The four most expensive words in the English language are “this time it’s different.”
– Sir John Templeton, Investor
It’s different this time, and it’s also not different this time.
It’s different this time because the credit-driven global U.S. economy is burdened with a monumental level of financial obligations relative to GDP. According to the Bank of International Settlements (“BIS”), loans and debts outstanding which burden corporations, households, and the government in the United States have reached $48.3 trillion in the United States or 250% of GDP. Including off-balance sheet items, the effective level of debt outstanding is almost $100 trillion, at $99.6 trillion, or more than 500% of GDP. It’s different this time because the U.S. economy has never piled on so many financial obligations.
With that said, it’s also not at all different this time, because this is not the first time in history that a society’s financial obligations have grown to unsustainable levels. As just one example, students have amassed more than $1.5 trillion of student loans, which have increased at a rate of more than 10% per annum since 2006. This story has been repeated often through history, and it usually ends in pain for those who hold their savings in cash or bonds. The downside risk today for investors trying to save for retirement is captured in Charles Bullock’s account of Dionysus of Syracuse, from more than 2000 years ago.
Having borrowed money from citizens of Syracuse and being pressed for repayment, he [Dionysus] ordered all the coin in the city to be brought to him, under penalty of death. After taking up the collection, he re-stamped the coins, giving to each drachma the value of two drachmae, so that he was enabled to pay back both the original loan and the money he had ordered brought to the mint.
Displaying a level of creativity that could compete with today’s central bankers, Dionysus defaulted on his debts, to the detriment of Syracusans who held their savings in drachmae. When a debt obligation becomes too big to repay, it’s no longer a problem for the debtor; it’s a problem for the creditor. The warning caveat emptor, which translates to “buyer beware,” is timeless because “this time” is hardly ever different.
Adding up almost $100 trillion of financial obligations
Let’s review the U.S. economy’s financial obligations one-by-one to better understand what makes up the $100 trillion of financial obligations of U.S. consumers, households, and government entities.
For indebted economies, policymakers are likely to continue a set of policies known as financial repression until debt/GDP ratios decline to historically normal levels. Carmen Reinhart, who wrote the book about debt crises and financial repression (titled This Time is Different), suggests that advanced economy countries generally pursue a set of policies known as financial repression to reduce the impact of excessive domestic debt. These policies include:
- Maintaining negative real interest rates: Keeping real (i.e., inflation-adjusted) interest rates persistently negative over several decades is the cornerstone of financial repression. While harmful to fixed income investors, negative real interest rates make it easier for GDP to grow faster than public debt, thereby reducing the debt/GDP ratio over time. Alternatively, a surprise burst of inflation accomplishes the same goal, but in a shorter timeframe.
- Herding domestic investors into public debt: Laws and regulations that force or coax investors into owning more public debt represent the other critical component of financial repression. For example, regulatory changes regarding money market funds have thus far resulted in a trillion dollars of additional domestic capital that own U.S. government debt since 2016.
In the aftermath of World War II, financial repression helped to reduce the Federal debt/GDP ratio in the United States from 106% in 1946 to 22% by 1974. Thus far, these policies have not worked as successfully as they did after World War II, as the debt/GDP ratio has only continued to increase since the Financial Crisis. Also, more recently, Congress and the Trump administration have enacted revenue cuts along with budget increases which should further increase the budget deficit and government debt. For those reasons, the likelihood of a surprise burst of elevated inflation seems to be increasing.
If successful, financial repression should reduce the real value of U.S. financial obligations and reduce wealth inequality over time. However, it also creates challenges for people who are planning to save and invest for retirement. Given the high probability of a protracted negative interest rate environment, it will be more important than ever to maintain a high savings rate to grow your assets over time.
At the present moment, interest rates and inflation are rising, U.S. stocks are generally expensive, geopolitical risks are increasing and the economy, while seemingly firing on all cylinders, has been expanding for nearly a decade. Given this backdrop, taking asset allocation measures that err on the side of prudence and defensiveness seems appropriate.
Set forth below are my thoughts on the relative attractiveness of various investment options:
- Deposits and CDs (Unattractive): Bank deposits and bank CDs generally earn a lower return than the inflation rate, but they also earn a lower return than what is available today from short-term U.S. Treasuries and short-term corporate bonds. While holding a certain amount of cash is always prudent, short-term bonds seem more attractive.
- Short-term, high-quality bonds (Depends): With the Federal Reserve raising interest rates, two-year U.S. Treasuries are providing a nominal yield of 2.7% while, consumer prices have risen 2.9% over the past twelve months. While still generating a negative inflation-adjusted interest rate, short-term Treasuries can be a worthwhile temporary placeholder as you wait for more attractive investment opportunities. In addition, short-term corporate bonds can, in some cases, offer a slightly positive real interest rate, but corporate bonds have come with varying amounts of credit risk. Given how leveraged many companies are at this point in the business cycle, being smart and selective about your corporate bond picks matters a lot.
- Long-term bonds (Unattractive): If inflation grinds on for years at a rate slightly above the long-term interest rate or if an inflation surprise arrives, long-term bonds will not be a good way to generate positive real returns.
- U.S. equity index funds and ETFs (Unattractive): U.S. index funds and ETFs have outperformed almost every other asset class over the past ten years, just as they did during the 1990s. Importantly, two-year U.S. Treasuries currently provide a better income yield than the 1.9% dividend yield of the S&P 500 Index. On almost every possible valuation measure, the U.S. stock market trades at a level which is well above historical averages and which is greater than almost any other period of history except for the peak of the Dot-Com bubble in 2000.
- Precious metals such as gold (Attractive): Historically, gold has generated better returns than bonds in negative real interest rate environments. As the dollar’s role as the world’s reserve currency weakens, it’s possible that gold will become an important reserve asset once again. Finally, if an unexpected large burst of inflation arrives, gold should serve as a useful inflation hedge and store of value.
- Commodities and commodity-related stocks (Attractive): Commodities and companies whose earnings increase with commodity prices tend to do well in an environment of rising inflation. Select farmland and agricultural sector investments appear particularly attractive right now, as agricultural commodity prices have been depressed due to bumper crops in recent years.
- FANG stocks (Unattractive): Facebook, Amazon, Netflix, and Google are great companies with fantastic future prospects, with no less promise than Cisco Systems had in 2000. However, a great business alone does not make a sound long-term investment, because the price you pay for any investment matters. Cisco Systems shares generated a negative return during the decade that followed its peak in 2000, and I suspect that the FANG stocks will have a similarly difficult decade between 2018 and 2028.
- Selected value stocks (Attractive): Just as bargains could be found at the peak of the Dot-Com bubble, bargains are out there today, but it requires an active stock-picking approach and an effort to minimize exposure to the most wildly overvalued sectors of the U.S. stock market. If inflation accelerates, valuation ratios (such as the P/E ratio) should compress, but more so for those companies that trade at an expensive P/E ratio than for those companies that trade at a discounted P/E ratio.
- Foreign stocks (Attractive): Equities outside the United States are generally more attractively valued than U.S. stocks, and emerging market stocks, while somewhat more volatile, look particularly attractive as long-term investments. If a U.S.-centric inflation surprise happens, companies with profits denominated in foreign currencies should perform better than U.S. companies.
- Real estate (Depends): Real estate is generally an attractive asset class under financial repression. If you purchase an attractively-priced property, you should be able to increase rents with inflation. Furthermore, if you finance your investment with a low-cost mortgage, your returns are likely to be enhanced by the negative real interest rate environment. On the other hand, finding an attractively-priced property is challenging right now.
In summary, it makes sense to be wary of rising interest rates and compressing P/E ratios which can often accompany inflation. In this environment, you should consider holding a diversified portfolio of investments that should probably include short-term bonds, inexpensively priced stocks, of which there are few in the United States right now, along with hard assets and companies whose earnings are most likely to benefit from accelerating inflation.