This is a summary of an article by Senior Portfolio Manager, Warren Buhai. We would highly recommend reading the full article on STANLIB.com, by clicking here.

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.

Financial repression

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 and interest rates have fallen, thanks largely to quantitative easing. Increasing levels of debt have been accompanied by declining levels of real GDP growth.

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.

Developments in 2020

A couple of important policy decisions were made by the world’s most important central bank, the US Federal Reserve (Fed), in 2020:

• It engineered a way to gain authority to directly buy corporate bonds, including high yield ETFs.
• It 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 its previous goal of 2% “for some time”, following periods when it has run below that objective.

The Fed is signalling 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.

Implications

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.

Higher equity prices increase consumer confidence, which in turn increases consumer spending and hence real GDP growth. If the Fed’s policy change ensures the bond market accepts higher inflation for longer than it has historically, it will provide a tailwind for the equity bull market.

Outside intervention in markets is not always a good thing

There are two problems with policies that keep a lid on interest rates and fuel bull markets in risk assets:

• 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 leads to a second risk: 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.

One of the main reasons inflation has not picked up materially since the seemingly endless money printing started after the Global Financial Crisis of 2007/8 is 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 found its way into risk assets.

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. Government bonds 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 was prudent over long periods of time, because they act as a hedge to equity downside risk, where timing is very difficult to predict.

However, the lower the starting yield, the harder it becomes to generate real returns from bonds.

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, when starting bond yields were materially higher than in the current age of financial repression.

Looking forward, there is a higher risk that bonds will provide even less diversification benefit during the next equity drawdown.

Gold as a diversifier

This brings us to one of the other well-known, yet often much-maligned traditional hedges: gold. It can act as both a hedge against uncertainty, and as an alternative to endless fiat currency debasement in the age of financial repression.

Although gold did not move up aggressively during the latest equity drawdown in March 2020, it outperformed US equities by 46% in that period. At the same time it also rose, in rand terms, when both local equities and bonds fell materially. The same is true for previous periods that were similar to March 2020.

Gold in the age of financial repression

During this age of financial repression it is also critical that investors are protected against the implications of negative real interest rates. Gold has had two distinct bull market periods, 1970-1980 and 2002-2020, both of which coincided with a predominantly negative real Fed Funds Rate environment.

Since the GFC, despite ample money supply growth brought on by various iterations of QE, high inflation has not been a problem. However, the co-ordinated policy shift that we are now seeing could change that, since it effectively bypasses the banking system and puts newly-printed money directly into the hands of companies and households.

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. Since 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.

US dollar risk skewed to the downside

The excess debt conundrum for central banks raises questions about the outlook for currencies

The co-ordinated policy response of 2020 has increased the risk of a US dollar bear market over the next few years:

• It implies that the US’s twin deficits are likely to remain much wider for longer than its major trading partners.
• On a long-term purchasing power parity basis, the US dollar is 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, which is important for gold and commodity prices in general.

Concluding thoughts

Looking forward, given the level of interest rates globally, government bonds are unlikely to give investors the same protection as 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. 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).