Edition 10

This is the 10th BLOG since the pandemic.This is not an attempt to forecast future events which are unknowable nor is it a recommendation to purchase a security or make an investment.

We have always found, where a government has mortgaged all its revenues, that it necessarily sinks into a state of languor, inactivity, and impotence.

Of Public Credit by David Hume, 1752

This statement made by the Economist David Hume in his paper ‘Of Public Credit in 1752, perhaps the most influential thinker of the enlightenment according to Adam Smith regarded by many classic economists as the Father of economics, accurately describes where we are today with central banks monetary policy which they have been enacting since the financial crash of 2008.

The effect of a negative yield

The 10 year Treasury Bond is the global benchmark for credit and the security that central banks pay attention to. The US Dollar is the world’s reserve currency. US Dollars account for 72% of Global trade, 97% of oil transactions and the US Treasury Market is the deepest most liquid global market by far. All other sovereign bonds are priced off the US 10 year. With a nominal yield of +0.50bps and with the decline in purchasing power of the USD of 1.5% pa, the real yield of the bond is negative -1.0%. If held to maturity investors are guaranteed to lose capital. The sceptics refer to this as ‘Return Free Risk’ as opposed to ‘Risk Free Return’ which is how bonds were traditionally described when giving a positive real yield. This is the current dilemma facing risk averse investors

In the Japanese economy and now in Europe nominal yields are negative and real yields adjusted for a decline in purchasing power negative. UK Gilts also for the last two years have given a negative real yield.

Consequences of Central Banks increasing reserves

However, with economic productivity flat and Central Banks unable to stimulate consumer spending the only tool they have left is to keep increasing their reserves. Chairman Powel of the FED recently said as much and like Mario Dragie the ex Chair of the ECB before him ‘would do whatever it takes to stimulate growth’. Central Banks including the FED are now politicised so nothing is ‘off the table’. Interest rates and sovereign yields could still go lower. The zero interest rate band in the US currently between 0 – 0.25 Bps is not a policy target and could follow Europe and Japan and go negative. The Bond Gurus, all smart people, have been consistently wrong over the past 5 years calling for inflation and higher bond yields with the US 10 year yield to go to 3% – 4%.

At positive 0.70bps on the US 10 year and positive 1.4% on the 30 year, a further decline to zero or negative would give a capital appreciation of around +20% on the 30 US 30 year Treasury and in Europe if the current negative nominal and real yields on German Bunds drift lower investors will receive a capital appreciation.

Inflation, Deflation or Stagflation?

For this to be likely the economic outlook for the near term needs to be mild deflation. We believe that the risk of mild deflation is greater than that of inflation in the near term nevertheless the rising excessive indebtedness is in the longer term inflationary. 

Mild deflation in the near term is principally predicted on the fact that despite the trillions pumped into the financial system during the last 11 years we have not had an increase in inflation. Interest rates may go lower or will remain low for longer than we would want. In mild deflation bond holders also receive an increase in their real purchasing power as prices decline. The value of debt increases and the purchasing power of cash increases, wages fall. 

Technology, demographics, the gigantic over indebtedness gave rise before the pandemic to falling productivity, flat velocity of money (the number of times a paper currency note changes hands in a given time period) and little growth. The commercial application of technology is deflationary. The average earnings growth of the S&P 500 Index without the top five giant technology companies during the last 5 years was zero!

The liquidity pumped into the financial system did not stimulate retail consumer inflation but gave rise to asset price inflation as witnessed by the all time high US stock market.

In our strategy we hold treasuries and physical gold as a hedge against risk assets. Treasuries as the safest paper in a financial world of excessive leverage and overindebtedness and Gold as the only asset that is not someone else’s liability. We prefer long duration to take advantage of capital appreciation in a mildly deflationary economic environment which we believe we will experience in 2021. The effects of ‘an output gap’ (the amount of redundant resources in labour and capital) coupled with increased insolvencies, credit default and increasing unemployment will produce a decline in demand.

The average savings rate for the US consumer since the 1900’s is 8% pa. Prior to the pandemic the savings rate was 2.3%. It is now 32%. The private sector is beginning to deleverage which is a further headwind to consumer spending. 

The US and Global economy before the pandemic was weak and over indebted . The economic ‘Fisher’ Law of diminishing returns has now kicked in. The money multiplier is negative. Every Dollar issued results in less than a dollar of production. In terms of economic growth more actually means less!

With the declared intention of Central banks to keep interest rates artificially low (a stealth tax on savers) as long as the Fed and Central Banks increase their reserves and try to create consumer demand and inflation by making capital available asset prices will keep rising, unless a sharp shock nerves investors confidence . As long as the Fed continues to buy ‘junk’ debt with a high risk of default, corporations will keep leveraging their balance sheets. Any pretension of avoiding moral hazard, the rallying cry of government regulators post the financial crisis, has long been forgotten. 

The largest participants in the tradable securities market pension and life assurance companies must achieve a 7% net return on capital to fund their current liabilities. Negative yielding bonds forces them to leverage capital and purchase risk assets. 

Our investment strategy does not attempt to time the market but is fully invested with an emphasis on owning businesses diversified globally and hedged against interest rate, market and economic risk.

Central Banks are obsessed with inflation. Prior to the US abandoning the Gold standard in 1971 there was no inflationary pressure on the US Dollar nor on Sterling before the UK left the Gold standard in 1931.

Central Banks are fearful of deflation as governments have still to work out how to raise tax revenue on falling prices and wages. With government deficits rising and unfunded liabilities at record levels, no doubt they will think of something!

Of Public Credit by David Hume, 1792
The Wealth of Nations by Adam Smith, 1776
Financial Times