Why are central banks treating savers with such contempt? There are two answers to this question. The first is that they are more concerned with keeping their banking systems afloat.
The primary objective of any central bank, our own included, is to maintain the stability of the financial system. They may have failed catastrophically to do that since the crisis began, but nevertheless we are where we are.
The second is that they have become lenders of last resort to their own governments. All roads ultimately lead back to the terrifying issuance of government debt throughout the western economies. How is all that government debt going to be funded? The answer, whether we like it or not, is that governments and central banks will effectively force us to buy.
The Bank of England and the US Federal Reserve are debasing their money like crazy â and theyâre doing everything by the book. If youâre interested in knowing which book, the answer is The Liquidation of Government Debt, a research piece by Carmen Reinhart and M Belen Sbrancia.
Western governments have issued more debt over the last 40 years than they will ever be able to repay. That leaves three options. One is to formally default on that debt and repudiate it. You can call that option ‘Armageddon’.
The second is to force austerity on the entirety of the economy, slowly rein in the issuance of further debt, and endure a long and painful depression as national debts and deficits are slowly reduced. You can call that option ‘Greece’, at least for the moment, until it implodes.
The third option is to inflate it away and to coerce investors to buy it through financial repression.
You can call that option ‘where we are now’.
Ms Reinhart describes the various forms of financial repression as follows:
â˘Â Directed lending to government by captive domestic audiences, such as pension funds;
â˘Â Explicit or implicit caps on interest rates;
â˘Â Regulation of cross-border capital movements;
â˘Â A tighter connection between government and banks.
The government has already orchestrated the first and the fourth mechanisms. Under âcaptive domestic audiencesâ you can include the banks, given that the likes of RBS and Lloyds are already largely under the control of the state.
That brings us to the second mechanism â implicit caps on interest rates. With cash in the bank yielding next to nothing, and the central bank pledging to keep base rates at current levels for the next three years, suddenly parking money in ‘riskless’ government bonds yielding just a smidgeon more doesnât seem like such a bad deal, does it?
The third mechanism â the reintroduction of capital controls â is one that I have been concerned about for some time. Itâs the logical next step in the financial repression playbook. But given the success of the other mechanisms to date, perhaps the authorities never need resort to it.
CLSA analyst Russell Napier wrote a report last year entitled Darkness on the Edge of Town. He pointed that out last summer:
â…a terrible burden fell upon the people of the USA. For the first time in 15 years, those who had money (savers) began to fund their government, rather than the printers of money (central banks).â
In other words, in the summer of 2011, the US government was no longer able to sell its new debt to foreign central banks. It was reliant upon domestic investors to get its debt away.
The next point is crucial in understanding what may drive financial markets over the coming decade. Central banks can simply print money to buy government bonds issued by other sovereign borrowers. Since they control the printing press, they can be almost completely price-insensitive to what those government bonds yield, and how they perform.
But the private sector is different. The private sector cares about the return it makes on its investments and savings. Secondly, the private sector cannot just conjure money out of thin air. To buy government bonds, the private sector needs first to raise money by selling something else. That âsomething elseâ is likely to be common stocks.
There is now over $10 trillion in marketable US government debt. Notwithstanding the huge number of Treasury securities in issuance, the average yield across all the different maturities of that debt is just 0.9%. No surprise that foreign central banks (including the most important, the Peopleâs Bank of China) have lost their appetite for the stuff. If central banks arenât willing or able to fund the US government, then who will? Answer: the private sector, but the arrangement may not be that voluntary. See Ms Reinhartâs list of coercions for more.
The same holds here in the UK. There will surely come a point when foreign investors lose their appetite for UK gilts (which I have long written about disdainfully). Five year UK government bonds yield just over 1%. That is some 3% or so adrift from inflation â so they do not make sense for anyone to hold, except for those terrified of credit risks in the private sector. Even ten-year UK government paper yields just over 2%, still a negative real return.
The private sector may increasingly be coerced into buying UK government debt. Large institutional pension funds will be encouraged to invest in gilts as ‘riskless’ assets, supported by ‘macro prudential regulation’. But remember: if the private sector is going to be forced to buy gilts, they will equally be forced to sell other assets in order to pay for them. I think those assets are likely to be stocks.
Donât believe the hype about stocks
Do I think the latest rally in the stock market is sustainable over the longer term? Of course not. There is another reason to keep an open mind about equity market valuation. US corporate profits are currently at record levels as a percentage of US GDP. They are unlikely to remain there.
Why? The US corporate tax take as a percentage of GDP is currently near its 30 year average (roughly 3% or so). In the 1960s, for example, the average federal debt to GDP ratio was 46%. Over the coming decade, as Russell Napier points out, the corporate tax take will have to be large enough to support an average federal debt to GDP ratio of some 100%.
The US government will ensure that somebody buys its debt. It can either force the private sector to buy it â or it can impose higher taxes on corporations. Higher taxes on corporations mean lower net profits. US corporate profits as a percentage of GDP are, I think, going to fall.
By the same logic, so will US equities. My take is that the stock market rally of the last few months has been driven by a combination of quantitative easing and wishful thinking. Now that central banks are less willing to fund over-borrowed foreign governments, there will be implications for stock markets, and they will not be positive.
This is another reason why I believe in asset class diversification across: high quality bonds (expressly NOT US or UK government debt); high quality equities; âabsolute returnâ funds; and real assets, which will ideally give us protection against currency depreciation and state-sponsored inflationism.
The European Central Bank was expected to swap billions of bonds issued by Greece for new bonds that will shield the central bank from any losses. Private sector Greek bondholders (the likes of private individuals and hedge funds), on the other hand, will be exposed to massive losses.
If that doesnât seem fair, itâs because it isnât fair. The ECB is driving a coach and horses through traditional bond market practice â and the rule of law â in order to avoid its own bankruptcy. The free market can be left to those poor saps from the private sector that were silly enough to be left holding the bag, and all those Greek bonds, when the music stopped.
The ECBâs own ‘fraud’ is bad enough. But the greater ‘fraud’ is the one occurring even now, practically on a daily basis â central banks conjuring money out of thin air.
This fraud works against anyone who holds cash, since those deposits are going to be worth less and less in real terms. Both the US Federal Reserve and the Bank of England have pledged to keep interest rates at artificially low (and for private savers, loss-making in real terms) levels until 2014.
The system is rigged. There is no other way to describe it. Happily, I believe there are investment solutions out there that offer some protection against the malign workings of the state, and the central banks who represent it.
⢠Tim Price is Director of Investment at PFP Wealth Management. He is also the editor of The Price Report, a fortnightly investment advisory letter focused on asset allocation.
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Category: Market updates