The unprecedented gyrations in the world’s stock markets suggest there are problems afoot with the global economy. Investors are worried that growth is slowing and they are unsure about where they should be placing their money.
In times of uncertainty, professional money usually retreats to the perceived safety of the US bond market. This flight of capital increases the demands for bonds and as they bid prices up, the effective interest rate received goes down. Hence we now see yields under 2% for ten year investments.
Frankly, I see this play as among the riskiest for any investor. Here’s why.
The US government has flagged that it will start to increase interest rates later this year. It actually has little choice as so many of their pension and municipal funds are reliant on interest income to meet their liabilities. These funds have been slowly going broke under the zero interest rate policy of the past six years.
As interest rates rise, the value of bonds declines and those holding them will face a significant capital loss if they need to sell. If they don’t sell, their interest rate return will be significantly less than what is obtainable elsewhere.
Poor returns and/or capital losses aren't the key to investment success!
As interest rates rise, emerging nations who have borrowed money in US dollars will face increased repayment hurdles. Even the United States itself will have to pay more for the annual deficit funding. This will require a larger allocation of tax revenue to debt servicing, leading to the hunt for greater revenue (taxes), and so the cycle continues. A catch-22 if you will.
At some stage soon we will also see what has been referred to as a ‘crisis of government’. Investors will realise there is no hope of governments around the world actually honouring their liabilities (pensions, debts etc), that the quest for taxes is out of control and that the entire system has become unsustainable.
As this dawns, investors will seek the safety of private assets (stocks, property, commodities) investments that are removed from government obligations. Eventually, the value of these assets will soar as the value of government declines.
It’s not a pretty scenario but we are literally facing an unprecedented circumstance where the level of debt, high levels of welfare and artificially low interest rate policy has created the ‘perfect economic storm’.
History has demonstrated that as economies flounder, there is a change to the political paradigm. The populace starts to reject the status quo and searches for a different way. Perhaps the popularity of Donald Trump as the possible US republican presidential candidate reflects that sentiment.
I have no idea if Trump will win the nomination, but I do believe that he is indicative of what is to come. A change in politics as usual will ultimately be driven by a change in economics. It’s now up to all of us to be prepared for both of those changes.