What financial repression means to your investment portfolio
There has been a lot of talk in the media of late about financial repression. This newsletter article is designed to explore what financial repression is, what it means for your portfolio, and what you can do to mitigate its ill effects.
What Financial Repression is
A recent article by Carmen Reinhart of This Time is Different: Eight Centuries of Financial Folly fame does an excellent job of outlining what financial repression is and how common it has been. Let me quote from that article and make a few observations first.
As they have before in the aftermath of financial crises or wars, governments and central banks are increasingly resorting to a form of “taxation” that helps liquidate the huge overhang of public and private debt and eases the burden of servicing that debt.
Such policies, known as financial repression, usually involve a strong connection between the government, the central bank and the financial sector. In the U.S., as in Europe, at present, this means consistent negative real interest rates (yielding less than the rate of inflation) that are equivalent to a tax on bondholders and, more generally, savers.
In the past, other measures also included directed lending to the government by captive domestic entities (such as pension funds or banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter coordination between governments and banks, either explicitly through public ownership of some institutions or through heavy “moral suasion” by officials.
Central banks in both developed and developing countries are being subjected to complementary pressures. Emerging markets may increasingly look to financial regulatory measures to keep international capital “out” (especially given the expansive monetary policy stance pursued by the U.S. and Europe). Meanwhile, advanced economies have incentives to keep capital “in” and create a domestic captive audience to absorb the financing for the high existing levels of public debt.
I am not concerned about the inflationary impact of repression yet because inflation will only be the result of full employment and economic growth and we are a long way from there. The inflation we are getting now, commodity price inflation, is cyclical in nature because it creates demand destruction. Until it feeds through into wage gains, there is nowhere for this inflation to go except killing consumer demand and creating recession. My concerns are about the distortions to the economy that easy money creates in misallocating resources and leading to growth under-performance. If this post doesn’t get too long, I will explain some of this below. But first let’s get to why now that we know the what of financial repression.
Why governments resort to financial repression
The key here is to understand what has happened and why governments are artificially suppressing interest rates. We have witnessed a debt supercycle during which private sector debt accumulation has gathered pace for the last sixty years. The blow-off or Ponzi phase of the supercycle has just come to an end with interest rates reaching their nadir and now offering no hope of policy support to continue robust credit growth. In short, we have reached a dead end in terms of reflating economic growth via credit accumulation that is jump started by lower interest rates.
As an aside, when people talk of ‘liquidity traps’, this is what they are referring to. I tend to downplay the liquidity trap arguments because I am more focused on the demand for credit. This balance sheet recession is not really about liquidity traps and and the zero bound for interest rates. It’s about over-indebted private sectors that have limited increased demand for credit.
Moreover, the debt distress in the financial sector itself was so acute because of the prospect of huge loan losses without government intervention that governments around the world socialised a massive portion of the losses themselves, effectively taking the debt onto their own balance sheet and transferring private risk to the public writ large. So what was a case of high private sector indebtedness has become a case of high private and public sector indebtedness. In April of 2010, I argued that the origins of the next crisis were going to be an attempt to deleverage in both sectors simultaneously across a wide swathe of developed economies, something that is mathematically impossible to do without huge amounts of economic growth.
So, paying down debts via accumulated savings only is out. That leaves a combination of inflation and default as other means to reduce the debt burdens. What governments are then forced to do is repress the interest rates private investors receive so that the rate of economic growth and inflation can eat away at the debt loads. This is true as much for the effect on private as it is on public debt.
How governments repress interest rates
Reinhart talks a bit about developed economies trying to "create a domestic captive audience to absorb the financing for the high existing levels of public debt." I think this is where she goes off the rails a bit. First, the problem from the start was private debt, not public debt. The public debt has only exacerbated the problem. This fixation on public debt is totally unwarranted and is exactly what has led the euro zone down the blind alley of crushing austerity programs and debt deflationary spirals.
Second, governments don’t really need to create captive audiences for their money. This is a theme in bond vigilante crowds which belies every bit of financial history we have witnessed regarding sovereign debtors with fiat currencies. Everywhere, in the US, in the UK, in Japan, despite the swelling debt levels, investors have been falling all over themselves to invest in these countries’ sovereign debt. For example, If the US private sector is indebted and is trying to increase savings, there is automatically a greater domestic bid for US treasury securities. It simply ignores the financial sector balances to assume that this public debt can only be maintained via creating artificial demand.
Here’s what really happens. The government, as monopoly issuer of its own currency, has given the central bank monopoly power in the market for base money. The central bank exercises this monopoly power by targeting the overnight rate for money, the policy rate called the fed funds rate in the US. Modern central banks use a price rule in targeting interest rate, not a quantity rule as in targeting reserves or monetary aggregates. Any monopolist can only control either price or quantity, not both. And central banks want to target rates i.e. price. They can’t do that unless they supply banks with all the reserves the banks desire to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target.
Long-term interest rates are a series of future short-term rates. Since central banks are monopolists for base money and the link between the target rates they set with their monopoly power and longer-term interest rates are expected future policy rates, the principal way that central banks control long-term interest rates is through changing expectations of those future policy rates. So, if the economy is weak and expected to be weak for a long time to come, a central bank will telegraph its desire to keep interest rates low as a way of lowering the interest rate to help increase credit growth and reduce the real burden on borrowers. That’s why you have heard the Fed saying it will keep rates at essentially zero percent through late 2014. They are manipulating expectations of future policy rates to suppress yields.
The distortions of financial repression
Now imagine you are a second-tier competitor in the auto industry like General Motors. Your cost structure is too high and so your profitability is too low. And for the sake of arguments, let’s say you also have too much debt. In GM’s case, they reduced a lot of the debt via bankruptcy but here I’m assuming the debt is still there. Wouldn’t you like it if interest rates were low? You could borrow for less, and if you could maintain consumer financing of your vehicles at high rates of interest, you could get a nice interest spread just like banks do when interest rates are low. Meanwhile, your first-tier competitor gets a bit of the stick because, while they get helped too, the fact that you are still in business lowers their return on capital. Customers (and profits) that legitimately should go to them are now going to you because you live and die by the artificially low rate of interest. If the market set the rate, you would be bankrupted and all the gains would go to your first-tier competitor.
The issue here is separating liquidity and solvency. In a systemic crisis, the illiquid can be rendered insolvent. And so, it makes sense that government intervenes in some respect since panics lead to artificially high rates. But whatever happened to liquidity against good collateral at a penalty rate? The goal is not to prop up unsound enterprises artificially but to prevent sound ones from failing unnecessarily. What does happen, however, is that easy money introduces a distortion whereby weaker competitors are handed a lifeline and their inefficiency and weakness is rewarded, making the economy as a whole less efficient, lowering economic growth and competitiveness. This is exactly what artificially low exchange rates do as well, since they are often also the outgrowth of artificially low rates. Weaker companies are shielded from foreign competition and get a leg up that they don’t deserve. It is as if they had been rewarded for being inefficient.
What we should anticipate is that a company like GM may not actually be a strong competitor across the business cycle. When the business cycle turns down again, we will see differential abilities to withstand the downturn. And the weakest ones will not necessarily have used the policy bailout to improve their competitiveness. So financial repression distorts the shape of the economy by misallocating capital, pouring on an over-abundance of capital into marginal enterprises and more capital intensive industries. This distortion ends in economic under-performance and credit writedowns when the distortion is discovered at the nadir of the business cycle, just as we have witnessed during the twin technology and housing bubbles.
What financial repression means for portfolios
In general, financial repression means under-performance. By definition, you are getting less than inflation as a bond investor. It’s as if Ben Bernanke reached into your pocket and stole from you. I know some people argue that bondholders are rent seekers and are not guaranteed a return on their investment. But, of course pension funds are huge bond investors. Tell your grandmother she’s a rent-seeker!
More than that, as I just recounted, if real returns remain low, it will skew capital investment. Initially, portfolio preferences shift toward risk as risk seeks return due to the low to negative real yields and because the easy money seems to reward riskier enterprises. But when recession hits, debtors backing these investments will be caught out and forced to delever aggressively as resource misallocation becomes evident. That’s the result of bad economic policy. And it means a secular bear market in stocks from lower earnings growth and lower P/Es, not just lower returns in bonds.
Here are the strategies investors employ to deal with all of this:
Leverage up: Ben Bernanke has made it clear that the Fed will not raise rates until well into 2013. This is good news for those doing the carry trade because Bernanke is telling you now is the time to leverage up because the carry trade is risk free. This is a major reason Treasuries are well bid. With leverage, you make a nice return there. Caveat Emptor!
Move abroad: I said last year that inflation is rising across the emerging markets and a number of markets have building external imbalances. Sure enough, people who tried this strategy in 2011 got crushed because emerging markets were hit hard.
Move out on the risk curve: You could load up on high yield right now. Defaults have been low and you get an extra few hundred points of pickup. Bond managers like Jeffrey Gundlach are cautious on high yield though. Bonds issued in 2009 or 2010 were of dubious quality. Gundlach sees defaults coming in the next year or two. Again, no free lunch.
Move into riskier asset classes: That means overweighting equities or farmland or precious metals or commodities. Now, a lot of the total return from bonds over the past two decades came from the decline in interest rates. Bond guru Bill Gross now has an equity fund going. He’s saying the bond bull market is over. And that makes sense since interest rates are zero percent. So moving into equities is one way to get greater return. However, this means greater risk too. And I think the risk is unwarranted. Equities are still in a secular bear market in my view and these other asset classes are well bid. Leading up to and during the next recession, they will get hit.
My thinking: Avoid risk, get greater fixed income return from dividend paying stocks, high grade corporates and foreign sovereigns, and take out black swan protection. This is a cyclical bull market within a larger bear market. Obviously you want to make gains. But the first rule in bear markets is to avoid losses and the best way to avoid losses is to reduce risk. That means lower beta, lower risk asset classes, less leverage. Moreover, you can still get a high return by reweighting your equities into higher dividend, lower beta stocks. This caps your upside but does lower your downside too. That’s what you want. I would caution against going overweight munis though because bad things will happen there. More importantly, we are living in a world of unknown unknowns. You need downside protection via hedging strategies or covered puts.
Bottom line: There is still some upside left to this cyclical bull but I think the macro outlook is weak and therefore, caution is warranted. The secular bear will re-assert itself soon.
That’s it for this week.