Diversification and Gold in the Age of Financial Repression – Full Article
The coronavirus pandemic has generated a new level of co-ordination between central banks and governments, with potentially profound consequences for the economy and markets.
The world became familiar with central banks printing money and buying government bonds to reduce the cost of capital (termed quantitative easing or QE), but enforced economic lockdowns required new ideas to avoid an inevitable depression. This included central banks effectively printing money, to different degrees around the world, to fund new government bond issues. Those governments also applied fiscal stimulus, including sending money directly to companies and households that were struggling due to the economic shutdowns. A pertinent example was the US, where the extent of fiscal support was so significant that despite unemployment initially spiking to almost 15% and GDP falling by 31.4% (annualised) in Q2, overall personal income continued to grow, thanks to these government transfers.
Financial repression is a term developed by two Stanford economists in 1973. It has attracted renewed attention in recent years, as debt levels globally have continued to soar higher and interest rates have moved in the opposite direction, thanks largely to QE. Since the US took the world’s reserve currency off the gold standard in 1971, we have lived in a world of increasing levels of debt accompanied by declining levels of real GDP growth.
History has many examples of excessive debt leading to a fall in growth rates, but this is only possible if interest rates are pushed so low that the increased debt can continue to be serviced, otherwise the whole over-indebted system is at risk of imploding. The chart below shows the example of the US. It has been able to materially increase its debt-to-GDP levels, which have accelerated since the Global Financial Crisis (GFC), while simultaneously reducing the cost of this debt using QE, forcing interest rates to all-time lows.
One of the key principles of financial repression is to keep interest rates below the level of inflation to get nominal GDP to rise faster than debt, so as to inflate that debt away over the long term. The world has been unable to achieve this in recent times, given the explosive growth in debt levels relative to both drivers of nominal GDP (low real GDP and inflation). The historic example often cited of successful financial repression was how the US reduced its very high debt-to-GDP levels after the Great Depression and Second World War by keeping real (after inflation) interest rates for government bonds below 1% for two-thirds of the time from 1945 to 1980. Since the pandemic has pushed debt levels in most countries to new record levels, it is unlikely that the widespread policies of record low interest rates can end any time soon.
Central banks broaden their policy scope
Apart from the more co-ordinated fiscal policy funding mentioned above, a couple of other important policy decisions were made by the world’s most important central bank, the US Federal Reserve (Fed), in 2020. The first was at the height of the initial lockdown market stress, when the Fed engineered a way to gain authority to directly buy corporate bonds, including high yield ETFs. This was viewed by many long-term Fed observers as illegal under the Federal Reserve Act, however we should never underestimate the desire for new policies to be embraced in times of crisis.
The pandemic certainly opened the door for the Fed to take much broader control of bond yields, moving away from its historic focus on US Treasury securities and into the world of capping corporate financing rates. This was also the most obvious next step for it to take, since it had taken the financial repression playbook to its historic limits, with policy rates back at the zero level and government bond yields deep into negative real territory.
In many ways the US is trailing other central banks’ evolution since the GFC. Examples of this include two central banks older than the Fed.
Other than almost monopolising its entire domestic bond market, the Bank of Japan (BOJ) has been buying Japanese-focused equity ETFs since 2013. A central bank official informed a parliamentary session earlier in 2020 that the BOJ held 77.5% of Japan’s equity ETF market (23 trillion yen’s worth)! While this is less than 10% of total listed Japanese equities, it obviously brings into question why a central bank should have a stated annual policy target to buy six trillion yen of local equities, regardless of market or economic conditions.
The other example is the Swiss National Bank, which now owns over $100 billion of US listed equities, part of its official policy target of a 20% allocation to global equities.
The other new policy decision made by the Fed was announced at the annual Jackson Hole symposium in August. After an in-depth review of its main goals, the Fed decided to move to an average inflation targeting policy (rather than a specific target of 2%), which means it will allow inflation to run “moderately” above the Fed’s 2% goal “for some time”, following periods when it has run below that objective.
While this may appear to be semantics, it is an important signal from the Fed to the market that it will tolerate higher inflation in future, implying that it will not raise rates as early as it has done in prior cycles. Given that its favoured measure of inflation, core personal consumption expenditure (PCE), has averaged marginally above 1.5% since 2009, the Fed’s idea is that, by removing the previous 2% inflation cap, it can stoke higher future inflation expectations in the US.
In the age of financial repression, this is an important change as it means the bond market is less likely to price in interest rate increases if inflation does start to rise. One of the associated implications of financial repression is pushing savers out of lower-risk fixed income assets yielding negative real returns into higher-risk, longer-duration assets, including equities.
Former Fed Chair, Ben Bernanke, was a strong advocate of this link to the wealth effect, where higher equity prices in turn increase consumer confidence, which in turn increases consumer spending and hence real GDP growth. Consequently, if the Fed’s policy change ensures the bond market accepts higher inflation for longer than it has historically, it will provide a tailwind to the equity bull market.
The other obvious way for the Fed to cap the risk of rising bond yields is to carry out further QE across the bond duration curve, now being referred to as “yield curve control,” which is a likely future policy tool if bond yields rise above inflation again.
Outside intervention in markets is not always a good thing
With perfect hindsight, we now know that the fastest 30%+ drop in equities in Q1 2020 was swiftly followed by the fastest 50%+ rebound in history, mostly thanks to the new co-ordinated actions of central banks and governments described above. The obvious question is then: what is so wrong with policies that keep a lid on interest rates and fuel bull markets in risk assets? The risk with this co-ordinated policy mix of monetary policy directly funding fiscal policy, while potentially capping bond yields, is two-fold.
Firstly, if bond market yields do not rise to reflect the increased level of deficits and debt to fund the new fiscal stimulus, then governments will take it as a signal to fund all kinds of populist agendas that were previously seen as dangerous to countries’ long-term financial health. This in turn leads to a second risk: that if the excess money supply that is directly put into the hands of citizens is mostly spent in the economy, we could finally release the inflation genie as happened in the 1970s, shortly after the US officially moved the world’s main reserve currency, the US dollar, off the gold standard.
One of the main reasons inflation has not picked up materially since the seemingly endless money printing started post the GFC is that the traditional banking system transfer mechanism has not functioned as intended by the Fed for various reasons. This meant that new QE-fuelled money supply never found its way into the hands of citizens en masse, as has potentially just started in 2020 with these new co-ordinated policies. Instead, most of this newly-printed money put into the banking system by the Fed has found its way into risk assets. This explains the high correlation between changes in central bank balance sheets and rapidly rising risk asset prices (per chart below).
This raises another important market-related consequence of QE: the historic diversification benefits of holding bonds as a hedge against the risk of equity drawdowns.
During the equity bear markets that occurred after global bond yields peaked in 1981, one of the few liquid hedges available was government bonds, which are usually seen as the ultimate (developed market) risk-free asset and therefore attract flows when there is panic and/or general negativity in risk-asset markets. This attraction has meant that allocating money to bonds has been a prudent allocation over long periods of time, simply because they act as a hedge to equity downside risk, where timing is very difficult to predict.
However, the risk with using bonds as a hedge in developed markets has been rising the longer this almost 40-year bond bull market has gone on. The reason is that the lower the starting yield, the harder it becomes to generate real returns from bonds. When central banks in all the large developed markets have reduced interest rates to zero and in some cases below zero, you have to rely on bond investors being happy to take yields deeper into negative territory to generate any hedge-like qualities seen during prior equity bear markets.
So even though bond yields came down (bond prices went up) during the initial pandemic uncertainty of Q1, given how low (expensive) the starting point was, they did not provide the hedge-like cover of previous cycles. As shown in the chart below, during the prior two recession-related equity bear markets, global bonds outperformed equities materially over a one- to three-year period.
During 2020’s bear market, the outperformance of bonds was only for a few short months and the magnitude of diversification benefit was clearly substantially lower than in the prior two cycles, where starting bond yields were materially higher than now in the age of financial repression.
From a local perspective, we are in the globally enviable position of having high nominal and real bond yields. While they are high for negative reasons – SA’s historically high inflation and currently weakening fiscal position – it should be remembered that, unlike developed market government bonds, emerging market government bonds are often seen as risky assets by global investors and therefore initially sold during risk-off periods.
The chart below of SA bonds vs. SA equities shows a similar pattern to the global one above, but it conceals what happened over a very short period in Q1 2020. Local bonds did indeed outperform local equities during the March sell-off, because they fell less than equities, rather than gained in price.
Consequently, in both global and local markets, government bonds did not provide the diversification benefit nor anywhere near the same level of outperformance they delivered during the prior two equity bear markets. In our view, this is a direct consequence of financial repression. Given that yields are now even lower than pre-pandemic levels, looking forward there is a higher risk that bonds will provide even less diversification benefit during the next equity drawdown.
Gold as a diversifier
History shows us that no matter how much money is printed, or interest rates are cut, investors always need to think about ways to diversify and therefore protect themselves against future risk asset drawdowns. As described above, this has become even more important when bonds are potentially not the portfolio hedge they have been historically. While co-ordinated policies can provide a strong tailwind for a risk-on environment, adding ever-increasing amounts of debt into the global financial system will make it inherently more fragile and more vulnerable to ever-smaller shocks in future.
This brings us to one of the other well-known, yet often much-maligned traditional hedges: gold. It is seen by many as a poor investment because it does not generate any cash flows. Yet the reality is that gold can act as both a hedge against uncertainty, and an alternative to endless fiat currency debasement in the age of financial repression.
While this may appear to be a bold statement, consider the depreciation in the value of the world’s main reserve currency in relation to gold since the US abandoned the gold standard in 1971. Relative to how much gold each dollar can buy, it has lost over 98% of its purchasing power (per chart below)! This has mostly been caused by the endless new supply of dollars created by the Fed, relative to the finite number of gold ounces that can ever be mined.
In trying to answer the question whether gold can act as a hedge during equity drawdowns, it is instructive to start with the latest and most violent 30%+ equity drawdown in history which occurred in March 2020.
The charts below show that although gold did not move up aggressively during the equity drawdown, it outperformed US equities by 46% during the very rapid drawdown period. Doing the same exercise for the four US equity bear markets prior to 2020 produced the following relative returns of gold over the S&P500 Total Return Index (from peak to trough equity drawdown):
- 1987: +63%
- 1990: +32%
- 2000-2002: +113%
- 2007-2009: +179%
The other way to think about gold as a hedge is to compare the performance of gold with equities over a reasonable timeframe. From a local investor’s perspective, the chart below compares the rolling 12-month performance of gold in rand terms against the FTSE/JSE All Share Total Return Index (since the GFC when QE policies started). It clearly shows that, when equities are struggling with negative returns, gold has mostly had high positive returns.
In the most recent risk-off period, the chart below shows that when both local equities and bonds fell materially during March 2020’s market panic, gold (in rand terms) moved up materially over the same period. This was a combination of a relatively stable US dollar gold price shown above and a weaker rand, which is usually how emerging market currencies behave in times of unpredictable risk-off global events.
If we consider periods historically similar to March 2020, i.e. periods of increased market volatility when the rand weakened and the US dollar gold price strengthened, we find very high hit rates for gold in rand terms outperforming other liquid domestic asset classes (depicted in the chart below).
Gold in the age of financial repression
As illustrated, historically gold has performed well as a diversifier for the risk of equity drawdowns, but during this age of financial repression it is also critical that investors are protected against the implications of negative real interest rates. This arises both because of ultra-low policy rates and the risk of inflation making a long-awaited comeback if the US continues to bypass the traditional banking system to stimulate company and household spending directly.
As shown in the chart below, gold has had two distinct bull market periods, both of which coincided with a predominantly negative real Fed Funds Rate environment. This makes intuitive sense both from the perspective of the lower opportunity cost of owning gold and as a hedge against fiat money debasement. Although interest rates in the 1970s were materially higher than today (7.2% average Fed Funds Rate), there was also a much higher inflation range (above 14% at its peak), which meant most of the decade exhibited negative real interest rates.
When the US came off the gold standard in 1971, this initially led to a material increase in money supply growth, which in turn led to inflationary spikes (see chart below) that infamously forced the Fed Chair at the time, Paul Volcker, who was only appointed in 1979, to raise the Fed Funds Rate aggressively to a previously inconceivable 20% to get runaway inflation under control again.
Since the GFC, however, despite ample money supply growth brought on by various iterations of QE, high inflation has not been a problem. Modern day negative real rates are more a consequence of central bankers taking policy rates down to zero or below zero in some countries.
As mentioned above, the traditional banking transfer mechanism for money supply growth to get into the economy has not been functioning as intended. However, the co-ordinated policy shift that we are now seeing has the potential to change this recent benign historic inflationary outcome in future years, given that this effectively bypasses the banking system and puts the newly-printed money directly into the hands of companies and households. As the chart above shows, 2020’s co-ordinated policy response has pushed money supply growth to new all-time high levels, thereby increasing the risk that higher inflation may finally return.
From a gold perspective, it is important to keep in mind that there is a high correlation between its price performance and that of real bond yields. As the chart below shows, since the GFC, gold has tended to do better as real bond yields decline and especially when they move into negative territory. Given that the Fed will have to keep a cap on bond yields to ensure that financial repression works and debt service costs do not become unaffordable, any rise in inflation will re-assert the trend of real bond yields moving back into deeper negative territory and acting as a tailwind for the gold price.
It is difficult to see the world moving out of this negative real interest rate environment for years to come, given the extent of the excess debt levels globally. While recent history implies that it is highly unlikely to solve the debt problem on its own, it appears to have been generally accepted as one of the primary central bank policy tools in attempting to solve the global over-indebtedness problem.
US dollar risk skewed to the downside
The excess debt conundrum for central banks raises questions about the outlook for currencies, as policy experimentation ramps up the longer financial repression persists.
The co-ordinated policy response of 2020 has increased the risk of a US dollar bear market over the next few years. This is linked partly to the belief that the US’s twin deficits are likely to remain much wider for longer than its major trading partners. The lingering deficits largely reflect the high level of US inequality that has worsened further during the pandemic, driven by higher youth and low-end unemployment levels. This implies that the new fiscal stimulus policies funded by the monetary policy tools of the Fed will probably raise headwinds against the US dollar in the years to come. The Fed’s new average inflation targeting policy could exacerbate the trend, as it implies that the Fed will delay increasing interest rates when inflation rises, at least compared with historical precedent. On a long-term purchasing power parity basis, the US dollar is also overvalued against most currencies following its strong outperformance since the GFC.
Risk assets (outside the US) tend to perform better during weakening US dollar environments. This is also important from a gold perspective, because since moving off the gold standard in 1971, the dollar and gold tend to have a strong negative correlation (see chart below), therefore a US dollar bear market would provide another tailwind for gold in future. A weaker US dollar also tends to be positive for rising commodity prices in general, which adds fuel to any rising, excess money supply-driven inflationary pressures.
2020 has again reminded us why it is so difficult to make bold predictions with conviction and sit comfortably with long-term strategic asset allocation decisions. It was not only difficult to predict the surprise of a 100-year pandemic which rapidly impacted the whole world, but also the market’s reaction to the swift central bank and government interventions.
Given this new reality of potential co-ordinated monetary and fiscal policy, it has become even more important for investors to consider what this means for their portfolios and actively shift tactical asset allocation positions as the world progresses out of this crisis.
Looking forward, given the level of interest rates globally, government bonds are unlikely to give investors the same protection they have provided in prior years when interest rates were materially higher. This contrasts strongly with a hard asset like gold, which has proven to be a decent hedge against both equity drawdown risk and central banks pushing interest rates negative in real terms and printing seemingly endless amounts of new fiat money.
It is difficult to justify having an equivalent allocation to gold that was historically made to fixed income because of the higher inherent downside risk and because, as South African-based investors, we are aided by very high real bond yields. However, in the current age of financial repression, it remains prudent as part of a multi-asset solution to consider an allocation to gold (in rand terms).