Investment conclusions – US government debt – Part 3

 

In the third and final part of this series of articles we want to reflect on possible investment conclusions.

 

FED will finance increasingly undisguised US government debt

What is this analysis good for, what could be the investment relevance? Investors can assume that an increasingly large share of government debt must and will be financed by central banks.

 

Very high probability of negative real interest rates

It is very likely that interest rates in the US will have to and will become negative, at least in real terms, in the coming years.

 

High probability of negative nominal interest rates

Despite the negative experience of Japan and Euroland with negative nominal/negative interest rates, the probability of negative nominal interest rates is also high in the US, as the point is likely to be reached where negative interest rates are necessary to ensure the financing of US government debt.

 

Existence of cash at risk in the medium term

If nominal interest rates are strongly negative, the existence of cash is highly endangered. If the interest rate is negative enough, all investors would withdraw their savings from the banks and hold only cash. Thus, the banking system would be broken unless the central bank replaced the deposits of private individuals. In that case, the central bank would be the lender to the banks (instead of private savers). Thus, the FED would become even more planned and communist than it already is. In order to save the banks and to prevent the FED from granting direct loans, politicians could try to decide “overnight” to abolish cash. Whoever abolishes cash abolishes freedom. Investors would be at the mercy of state arbitrariness. Every transaction with money could now take place exclusively electronically and there would be a danger that expropriations could be carried out at the push of a button.

 

Declining economic efficiency and labour productivity

In order to prevent expropriation and escape state arbitrariness, a barter economy could be established in some areas (as in the Stone Age, goods were directly exchanged, mammoth fur for sabre-toothed tiger chains), which would destroy economic efficiency. If we go to the beginning of the chain of effects, the following statement can be made: Those who have too much national debt will abolish freedom and economic efficiency.

 

Low interest rate landscape and flat yield curve

Banks look “visually cheap”, especially in Europe, but also in the USA. However, in order to be profitable, banks need sufficiently high nominal interest rates and a sufficiently steep yield curve (to raise money in the short term at low interest rates and to lend it out in the long term at higher rates). Soon, the FED is likely to manipulate the yield curve even more massively and ensure that it would be “flat as a flounder”. At the same time, the FED has already, more or less directly, extended loans to companies and bought bonds of dubious credit quality in order to manipulate the interest rate premiums that riskier borrowers have to pay down. As a result, no adequate interest spreads are currently available on the market to compensate for the higher default risks. Not for the investors in junk bonds, but also not for the banks’ lending to risky companies. It is therefore to be feared that the US banking system, similar to the european system, will also be structurally unprofitable and may prove to be a value trap.

 

Profitability of banks’ traditional lending business no longer given, cross-subsidisation necessary

Negative interest rates at the short end and a flat yield curve due to FED intervention mean that banks can earn almost nothing from maturity transformation. If the banks cannot pass on the negative interest rates to their customers, the resulting losses must be cross-subsidised, for example through higher fees, more expensive loans, etc. The problem is that banks will then be at a structural disadvantage compared to other credit providers who penetrate into sub-sectors of the market, such as insurance companies and pension funds. In many countries, pension funds and banks offer cheaper real estate loans than the banks, not only in Switzerland. Banks are currently favourably valued according to some key figures, such as price-book value. Due to the structural unprofitability of the banks’ core business, the threat of payment defaults in the future (at very low margins) and attacks by the Fintech sector, which can operate without maintaining an expensive branch network and without so-called “legacy costs”, it is highly probable that apparently cheap bank shares will prove to be “value traps”. For bank shares to become structurally interesting investments again, the interest rate landscape would have to normalise in two respects: Firstly, short-term interest rates would have to rise significantly, and secondly the yield curve would have to steepen. This scenario is unlikely due to the enormously high national debt.

 

Enormous outperformance of growth stocks driven by yield curve manipulation

The flat yield curve means that cashflows lying far in the future are as valuable as cashflows lying close to the present. This development is good for expensive growth stocks, especially technology stocks, and bad for favourably valued asset values (not least banks). Thus, the emerging yield curve control could prevent an overdue valuation correction of growth stocks and technology stocks or even inflate their valuation even further. The outperformance (underperformance) of growth stocks (intrinsic value) is mainly driven by the FED and government debt.

 

High gold ratio within the currency allocation makes sense

Should this pessimistic scenario materialise, allocations in gold and “responsible borrowing” could pay off (in order to be able to profit from the state’s policy of repression). Physical gold should not be considered as an investment, but as a currency. A high proportion of physical gold within the currency allocation is recommended.

 

Gold stocks attractive in the medium term

Historically, gold stocks have outperformed physical gold by 300%-500% over the medium term. Within the equity allocation, gold shares should have a firm place.

 

Consider short-term borrowing

How should real estate be financed? The trend in real estate financing should be towards short-term (partial) financing, as the interest rate curve is flat but still rising slightly and interest rate increases are very unlikely due to the precarious situation of national budgets. The precarious situation of public finances in key countries such as the USA and Italy also prevents interest rate increases in countries that are structurally better off, such as Switzerland.

 

Influence of the low interest rate environment on fair equity valuations

Downward manipulation of interest rates means that the discount rates are too low and generally “everything” (stocks, bonds, real estate, private equity…) is too expensive – measured against the benchmark of a world where interest rates are not downward manipulated. As long as central banks succeed in preventing interest rate rises and politicians succeed in ensuring that, despite possibly rising inflation rates, central bank money does not remain merely legally official currency but is actually accepted and used by market participants as a means of payment, the fair valuation of “everything” has thus shifted upwards. Comparisons with historical averages of valuation ratios then bear the risk that assets are generally considered too expensive too soon. The Shiller price earnings ratio, for example, asks how much one has to pay for 1 unit of trend profit. In doing so, past borrowing costs are implicitly included in the calculation of the trend profit. If the FED succeeded in manipulating the cost of borrowed capital downwards on a permanent basis, future trend profits would be permanently higher, whereas the Shiller calculation method assumes a mean reversion. Thus, the Shiller exchange rate profit ratio overestimates the overvaluation, again provided that the cost of borrowed capital does not increase.

 

The fate of the stock markets is decided in the long term on the bond markets

Bond markets are markets manipulated directly by the central bank. They are very expensive. Investors should bear in mind that the FED has successfully combated liquidity risks with its interventions for the time being, but not insolvency risks. Stock markets (at least in the US; not so in Japan) are the only indirectly manipulated markets. The stock boom is a derivative of the bond boom. In the long term, the fate of the stock markets is decided by the bond markets.

 

Influence of the US election: slight but insufficient easing of the debt front

The US voters have chosen not to have a “blue wave” and have chosen not to give a clear mandate to the future President, Joe Biden. With a presumably Republican-dominated Senate, the future rescue packages will be much smaller. The massive investments in green technologies that the Democrats are aiming for are also likely to be blocked in the Senate. Since two senators will have to be voted on again in January 2021, a Democrat-controlled Congress could theoretically become reality in January after all. A democratically controlled Senate could also be elected in two years, halfway through the next presidential term. Then, the left-wing agenda of the Democratic left wing, which is extremely heavy on spending and redistribution, could perhaps be implemented after all. But we think the likelihood of that happening is rather slim. We expect to be able to pass the next 500 billion US dollar rescue package in January/February 2021. The Democrats are likely to fail in the Senate with their demands for a $2000 billion rescue package. Thus, the US elections have provided a slight but insufficient relief on the debt front. Much more would be needed.

 

One last objection and twice Winston Churchill

First a quote from Winston Churchill: “A good speech should exhaust the subject, not the listeners”. I hope you, dear readers, are not exhausted. Unfortunately, some subjects can only be exhausted by accepting exhaustion. Superficial analysis can be harmful and dangerous!

 

There is a tiny chance to get out of the over-indebtedness dilemma after all. In 1940, Winston Churchill said, “I have nothing to offer then blood, toil, tears and sweat.” If one were to optimise in the long term, one would now have to restructure the US state budget and accept a (still) severe recession lasting years. It is a deep human trait to avoid short-term suffering, even if the long-term price for it will be very high. Would you elect politicians who promise you years of bad times? Would you vote for these politicians for the benefit of your grandchildren or great-grandchildren and accept bad times for the rest of your life? Do you believe that they would be elected and if so, that if they lived up to their promises of bad times, they would be re-elected at the next election?

 

When could the crash in the US bond market happen, when would the debt pyramid collapse?

The author himself cannot make a serious forecast at present. As long as inflation rates are under control, the FED can keep the voracious debt monster alive with even more debt. This could succeed for a long time to come. Only when inflation is out of control will the central banks’ possibilities of manipulation come to an end, because then no one will want to hoard central bank money or accept it as a means of payment (regardless of whether this is prescribed by law). Only when the US monetary system is fully zimbabweanised or venezuelanised will the US economy and US policy be weimarised.

 

Part 1 of this series

Part 2 of this series

 

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Thomas Härter
Chief Investment Officer Aquila