The distortions and dysfunction in markets have reached a point where it has become essential to recognize that the financial system has become a system of financial repression (FR). While this viewpoint has been openly discussed for some time, as described below, I have preferred to think of it as just one perspective among many, until the current quarter.
Unfortunately, I believe that FR has now become a central thesis. It needs to be clearly stated and understood that the prime objective of any investment plan, in current circumstances, should be fully focused on surviving FR.
Many investors may not yet have become fully aware of what FR is, let alone how to survive it. So this article will fall into several parts. First of all, provide a definition, secondly describe how the problem seems to be accelerating, highlighting new liquidity risk, and lastly discuss approaches on how FR can be survived.
My own view is that investment risk has never been higher, and it has never been more widely misunderstood. Understanding how FR works fully reveals the scale and scope of the problem.
I hope that what follows is a clear and concise introduction to what is admittedly a complicated subject.
What is Financial Repression?
The world economy has entered an extended period of high debt burdens and low growth. If governments cannot easily bring debt ratios down to sustainable levels then economic policy is tasked with making high debt levels easier to live with. Central banks have initiated a range of policies to cope with these circumstances, largely focused on very low nominal and real interest rates, weaker currencies, and QE.
A world of FR is very uncomfortable for investors, as they are left with a choice between very low, or even negative, risk free returns, and increasingly high risk, distorted and dysfunctional markets.
For much more depth on this subject, Gordon Long has done a great service in compiling a web site specifically dedicated to FR. It includes an extensive list of interviews with experts around the world on how they each look at this.
Why the problem is accelerating
As previously described in these notes, Steve Keen’s economic model has major advantages over most conventional models, and once again the economy seems to be tracking his forecast. As the article below shows, GDP is already just over 14% below trend GDP growth. This means that this “recovery” is not only the worst since the 1930s, it is also a multiple year period of underperformance relative to trend. As Jim Rickards has pointed out, this is more accurately described as a depression. Furthermore, the current economic cyclic is also showing clear signs of faltering.
Yesterday there seemed to be some official recognition of the problem as the IMF uncharacteristically decided it was time to recommend that the Federal Reserve should delay raising rates until next year at the earliest.
Indeed, the depth of the problem could be far greater than policy makers seem to recognize. ECRI also has a very impressive track record and they state that the US is already in a productivity recession, with very modest prospects for long term growth.
Thad Beversdorf also examines this issue in depth with some remarkable insights on the true scale of the issue.
It is also possible to view current financial repression as a destructive inversion of capitalism. Charles Hugh Smith describes the growing gap between policy makers and the majority of people who feel the consequences.
New Liquidity Risks
FR has many unintended consequences of growing significance. Volatility is now on the rise in most markets, and this is a direct result of the dominance of intervention and its growing impact on illiquidity even in major markets.
“This explains why the air pockets have not just been in markets where the street acts as a warehouser of risk. It explains why they have occurred not only in the form of sell-offs which could have caused multiple market participants to suffer from procyclical capital squeezes. It also explains why the catalysts have often, while often trivially small, have nevertheless been macro in nature, since they have boosted expectations of a change in central banks’ support for markets.
Unfortunately, it leads to a rather ominous conclusion. The bouts of illiquidity will continue until central banks stop distorting markets. If anything, they seem likely to intensify: unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.”
How to Survive FR
No one has a crystal ball and this is not a static situation. Anyone who claims to have an infallible solution most likely does not understand the complexity of the problem. Jim Rickards provides a good outline in his recent book “Death of Money”, but the dynamics will most likely be decisive. This involves understanding how the economy will unfold as well as how and when policy makers will respond.
The best that investors can do will most likely revolve around how and when to allocate between the three main asset classes – stocks, bonds, and tangible assets.
In each case there are pros and cons. As regards stocks, according to Goldman Sachs, they are currently held up by relentless buybacks which are no longer an “optimal use of cash”, and are overvalued according to almost every measure.
Bonds provide a non-correlated asset, and lower risk at short maturities, but the yields are near record lows and the upside is limited.
Real assets are in general in a bear market, and continue to be held back by deflationary forces, but at some stage may provide the greatest potential for upside return when the cycle finally turns. Most likely precious metals will be the most important tell for a turn up in the cycle.
Deciding the allocation between sectors, and timing the shifts can be effectively guided by an appropriate model. Using a back tested model, or series of models can provide a significant edge. This is what lies behind the construction of the Cycle Dynamics portfolio.
Investors also need to recognize that short term returns may not tell investors very much. As the heading chart shows, all across the markets current prices may have no connection with either risk or underlying fundamentals anymore. It is now far more important to have a consistent and effective strategy that increases the likelihood of good results over time. The measure of investment management should therefore be far more informed by an assessment of long term risk, realistic stress testing, and adaptability.
Understanding FR has now become crucial in how to understand investment strategy and how manage portfolios for long term success.