Sifting through financial information online is becoming quite onerous with so many opinions out there, so we've consolidated what we believe to be informative and insightful into one Market Commentary.
The middle of 2023 has seen a steady increase in asset valuations as interest rates have levelled off. With inflation still rearing its ugly head, and with employment data still showing surprisingly strong underlying numbers, it’s times like these when many people get tempted to predict what will happen next.
As always, I like to put instances into context with respect to a larger picture so that we can step out of the daily/weekly/monthly noise and focus on a broader, longer-term view.
Some context
To add some context to this commentary, please feel free to revisit the last Market Commentary from Spring 2023 here:
Throughout 2020 and 2021, governments and central banks shifted wealth from their grasps to their populations in the form of borrowing, benefits (think CERB), and monetary expansion – all to help stimulate a scuffling economy inflicted with stagnation from the Covid-19 pandemic and subsequent supply chain disruptions.
Throughout this time, populations saved and saved, and shuffled those savings into assets (bank accounts, real estate, stock investments, and more).
For central banks, now devoid of wealth and burdened with higher borrowing costs, the balance needs to be shifted back to some degree…
Financial Repression to control debt burden
Financial repression is a nuanced strategy employed by governments and central banks to manage their financial affairs.
Financial repression involves a set of economic policies and maneuvers orchestrated by governments to bolster their fiscal positions, often at the expense of savers and investors. This financial wizardry encompasses a range of tactics, including interest rate manipulation, capital controls, and the strategic promotion of government debt.
These seemingly innocuous policies are the building blocks of financial repression, and they hold significant ramifications for the average citizen.
A real-world example of Financial Repression for illustrative purposes
To illustrate Financial Repression with more simplicity, we’ll use a fictional individual character called Lear, who is both powerful and irresponsible.
Lear has high aspirations of how he thinks he should live his life, and this elevated lifestyle is quite costly. Lear doesn’t earn nearly as much as he would like to spend, so when his spending is superseded by his earnings, he needs to borrow from lenders.
At the end of the term when his loan comes due, he does not have enough to repay it, so he simply borrows a new larger amount from another lender (enough to repay the old lender with some more to maintain lifestyle) in order to pay off the original lender, and he continues to spend freely.
Short-sighted (both literally and by nature), Lear views this mechanism as an amazing idea, and so he keeps living the high life, higher and higher. And it keeps working! Although his debt liability becomes larger and larger.
Lear does, however, need to make interest payments, but due to the royal power he wields, he can influence the interest rate on his debts to ensure they are manageable, which allows him to continue borrowing and spending.
The cycle continues; borrowing more and more to both pay off the previous loan, with some added capital to continue increasing lifestyle.
Once the debt reaches a certain point, no creditor will lend Lear any more money at these low interest rates, so he needs to start sourcing new loans at higher rates.
The higher interest rates from these other lenders start to make the burden of debt-servicing more difficult. Lear has a massive amount of debt, and the amount he needs to pay each month just to make his minimum interest payments is starting to become unmanageable.
Lear, realizing his great royal power once again, goes into his basement and begins to print money in order to get a handle on things.
Lear’s creditors are happy about this, as they begin to receive payments on time and in full!
But what Lear doesn’t realize (or perhaps this was his plan all along), is that his newly printed money has made its way into the economy. There are now more dollars competing for the same amount of goods and services, which bid up the prices of those goods and services (assuming the amount/supply of goods and services has remained constant).
Lear’s rapid pace of borrowing and money-printing (more dollars in the economy) have caused prices to go up overall going forward.
When Lear was spending money on goods and services, it was at one price point… but now the prices have increased! When Lear’s lenders are paid back with his printed money, the cost of these same goods and services is higher than it was when they lent it to him.
These lenders (newly repaid with printed money that is being newly put into the economy) now use the money to buy the same goods and services but at a higher cost! What has happened here?
The money they lent was worth way more when they lent it than when they received it back!
This phenomenon creates a literal asset wealth transfer from the lenders to Lear! – who perhaps may not be as reckless and irresponsible as we might have originally thought.
Let’s use this same notion but with governments and central banks
The government has a tough time spending what it earns through tax revenues, so it borrows money.
When the debt comes due, it borrows from elsewhere to pay off the original loan, and more to continue to spend.
A government can create an infinite amount of programs, employ a seemingly infinite amount of people, create an infinite amount of bureaucracies, and can create an infinite amount of black holes to pour trillions of dollars into. There is no limit to a government’s spending.
All modern economies are based on growth; economies need to grow.
There are limitations on debts if there is no money available to be lent, so if governments want to continue to spend, they need to source alternative loans. An example of this occurred in the USA in 2019 when short-term loans between financial institutions increased sharply overnight. This sparked emergency intervention from the US Federal Reserve, which then immediately injected $75B of liquidity into the short-term loan markets. The cause of the spike was a temporary shortage of cash available in the financial system.
When a government gets to this point, they have some available options to them. I wrote about this over 3 years ago in an article titled “National Debt Explained” on July 3rd 2020, which you can access here:
I also briefly touched on this notion in our last market perspective, which you can access here:
When interest rates rise and a government owes a lot in debt, then the amount of money needed to service the interest on that debt (to pay the higher interest rates) goes up.
If the government can print their own currency, then they can use the newly printed money to service and repay the debt. Printed money is still considered a “loan” from a central bank, but it doesn’t necessarily need to be paid back since any interest paid to the central bank is swept back to the government as profits, making the printing process an interest-free endeavour.
And so… The extra money created in the economy puts upward pressure on prices.
Interest rates (bond yields), although higher than they were, are not as high, on average, as the percentage increase on goods and services (inflation).
This means that those who previously loaned money to the government (bondholders) are being repaid with dollars that are worth less than when they loaned them.
And who are these bondholders?
Most policies for pension funds and endowment funds have a mandate to hold a minimum percentage of their investment assets in government bonds. Most interest rates on GIC’s and savings accounts (although higher than they were previously) are lower than the average rate of inflation.
You/we may have the freedom to allocate your personal portfolio in a manner that helps to escape this notion of Financial Repression, but your pension or endowment fund likely cannot.
This is how the transfer of wealth (over time) moves from the individual to the state through an attempt at holding interest rates at less than the rate of inflation for a prolonged period of time; a notion called Financial Repression.
Some notes on Interest Rates
Central banks have a mighty tool in their arsenal—the power to set interest rates. In the realm of financial repression, this power is wielded to keep interest rates low, often below the rate of inflation. The immediate effect might seem beneficial—cheap loans, increased borrowing, and a shot in the arm for economic activity. But beneath the surface, it imposes a silent tax on savers, who see the real value of their money erode as they earn minimal returns on their deposits and fixed-income investments.
Some notes on Capital Controls
Governments can also resort to capital controls, effectively locking capital within their borders. These regulations limit the ability of individuals and businesses to diversify their investments and protect their wealth from unfavorable economic conditions abroad.
While they seemingly serve to protect domestic interests, capital controls can curtail the freedom of investors to make informed choices about their money.
Some notes on Forced Investment in Government Debt
A classic tactic of financial repression is the "nudge" toward government debt. Financial institutions, such as banks and pension funds, may be encouraged or coerced into allocating a significant portion of their assets into government bonds. While this can provide a steady stream of funding for governments, it diverts capital away from private sector investments.
Investing in this environment:
In the shorter-term, changes in public perception invoke changes to public market values (seconds, minutes, days, weeks, months). It’s important to detract from the short-term noise when determining the value of your investment into a business, a debt instrument, or any other productive asset. The current value of your asset (the market value) may fluctuate from time to time, but as long as you are not buying or selling that asset, the current market value is not relevant to you.
Now, more than ever, owning quality businesses (quality of cash flow and earnings, good competitor advantages, prudent internal decision-making processes, reduced sensitivity to interest rates, longevity of management, insider ownership, etc) versus speculating on the next great thing (cryptocurrency, psilocybin, metaverse, AI, etc) should help to reduce both your systematic risk (volatility) and non-systematic risk (the risk of something being inherently wrong with what you own).
Owning quality debt instruments (credit quality, risk versus yield, longevity/duration, etc) should assist in reducing volatility and diversify your portfolio further.
In addition, a continued investment into alternative asset classes (infrastructure, real assets, real estate, private companies, private income strategies, etc) will further help to manage risk in order to adequately round out a portfolio.
Your portfolio
Of course, I try my absolute best to ensure my human outlook does not spill into your investment strategy.
As a strategic asset allocator (decisions made based on past outcomes) versus a tactical asset allocator (decisions made based on future outlook), my belief is that future short-term outcomes are not yet known, and that past outcomes are a matter of fact.
Based on this framework, we make systematic determinations for portfolio shifts every quarter. The end result of these determinations was to reduce your overall equity/stock holdings in July of 2021, then increase them in July of 2022, and then reduce them again in July of 2023. Note that no change was determined for the quarter ending October 15th, 2023.
A graphical representation of what I describe above, contrasted against the S&P 500 index (just one of several market factors) over the past 3+ years, can be found below, whereby green dots represent a shift into equity, and red dots represent a shift out.
From a historical perspective, you may find that this strategy has yielded results that had your portfolio overperform in 2020, underperform in 2021 (shifting out as stocks went up), and overperform in 2022 (despite the down year).
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We continue to monitor any potential new holdings on an almost daily basis, and continue to evaluate your existing holdings to determine if the reasons we bought them in the first place remain true today.
I hope you find this both interesting and informative in keeping pace with the events of today’s financial world.
If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out.
We are available and accessible to you any time through email, phone, and video.
Be well and be safe,
Adam
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