or taking away government services.

3) DEFAULT: debt restructuring to obtain less onerous terms, or outright default on the debt, which has long-term reputational consequences in terms of limiting market access – not a good option if you want access to financing in the future. Argentina was shut out of international debt markets for fifteen years after its 2002 default. International investors have long memories, but not infinite – After regaining access in 2016, macro developments deteriorated, and Argentina is negotiating yet another debt restructuring as we write.[6] Outright default is the “nuclear option,” to be used when all other options have been exhausted.

4) INFLATION: attempt to inflate away the debt burden.  That is, allow the general price level to rise and pay down debt issued today with inflated dollars in the future. Because inflation does not require any painful fiscal adjustment it seems an attractive option. But does it really offer a way out of the debt crisis?  The answer is: yes and no. Inflation is a genie in a bottle – it is hard to control once let out. After embracing monetarist theory, the United States spent twenty years fighting a war on inflation, starting in October 1979 – this hard-won inflation fighting credibility is not something the Fed will abandon easily. The trick is to allow inflation to rise yet maintain control of inflation expectations, so they do not become embedded in decision-making, and reinforcing the upward trend in prices in a nefarious spiral. Hard to do.

And if markets are efficient, the inflation required to generate higher tax revenues will cause bond investors to demand greater compensation in the form of higher yields. All forms of borrowing including government debt will increase, at least in line with inflation and perhaps more so given the loss of credibility. All else equal, the increase in government debt service will wipe out any benefit derived from inflated revenues.

Clearly inflation alone does not offer an effective way out of a debt crisis. A complete answer would include a fifth response: while allowing inflation to run a little hot, figure out a way to keep a lid on nominal interest rates. This combination of policies will suffice to liquidate the debt burden. Policies that channel funds to government bonds, lowering nominal interest rates, are known as:

5) FINANCIAL REPRESSION. In practice, repression policies that cap rates, coupled with inflation, constitute a “subtle form of debt restructuring[7]  that allow governments to reduce their debt burden.

Financial repression is defined as “official policies that direct to government use…funds that would otherwise go to other borrowers, usually at below market rates.”[8]  These policies encourage the marginal additional purchase of government bonds, generally by the Fed. If Fed buying is insufficient to lower nominal rates to the desired level, governments will direct the commercial banking system to buy bonds through regulatory policy. The resulting lower interest rates can significantly reduce the cost of government debt service.

The History of Financial Repression in the U.S.

Financial repression is not unprecedented. The U.S. ran up huge debts to fund the war effort from 1941-1945 and debt service costs threatened to bust the budget. To address this problem, interest rates were capped during World War II (and beyond) through active collaboration between the U.S. Treasury Department and the Federal Reserve.[9] It is no stretch to say “…the Fed…fully ceded monetary policy to Treasury financing requirements during World War II.”[10] They fulfilled their commitment through open market purchases of U.S. Treasuries – these purchases resulted in a sizable expansion of the Fed’s balance sheet. Sound familiar? It was a form of Quantitative Easing before it was called QE.

Financial repression directly lowers debt service costs. But that is not the only benefit – it can be used to reduce the real value of debt when accompanied by a steady dose of inflation, producing negative interest rates. Generally, inflation needs to be just a little above an established target (2.0% under normal circumstances in the U.S.[11]), just as long as it is higher than nominal interest rates. Because inflation is not directly under the control of the Fed but is driven by other macro factors, sometimes you get much more than just a little inflation bump. Wars and inflation generally go hand and hand – the period from 1941 to 1953[12] was no exception. Inflation averaged nearly 6% during this period. For comparison, inflation averaged about -1% for the ten years before the conflicts, and +1% in the ten years after.

By capping nominal yields, inflation drove real interest rates well below zero. We suggest the observance of negative real interest rates is our best indicator that governments are implementing policies of financial repression. See Chart 2 below for the long-term series on U.S. Real Yields, from 1920 until the present.

U.S. Real Yields

Negative real interest rates “liquidate” the real value of government debt. That is, negative real rates reduce debt by transferring the real value from creditors (in the form of lost purchasing power) to borrowers (by allowing them to service the debt with inflated dollars). This debt liquidation is the equivalent of a tax on savers while providing significant benefit to borrowers – in this case, the benefits accrue to the government. For policy makers, the good news is the tax is not readily observable to the electorate, and hence much more palatable when compared to other politicized fiscal measures such as income tax increases or government service reductions – unpopular in the best of times. Financial repression is a “stealth” tax.[13]

Negative real rates can also be thought of in terms of a “revenue equivalent” for the government, calculated as the real (negative) interest rate times the stock of government debt outstanding. The magnitude of the revenue effect between 1945 and 1980 was often very large – Reinhart and Sbrancia estimate it to be 3-4% per year on average. Annual deficit reductions of this magnitude compound quickly, providing a substantial boost to government finances.[14] Negative real rates are great for borrowers, not so great for savers.

Note in Chart 1 above the steady decline in U.S Debt/GDP from 119% in 1946 to the low of 31% in the early 1980s. Compare that to the history of U.S. Real Yields in Chart 2.  In the thirty years following World War II, real rates were negative, on average,[15] corresponding directly to the period of greatest debt reduction. Good evidence that financial repression was the policy framework, and that it worked to reduce debt. Financial repression is not a fringe policy. It was the accepted method of debt liquidation in the post-WW II period, in the U.S. and much of the developed world. It remains the path of least resistance today.

Repression in the U.S. Today

We are deeply into negative real rate territory now. Policies now and in the future are expected to result in an extended period of negative real rates. Here is where we stand on nominal rate policies and the outlook for inflation:

The Federal Reserve controls short interest rates by setting the Federal Funds Target rate,[16] the Fed’s primary policy tool since the early 1980s. They dropped this benchmark rate to the so-called “Effective Lower Bound” or ELB (basically zero) on March 15, 2020, putting a lid on nominal rates at the short end of the yield curve.

Once the ELB is reached, other policy tools are required to achieve monetary objectives, including forward guidance and balance sheet policies. Forward guidance is the act of specifically communicating the Fed’s outlook for the economy and monetary policy and is used to reinforce objectives as implemented by rate and asset purchase decisions. Balance sheet policies include the purchase and sale of U.S. Treasury and mortgage backed securities to further inject or withdraw reserves in order to ease or tighten financial conditions. This is the well-known policy of QE.

By purchasing bills, notes and bonds, the Federal Reserve can theoretically set the rate on any security across the yield curve, from T-bills to long bonds. There is some nuance when discussing the “why” of the Fed’s actions. The stated purpose of securities purchases under Quantitative Easing is to inject money into the economy in order to ease financial conditions and expand economic activity. QE is not designed to fix yields at any pre-determined target level – just make them lower than they would be otherwise.  Targeting a specific yield in the intermediate or long end of the curve requires a new Fed policy.

We expect the Fed to announce such a policy, as early as the September FOMC meeting. It will have the wonderfully descriptive name of “Yield Curve Control (YCC).”  YCC is implemented in the same manner as QE – committing to purchase a sufficient quantity of intermediate or long-term bonds to achieve the policy objective. For YCC, that objective is to keep rates from rising above a target yield level. This will be increasingly necessary as the tsunami of U.S. Treasury issuance required to fund the deficit floods the market with new supply. Yield curve control directly creates Fed-driven demand to offset the expected supply/demand mismatch. This policy explicitly represses rates, keeping yields lower than otherwise in a truly competitive market. What about inflation?

The Fed has struggled to move inflation convincingly above their 2.0% target since the Great Recession. In fact, the Personal Consumption Expenditure Core Price Index (or Core PCE, the Fed’s preferred inflation measure) has averaged just 1.6% for the last ten years. An economic recovery will be required to boost prices above target in the near term. But over time, all the money injected into the economy during the COVID-19 mitigation efforts should eventually prove inflationary – in the meantime, the Fed is more worried about deflation than inflation.

The Fed is very worried about the effect that recent low inflation has had on expectations for inflation in the future. The Fed, therefore, will do whatever they can to keep inflation expectations from settling at current levels. The Fed targets a 2.0% Core PCE, not 1.0%, for a reason – it gives them sufficient space for prices to fall before we get to deflation, the bane of central bankers. Policymakers have many more tools to deal with inflation than deflation. Consider that the Effective Lower Bound in rates is a constraint on fighting deflation, and infinity is the limit to fight inflation.

The Fed has historically operated using a Phillips Curve model that describes the inverse relationship between the unemployment rate and wages – hence to inflation. When unemployment declines (and employment rises, causing a constrain in the labor market) then wages typically rise, feeding “wage-price” inflation. The Federal Reserve is specifically mandated to keep prices stable. They implement policy using a Taylor Rule-like reaction function: in effect, it says the Fed should raise rates if Core PCE reaches 2.0%. This level has historically acted as a kind of “trigger” to tighten policy. However, in the current environment, with the Fed more worried about inflation expectations moving lower than higher, many Fed-watchers believe it would be beneficial to allow inflation to run above target in order to reinforce the 2.0% level.

A new policy is required to make this adjustment to their reaction function. We believe that a policy to do just that will be announced as early as the September FOMC meeting: Average Inflation Targeting (AIT).  AIT is designed to retain the Fed’s inflation fighting credibility yet allow inflation to run above 2.0% by moving the reaction function from a “trigger” (when inflation hits 2.0%, the Fed raises rates) to an “average” (raise rates when average inflation is above 2.0% over a specified, or unspecified time horizon). In practice, given that Core PCE has averaged about 1.7% for the last 3 years, after adopting AIT the Fed would not need to tighten policy as PCE moved above 2.0% for some extended period. To achieve 2.0% average inflation over a six-year period (as an example), the math dictates that PCE average 2.3% for the next three years. We are at less than 1.0% today – a 2.3% average will likely require some pretty uncomfortable inflation prints. The policy is not uncontroversial – concerns about properly communicating the acceptable levels of inflation, the time period for averaging, etc. all may work to reduce the policy’s potential effectiveness.  But it seems clear to us that the Fed will announce AIT soon.

Nominal rates capped and inflation allowed to run above nominal rates. Negative real rates are the inevitable result of these policy adjustments. A summary of the of the Fed-directed financial repression policies that lead to debt liquidation are summarized in Chart 3 below:

Summary of Expected Policies of Financial Repression

All policies lead to a much closer connection between the government and the commercial banking system. The orange boxes above are Plan A – the first steps in the financial repression playbook. If the Fed cannot effectively cap interest rates through asset purchases, then the government moves to Plan B (the blue boxes above). Bank regulations or “macro-prudential policies” that encourage the purchase of U.S. Treasuries by commercial banks create a captive buyer base for government debt. The additional capacity of the commercial bank buying will support Fed purchases – regulations can be designed to increase demand/reduce rates to the desired level.

The Bank for International Settlements has promulgated several policies that encourage greater holdings of high-quality liquid assets (read: government bonds), collectively known as Basel III. The Basel III regulations promote safety and stability in the international banking system by increasing bank capital and liquidity in order to reduce the likelihood of taxpayer-funded bank bailouts. The BIS believes the best way to improve capital ratios is to substitute “safe” government debt for “risky” loans on the asset side of the balance sheet – the stability framework is tailor made for implementing financial repression. With the recent adoption of Basel III in the U.S., the necessary tools are already in place. The Fed can establish – and adjust – reserve requirements and liquidity coverage ratios that make increased government debt holdings a regulatory requirement.

To summarize: short rates at zero, Yield Curve Control arriving in September to cap rates further out on the curve, and Average Inflation Targeting to allow inflation to run higher than nominal rates. If needed, regulatory policies to create a captive domestic buyer base. Job done.

Investment Implications of Financial Repression

Understanding the framework of financial repression is an interesting intellectual exercise, but, at Beacon Pointe, our goal is to translate views on the macro-economy into prudent investment strategies. We believe the most important implications of debt liquidation strategies include:

Interest Rates and Inflation: Nominal interest rates will be lower for longer, and lower than they would otherwise be in a competitive market. Not controversial, as capped yields are the very definition of financial repression. The bad news: government bonds will not be the income-producing safe haven they were in the past. They will continue to provide some necessary ballast to portfolios in risk-off environments for two reasons: even though historically low, rates can go lower and even negative if demand is sufficient. And, with repression, a swift and dramatic rise in rates is possible but not likely, and so capital losses on bonds may be limited while these policies are in place. Opportunities in credit are more attractive with government yields historically low and are consistent with our “buy what the government is buying” theme to hold investment grade and select non-investment grade corporate credit. Better still: seek private investment vehicles that capture structural risk premiums – information asymmetries or liquidity – that are less than perfectly correlated to nominal public debt markets.

The key to debt liquidation is negative real interest rates – and that requires inflation. Our view is realized inflation will rise from very low levels, but only once the economy recovers. Inflation expectations are already moving higher – inflation protection is still cheap in some areas but getting more expensive. Select real estate investments can benefit in an inflationary environment, and inflation protected Treasury bonds (TIPs) are also a good idea in many portfolios. As inflation rises, the dollar depreciates, reinforcing the inflationary impulse via higher priced imports. We have had a good run of very low inflation – those days may be over.

Non-U.S. Dollar Assets: The U.S. dollar will likely continue to depreciate against our major trading partners given reduced interest rate differentials and increased inflation expectations in the U.S. As a result, financial assets denominated in currencies other than USD should do well. International equities purchased on an unhedged basis will benefit from a depreciating U.S. dollar. Non-U.S. stocks have underperformed for many years, making their valuations attractive versus the U.S. on a relative basis.

Stocks in the U.S. benefited from the significant reduction in corporate taxes legislated by the Tax Cut and Jobs Act of 2017. There is an election in November – fiscal policies can change if there is a new Administration and/or Congress. Any increase in U.S. corporate taxes will make international stocks more attractive on a relative basis.

International bonds, also unhedged, look slightly more appealing given our currency outlook, but yields remain uninspiring, and in many cases are negative.  Interest rates are likely to remain very low globally, reducing concerns related to capital losses.

Commodities and precious metals will broadly benefit. Industrial commodities such as aluminum, copper, zinc, iron ore and thermal coal have been on a tear, up almost 20% on average in the last three months. Commodities will continue to perform well as the dollar declines. Gold has already had a historic run, up 35% since the market bottom in March and validating the negative real yield environment. Silver is up a whopping 60% in the last three months with the dollar index down 6.1% over the same period. The search is on for a new reserve currency, and precious metals appear to be a pretty good option. This trend can persist. But we do not expect a credible substitute to the USD to appear in the intermediate term.

Conclusion

Reducing public deficits and debt will be at the forefront of the policy debate for many years to come. Governments have employed several different methods to achieve debt sustainability: growth, fiscal adjustment, default, inflation – and financial repression. Growth, the least intrusive outcome, will be difficult to achieve with very high public debt levels. The Fed, in collaboration with the U.S. Treasury, can implement policies that repress nominal rates. Allowing inflation to run above nominal interest rates, generating negative real rates, is also within their theoretical control. This is a proven debt liquidation strategy.

It is not the only option – in fact, some combination of the methods articulated above may be used to reduce debt. If some debt issued to mitigate the economic slowdown is spent on investment in addition to pure income replacement, then prospects for growth increase. Infrastructure and investment in human capital and the capital stock drives productivity, and hence growth. But the Fed and negative interest rates are likely to play the starring role in the effort to reduce debt.

Policies of financial repression best describe our outlook for the investment environment in coming years. Policymaker’s incentives are aligned – it is the least painful and most politically palatable of the available options. Negative real interest rates are the primary tool of debt liquidation.

Negative real rates produce investment winners and losers. Savers are likely to be unhappy about losing ground on a purchasing power basis. They are generally bad for traditional buyers of nominal bonds:  insurance companies and fixed income-heavy pension plans. In the winners’ category: gold and any country, company or household that issues debt/obtains a loan. Borrowers are particularly favored. Equities have benefited as the rate used to discount future earnings plummets to multi-century lows.  We expect to see differentiation within stock categories, as well. Banks tends to do poorly in low interest rate environments. Growth stocks do well when discounting earnings far into the future at lower rates. In some cases, valuations have adjusted to reflect these views.

We believe recent events have conspired to produce a secular change in the outlook for capital market returns. This change is best captured by our views on persistent, negative real yields – the hallmark of financial repression. For clients that have long relied on a traditional equity and fixed income portfolio comprised primarily of nominal bonds, caution is warranted. Looking farther afield will likely be rewarded: real assets and private investments that capture structural risk premiums will benefit if our views are correct.  Achieving your investment objectives in coming years will require embracing the challenges of investing in the age of financial repression.

 

For regular market flashes authored by Beacon Pointe’s CIO, follow @BeaconPointeCIO on Twitter.

 

Important Disclosure: This report is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions. Past performance is not a guarantee of future results.

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[1] Officially the World Bank classifies countries into four categories: low, lower-middle, upper-middle, and high using per capita Gross National Income, or GNI. In practice an emerging market generally falls into per capita GNI of less than $12,000.

[2] Barry Eichengreen & Ricardo Hausmann, “Exchange Rates and Financial Fragility,” 1999, NBER Working Papers 7418, National Bureau of Economic Research, Inc.

[3] “World Economic Outlook Update”, June 2020, International Monetary Fund

[4] Phill Swagel, Director of the Congressional Budget Office, CBO’s Current Projections of Output, Employment, and Interest Rates and a Preliminary Look at Federal Deficits for 2020 and 2021, April 24, 2020

[5] Stephen G Cecchetti, M S Mohanty and Fabrizio Zampoll, “The real effects of debt”, September 2011

[6] Argentina is now in its third default since 2000 and the ninth time in its history. It’s a “serial defaulter”.

[7] Carmen M. Reinhart and M. Belen Sbrancia, “The Liquidation of Government Debt”, NBER Working Paper No. 16893, March 2011, https://www.imf.org/external/np/seminars/eng/2011/res2/pdf/crbs.pdf

p6. “The term financial repression was introduced in the literature by the works of Edward Shaw (1973) and Ronald McKinnon (1973). …as we document in this paper, financial repression was also the norm for advanced economies during the post-World War II period and in varying degrees up through the 1980s.”

[8] Reinhart, Carmen M. and Kirkegaard, Jacob F. and Sbrancia, M. Belen, “Financial Repression Redux” (June 2011). Finance and Development, pp. 22-26, June 2011, Available at SSRN: https://ssrn.com/abstract=1864806  or https://www.imf.org/external/pubs/ft/fandd/2011/06/pdf/reinhart.pdf

[9] Specifically, the Federal Reserve set short-term rates at .375% and long-term rates at 2.50% by agreement with the U.S. Treasury.

[10] Carlson, Mark A. and Wheelock, David C., “Navigating Constraints: The Evolution of Federal Reserve Monetary Policy, 1935-59”, Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute Working Paper 205, October 2014

[11] The Fed did not follow an explicit or implicit inflation targeting regime at any time prior to 1994. From 1994 until 2012, the Fed’s policy coalesced around a 1.5% implicit target (from 2000-2007), moving to a 2.0% implicit inflation target (2008-2012) as an aid to achieving the Fed’s stable priced mandate. A 2.0% explicit inflation target became official on January 25, 2012.

[12] Encompassing World War II and the Korean War

[13] Reinhart, “Financial Repression Redux”, p.23

[14] Ibid., p26

[15] Ibid., p23

[16] The rate at which commercial banks borrow and lend their excess reserves.

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