So the Dow hit a record high. Good for it. Congratulations to Ben Bernanke. Does it mean we’re out of the woods finally? Sadly, no. What we are experiencing in the Dow, and increasingly here as well, are the fruits of financial repression. I wrote about this early this year:
Financial repression is a phrase used to describe a set of policies that reduce the real interest rate to zero or below. These are enacted by governments or regulators aiming to mitigate a debt burden in either the public or the private sector. The low interest rate has the combined effect of lowering debt issuance and servicing costs, as well as increasing bank margins. The knock-on effect of currency debasement boosts competitiveness, investment and inflation. All of these assist in rendering the debt-stock in question more manageable and, ultimately, shrinking it in real terms.
Readers will recognise that these conditions already exist in most advanced economies as private sectors in the United States, Europe and Japan are at various stages of unwinding debt bubbles of the past few decades. The technicals vary but the tools are the same.
Japan remains a contained mercantilist state, fighting its demographic headwinds and formerly corporate debt bubble via endless deficit spending of its government, which borrows from its people at extraordinarily low rates guaranteed by repeated quantitative easing measures conducted through its central bank.
The United States is a more open economy and is making more swift progress than Japan did in its deleveraging, but its household and corporate debt loads are still miles above historical norms. Its government also continues to deficit spend at rates in excess of sustainability, assisted in its endeavour by fabulously low interest rates across the curve, in part held in place by quantitative easing by its central bank.
Like Japan, this has stabilised its financial system and some renewed borrowing is apparent as household formation picks up. This will continue but with each successive year get more difficult. Growth from a low base has proved hard. Growth from each higher base will be tougher still. Owing to more favourable demographics and a more dynamic economy in general, US financial repression is unlikely to last as long as that of Japan. But if it takes half the time, the period from the GFC until now is about one-third of what will be required. Meanwhile, the US will export its weakness wherever it can.
Europe is harder largely because it barely exists beyond its putative bureaucratic dream. The disparate group of states with a shared interest rate and currency, but little else, uses a combination of super-low interest rates, fiscal engineering and constraint, as well as wage deflation to resolve its various debt bubbles. It’s approach has merit in the text book and in the capitalist ledger but its refusal to support the process with shared debt burdens constantly threaten political mayhem. Europe may win in the end but only if it can prevent civil war.
And it does not stop there. The same conditions of financial repression permeate much of the emerging market world as well. The matrix is different but the tools the same. In China, interest rates are also held at low levels relative to growth and inflation to boost bank margins in the face of mounting bad loans derived from years of overspending on uneconomic infrastructure to meet official growth targets. The underlying dynamism of the economy is real and its prospects for large productivity gains very large in the long term. But the rise to influence of companies and individuals that have a vested interest in sustaining the unsustainable means financial repression goes on. Capital controls ensure the currency is fixed and that domestic liquidity is ubiquitous. The unwind will be long and each subsequent year will face the same question as the last, more pressing each time. How much will the communists renew spending on bridges to nowhere?
Which brings us to Australia. So far, it has been different Downunder. Despite a huge household debt load, Australians have not faced a deleveraging cycle. We have to date disleveraged, reducing our borrowing growth rates not reversing them. This is has been made possible by a once in a century mining boom which boosted incomes, jobs and the simple velocity of money in the economy, easing the generational shift away from debt-accumulation which is part and parcel with financial repressions.
…Low interest rates should not be thought of in historic terms as either the “bottom of the cycle” or “emergency” settings, at least, not in any immediate sense. They are not even responding to an emergency any more. It’s the new normal, now just normal, in which the free flow of global capital is being sensibly crimped to stabilise global banking systems. A modicum of de-globalisation as it were. In this environment, current account deficits matter.
We’ve staved it off with government spending and guarantees to our banks, as well as a serendipitous mining boom. But the underlying fact will remain. Australian households have too much debt. The level must fall relative to the surrounding economy. Financial repression is the way it will do so. That is a structural shift, not cyclical.
What does that mean to you? It means that despite favourable tax treatment, solid immigration and an unbowed politico-housing complex, house prices will likely disappoint. The much-touted housing “recovery” is a dated term that has limited reference in today’s world of ongoing structural adjustment. When current account deficits matter, over the longer term house prices rise or fall in response only to the broader economy, they no longer drive it because the debt is not available. At a national level, flat in real terms is my guess, with risks to the downside mitigated by property investors’ “search for yield”, the flip-side of financial repression. In the longer term, the risks remain to the downside as the mining boom and demographic dividend passes and because of Australia’s lack of competitiveness in anything else.
Shares should do better. Though valuations are already remarkably stretched, earnings growth will be decent for the miners for the first half and the hope that a soft landing can be engineered by authorities has already lifted markets. More to the point, financial repression boosts financial assets as official interest rates fall and risk premia contract. Nonetheless, those seeking to buy and hold shares on anything other than the very longest of time-frames should be aware that they are in some way buying a fiction. Folks will periodically wake up. I continue to favour dollar-exposed industrials. They are our most globally efficient firms and will grow at least in line with the wider market, if not more so. More to the point, when the dollar corrects with falling interest rates the falls will result from weakness in everything else. It’s a natural hedge.
Fixed interest investors can expect yields on term deposits to fall further but the pressure on bank funding remains and the good news is that much of the financial repression spread that will be gifted to our financial firms will be on the asset side.
There is little prospect of a reversal for interest rates as far as my eye can see: inflation is quiescent, the trend in wages growth will continue to ease as national income falls after a bump upwards in the first half. Eventually the dollar will fall substantially but not until economic weakness demands it and that will cap inflation anyway. Productivity will also continue its rebound.
On the fiscal side, as MB has argued for three years, the surplus is and should be history. Anyone voting on that basis later this year needs to update their frame of reference. Although surplus politics will no doubt define the Coalition side of the campaign, make no mistake, it does not matter who is now in power, the Australian government will either borrow or the economy will weaken. While it might be argued that some of the weakness is welcome, cleansing past mal-investment, we’ve had years of pressure on our non-mining sectors already, coping with a real exchange rate at its current levels has been the greatest of disciplines. I hope that the Coalition, should it win office, will not have to learn the hard way that when wrestling with a debt-stock of the magnitude held by our households, economic weakness can spin out of control.
All across the world, major economies are converging on the same spot, some from the point of high private debt, some from the point of high public debt, some from the point of free markets and some from the point of central planning. All are using various configurations of financial repression to grow beyond the constraints of the national debts accumulated over of the past three decades of easy demographic dividends, Keynesianism and globalising finance. Now instead they are doing everything they can to seize the largest possible share of the globe’s limited investment capital.
So, time to party? Certainly financial repression is working over time in the US. And it is difficult to find any macroeconomic reason for it to stop now. The one serious threat to the US rally is rising long bond rates, which would snuff out US housing. But so long as Europe and China continue to struggle, safe haven flows should contain any sell-off in bonds. Inflation is no threat. The world exists in a state of grotesque overcapacity. Its underlying condition is deflationary. And the rebalancing away from China will only depress periodic bouts of commodity inflation. As for official intervention, phht, the uber-doves of the Fed are unlikely to upset things for years yet.
In theory, you might expect the rising dollar to have an effect at some point as other nations attempt to catch up to the US’s lead in financial repression but so long as long bonds are contained, Bernanke’s fairy dust seems able to see off even that.
Just don’t “buy and hold” it is my view. “Value” arguments that support “buy and hold” approaches to stocks make no sense in financial repressions (that’s the whole point). On the most fundamental level, the rally is an artifice.
