WindRock - Displaying items by tag: Debt
April, 2020
By late January, the die was cast: the virus had a name, it had reached our shores, travel screenings and restrictions were in place, and while not yet declared a pandemic, the World Health Organization declared COVID-19 a “Public Health Emergency of International Concern.”
Yet complacency reigned within financial markets. The stock market continued its march to new highs (reached on February 19th). The Federal Reserve, in its January 29th press release, failed to mention coronavirus in the list of variables it “will continue to monitor” save for a generic nod to “global developments.”[i] It began the missive by mentioning recent data “indicates that the labor market remains strong and that economic activity has been rising at a moderate rate.” Famous last words.
It was not until a full month later, and only after the U.S. stock market suffered its worst week since the Great Recession, did the Federal Reserve act. It was rather weak work. On February 29th they issued a statement describing how they were “closely monitoring . . . the evolving risks of the coronavirus to economic activity.”[ii] On March 3rd, they cut interest rates by a not uncommon 50 basis points.
But on March 15th, the Federal Reserve completed its year-to-date journey from satisfaction to concern to sheer panic. That Sunday’s emergency announcement marked the first of several major measures meant to stop the bleeding on Wall Street and stem the tide of anticipated economic hardship.
The Federal Reserve’s actions are unprecedented in both magnitude and breadth and will generate serious repercussions for investors down the road.
While the financial media widely reported how the March 15th actions lowered the federal funds target rate to 0.00-0.25%, it missed the far more drastic action of eliminating bank reserve requirements. Previously, banks had to retain 10% of demand deposits which meant they could theoretically increase the money supply by ten times. Now no limit exists to their monetary expansion.
March 23rd brought more unprecedented action when the Federal Reserve announced it was buying $375 billion in Treasuries and $250 billion in mortgage backed securities that week. For comparison, 2008’s QE1 was $700 billion (comparable in size) and it took months to deploy. It also announced it would continue buying assets “in the amounts needed” to support the economy. It started buying, for the first time ever, corporate and short-term municipal bonds.
Then, on April 9th, the Federal Reserve announced $2.3 trillion in loans to “support the economy.” Not content with corporate and municipal, it started buying junk bonds. It could have saved itself the trouble of buying various bond sectors by simply writing a check for most of the office real estate ($2.5 trillion), farmland ($2.7 trillion), or multi-family housing property ($2.9 trillion) in the U.S.
The Federal Reserve’s substantial and sustained efforts to pull the economy out of the 2008 Great Recession increased its balance sheet by $3.6 trillion in just over six years. It just added $2.3 trillion to its balance sheet in a month.[iii] This isn’t throwing the kitchen sink at a problem – it’s lobbing in the entire kitchen.
Even if the Federal Reserve stopped further actions and ceased its announced programs, its balance sheet will continue to swell as it finances proliferate spending by the U.S. Treasury. Given such actions as the CARES Act and its Paycheck Protection Program, the Congressional Budget Office estimates the 2020 deficit will reach $3.7 trillion – a multiple of anything seen in the wake of the 2008 Great Recession.[iv] This estimate will only increase with any additional spending initiatives by Congress.
Money supply has already exploded and is at the fastest rate in 92 months.[v] It is just getting started.
In response to 2008, the Federal Reserve increased the money supply dramatically, but much of that was held by commercial banks in excess reserves at the Federal Reserve where they earned some small, yet risk-free, interest. This time is different. Not just in magnitude, but in breadth, which is to say by recipient. No longer will money be injected into banks and primary dealers, but to companies and individuals who make up the economy as whole.
Inflation will ensue. Not right away, for the deflationary forces of loan repayments and defaults will counteract and potentially overwhelm inflationary forces. But that will be somewhat temporary.
Until then, it is an opportune time to build up inflation protections for an investment portfolio: certain types of real estate (e.g., farmland and some residential rental property), precious metals, and cryptocurrencies.
[i] Federal Reserve Bank of St. Louis. Timeline of Events Related to the COVID-19 Pandemic. https://fraser.stlouisfed.org/timeline/covid-19-pandemic#14
[ii] Federal Reserve Press Release. 29 Jan 2020. https://fraser.stlouisfed.org/title/federal-open-market-committee-meeting-minutes-transcripts-documents-677/meeting-january-28-29-2020-585165/content/pdf/monetary20200129a1
[iii] Federal Reserve Bank of St. Louis. Federal Reserve Total Assets. https://fred.stlouisfed.org/series/WALCL
[iv] “Coronavirus Relief Pushing U.S. Deficits to Staggering Heights” Associated Press. https://www.pbs.org/newshour/politics/cbo-says-deficit-to-reach-3-7-trillion-in-economic-decline
[v] “Money Supply Growth Surges to 92-Month High” McMaken, Ryan. Mises Institute. https://mises.org/wire/money-supply-growth-surges-92-month-high
Additional Info
WindRock interviews Dr. Gary Shilling, editor of A. Gary Shilling's Insight, and a long-time Forbes magazine columnist. As an expert in forecasting interest rates, Dr. Shilling is best known for his accurate 1981 prediction of the “bond rally of a lifetime." The podcast discusses: reasons why U.S. interest rates should continue decreasing; implications of world-wide negative interest rates; probabilities of a global recession; and likely future central bank and government actions. July 2016.
Additional Info
Forbes Columnist Forecasts the 10-Year Treasury Rate Crashing to 1%
WindRock interviews Dr. Gary Shilling, President of A. Gary Shilling & Co., the editor of A. Gary Shilling's Insight, and a 32-year Forbes magazine columnist. For years, Dr. Shilling has been steadfast in forecasting the global “bond rally of a lifetime.” He believes this trend will continue as interest rates decline further due to subpar economic growth, over-indebtedness, and excess capacity. May 2015.
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WindRock interviews Dr. Laurence Kotlikoff, economist at Boston University and expert on U.S. debt obligations. Dr. Kotlikoff addresses such issues as: U.S. financial obligations substantially in excess of the official $18 trillion debt due to pension obligations, Social Security, health care and other government programs as reported by the Congressional Budget Office; how the forthcoming retirement of 80 million baby boomers receiving an annual average of $40 thousand in government programs will overwhelm U.S. financial capabilities; and potential repercussions from financing U.S. federal debt levels by the mass printing of dollars. January 2015.
Brett K. Rentmeester, CFA ®, CAIA ®, MBA – This email address is being protected from spambots. You need JavaScript enabled to view it.
Japan, once a miracle growth story known as the land of the rising sun, has found itself mired in a stagnant no-growth world for over 20 years. During this time, they have accumulated massive debt and now have demographics making them the oldest country in the world. These forces threatened the stability of Japan’s ability to fund their spending and social programs as their rapidly aging population struggles with staggering debt. As the sun looks poised to set on Japan amidst a crushing debt load, unique opportunities arise for astute investors.
What is informative about Japan is that it represents the front edge of where the entire developed world, including Europe and the US, is heading - into a dangerous cycle with too much debt, aging demographics, and gross overspending supported only by the sheer printing of money. No other major world economy has as much risk of a debt crisis and resulting inflation due to a falling currency as Japan. Despite years of deflation or falling prices, Japan is on an aggressive path to weaken the Yen and spur inflation as part of official policy. Pushed too far, this could spiral into a state of high inflation as investors wake up to the realities that Japan has reached what is referred to as the "Keynesian End Point". This is a point where non-discretionary spending exceeds tax revenues, leading to money printing as the last tool at the disposal of policy makers. According to Hinde Capital “if Japanese yields returned to levels of the mid-1990’s (i.e. 5 year bonds at 6%), the entire tax income of the Japanese Government would be spent on debt servicing”. Japan’s official debt already exceeds 200% of their annual production (gross domestic product). This has only been possible given their extremely low interest rates. Academic research has shown that most countries face funding issues when they approach 100% debt to GDP.
How did Japan get in this position? In the wake of their real estate and stock market bubble in the 1980’s and subsequent crash, they have spent beyond their means to keep their economy afloat, albeit in a sideways zombie-like state. Analysts such as Dylan Grice (now of Edelweiss Holdings) have argued that Japan may have spent money in a futile attempt to offset the inevitable forces of an aging demographic base with increased social costs. Japan’s fertility rate stands at 1.2 children, well below the population-sustaining 2.1 child replacement rate. Their lack of immigration also makes their demographic situation more dire. Today, Japan has as many retirees as those working.
Given their predicament, many are puzzled how interest rates in Japan have remained so low. Part of the story is that the buyers of Japanese bonds have been loyal Japanese investors who actually were more rewarded in bonds the last 20 years than in Japanese stocks or real estate. However, a good investment the last 20 years may prove to be a terrible investment the next 20, as we suspect. Over the last 20 years, savings rates have fallen from the mid-teens to almost nothing today, so Japanese investors are largely tapped out. Also, Japanese bonds today have no built in expectation of expected inflation since it has not been a concern for decades. However, if inflation fears picked up, yields could jump and send Japan into a debt funding spiral. Given this, Japan will need to find outside buyers of its bonds. This will likely cause rates to jump since foreign investors will not be satisfied with the low rates on Japanese bonds. Japan ultimately has little choice but to continue printing money in increasing quantities to keep the system from collapsing.
Despite this dire situation, investors should not ignore the opportunity to profit from these forces in Japan. We believe Japan may ultimately mirror a handful of historical cases where countries have transitioned from low inflation to high inflation or even a dreaded cycle of hyperinflation (where people lose faith in the currency). During these transitions, markets are often mispriced as the inertia of the past blinds investors to the new future ahead after an inflection point. Extreme cases of inflation are well documented in Weimar Germany and Zimbabwe, but similar episodes befell the US and France in the late 18th century. In more recent cases such as Zimbabwe and even Israel in the 1980’s, periods of high inflation led to soaring local stock markets. However, these incredible gains were more than offset by massive inflation from currency depreciation to the point of worthlessness, negating any benefit of owning stocks.
Herein lies the opportunity: investors who can identify a country transitioning from subdued to high inflation would invest in the stock market of a country and then hedge the currency, resulting in tremendous profits if correct. Today, we believe investors have this opportunity in Japan. Owning Japanese stocks during a transition to high inflation may be rewarding if the falling value of the Yen can be hedged back to exposure in US dollars. According to analyst Dylan Grice, if Japan followed the pattern of Israel during their period of triple digit inflation in the 1980’s, a $1,000 investment would turn into $6.5 million (a 6,500% return). Although this represents an extreme example, we advocate a small amount of capital dedicated to this opportunity for the potential of huge returns if even remotely correct.
The problem with many high return potential investments is that they have equal downside risk. In this case, we think the risks are muted relative to attractive upside potential. Even if the thesis fails to materialize, investors are left owning Japanese stocks (still 60% of all-time highs) with price to book valuations near 1x relative to 2x for U.S. equities. Further, with currency hedged back to US dollars, Americans take on no currency risk.
We have a simple way to execute this trade for clients, which should represent only a small fraction of their wealth. Although the sun is setting on Japan, the sun has yet to rise for investors positioned for the likely inflationary path ahead.
Brett K. Rentmeester, CFA ®, CAIA ®, MBA is the President and Chief Investment Officer of WindRock Wealth Management (www.windrockwealth.com). Mr. Rentmeester founded WindRock Wealth Management to bring tailored investment solutions to investors seeking an edge in an increasingly uncertain world. Mr. Rentmeester can be reached at 312-650-9593 or at This email address is being protected from spambots. You need JavaScript enabled to view it..
All written content on this site is for information purposes only. Opinions expressed herein are solely those of WindRock Wealth Management LLC and our editorial staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation.
