“In the 1950's and 1960's, political leaders enjoyed much more public trust than they do today, enabling tougher economic decisions to be taken. The budget deficit culture, from which the western world is still trying to free itself, is symptomatic of a loss of political authority.”
-- Peter Warburton, Debt & Delusion (1999)
You’ve probably never heard of Peter Warburton, but he wrote one of the best books I’ve ever read on the nature of money and credit: Debt & Delusion. He wrote it in years leading up to the cresting of the epic credit bubble that popped in 2008. The book is hauntingly prophetic. Peter is one of those lonely economists who actually understands that supply matters. No surprise, perhaps, that he hails from the frozen north of England. He’s a true independent thinker, to whom I am indebted for helping shape my own framework on money, credit and inflation.
I met with Peter last week during his visit to New York, and as always, he got my wheels turning. His expertise and nuance on credit markets is particularly relevant. There is more debt today in the economy than before the 2008 financial crisis. (This is the case just about any way you measure it – domestically, globally, in real terms, in nominal terms, as a % of GDP, etc.) There is no one I know who has thought more deeply and creatively than Peter on this subject.
Two Key Questions
Peter contends that there are major structural forces gathering that threaten to break up the framework to which we have grown accustomed. There is potential for much more inflation than we have known for some time.
There are two key questions that Peter says we must each answer:
Do you believe today’s low interest rates are naturally low or artificially repressed?
Do you believe that central banks have adequate control?
Your answer to these questions should be reflected in your portfolio. If you believe that rates are at a natural level and/or that central banks are in control, you should feel comfortable that securities prices (stocks and long-term bonds) are rationally valued at today’s levels. If, however, you believe – or even suspect – that current rates are artificial and that the Fed may not ultimately be in full control, you should ensure your portfolio is properly balanced, or hedged, to defend against a potential shock to stock and bond prices now “priced for perfection”. Today’s prices are near historically high levels – levels that do not appear to contemplate the potential for a surprise pick-up in interest rates, inflation, or risk premiums.
Two Competing Theories
Peter explains that there are two competing theories explaining the nature of today’s extraordinarily low interest rates. One contends that they’re natural, a result of a “savings glut”. The alternative theory holds that rates are artificially repressed. Proponents of each would summarize them in this way:
“Savings Glut” – Excessive rates of savings globally have resulted in a glut of capital chasing a limited supply of opportunities. This over-supply of savings naturally led the price of money (interest rates) to fall.
“Financial Repression” – Government has orchestrated an unnaturally low cost of capital in order to foster an economic expansion fueled by debt. The result is that we have built a huge credit structure, which has inflated the prices of assets (financial and real estate).
Cause (or Effect?)
Effect (or Cause?)
Source: FactSet; “Debt per Capita” refers to total nonfinancial sector credit market liabilities
The implication of the Savings Glut framing is that capital was built up as a result of prudent behavior. There’s simply an excess of savings and a dearth of opportunities to put it all to work.
The implication of the alternative framework, Financial Repression, is that we have been profligate. We have committed income that we have not yet earned, and we are representing a level of demand that we cannot sustain. The fear of this unsustainability is putting a downward pressure on interest rates from a policy perspective. Our asset prices are thus conditioned on the ability to maintain this credit structure.
Why This Matters
It matters greatly which of these explanations you believe better reflects reality. If you accept the Savings Glut narrative, then you accept today’s low interest rates as natural. If you believe the Financial Repression narrative, then you believe that today’s low interest rates are artificial and that central banks’ interventions have distorted the risk/reward equation in the economy. Today’s interest rates thus reflect extreme monetary policy rather than the natural order of things. This challenges the central bank orthodoxy. Even for those with this contrarian view, it is an uncomfortable thought that, to normalize the system, central banks are going to have to stand down and get out of the way.
If, say, you believed that the natural real rate is 1%, and on top of that you expect inflation to be 2%, then interest rates shouldn’t be higher than 3%. But… if we don’t really know what the real rate truly is, and we instead look to the history of real rates post a recovery, we should expect closer to 2-2.5% real rates at the end of the cycle. Not many investors are prepared for this much of a shock.
For 50 years, the 10-year government bond rate has assimilated the nominal growth rate of the economy. If Trump, against expectations, gets the infrastructure spending bill passed in addition to the tax bill, he’ll have unleashed a fiscal beast. A pick up in nominal economic growth would thus imply a pick-up in nominal bond rates. This implies a higher discount rate, and that, in turn, implies lower asset prices.
What do you believe?
We believe it will pay to have an opinion … and a portfolio positioned to reflect it.
Yours in the Field,
Frank Byrd, CFA
Disclaimer: While the information presented herein is believed to be accurate, Fielder Capital Group LLC (Fielder) makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Fielder is under no obligation to notify you of any errors discovered later or of any subsequent changes in opinions. Nothing herein should be construed as a recommendation to buy or sell any of these securities. It should not be assumed that any of the securities, transactions, or holdings discussed will prove to be profitable in the future or that investment recommendations or decisions Fielder makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Fielder or its employees may have an economic interest in securities mentioned herein.