“Hold no bonds”.
Given investors still often think in terms of the traditional 60:40 equities to bonds split, that is pretty striking advice. It came from institutional investor advisor and financial historian Russell Napier, who I spoke to this week about financial repression and what to do about it.
Financial repression is when government pushes private sector capital to hold its bonds through legislation or incentives, with public debt inflated away as yields are kept down. Money is directed towards state concerns at artificially low rates.
With interest rates lower than inflation, this represents a tax on savers and bondholders. Or, as Napier puts it, “stealing money from old people slowly”.
Financial repression has a long history. Economists Carmen Reinhart and Maria Belen Sbrancia have estimated that the UK and US cut public debt by an average of 2 to 3 per cent of GDP a year through financial repression (via negative real interest rates) between 1945 and 1980.
Governments have used various methods of financial repression to reduce the real cost of their debt piles while pulling levers to make bonds more attractive. Think of regulations pushing domestic banks and pension funds to hold piles of national debt, taxes on shares, restrictions on cross-border capital flows, bank interest rate limits and controls on gold ownership.
At a time of rising public global debt (the Congressional Budget Office expects US public debt to hit a record 120 per cent of GDP by 2036 and the situation is much worse if private debts are added on top), financial repression is an attractive option for governments. Economic growth is too weak to come to the rescue and politicians would rather avoid the difficulties of slashing spending.
In the UK, banks have been pushed by regulators since the 2008 financial crisis to hold apparently “high-quality” government debt. That is financial repression in a nutshell.
It’s a reality that warrants closer attention, especially in a context where investors are used to regular central bank interventions in the bond market, which has implications for how reliable expectations are for interest rates.
Current examples of financial repression abound, as capital is directed to government priorities.
In the UK, the mandation of pension assets is getting closer as the Pension Schemes Bill nears legislative completion. This would give the government the ability to direct up to 10 per cent of master trust defined contribution (DC) pension investments into UK and private markets. That will not automatically mean better returns, especially when decisions are being made in terms of hard investment limits.
Lloyds Banking Group (LLOY) chief executive Charlie Nunn told the FT last year that the UK’s mandation plans are a “form of capital control” like “in China and many [other] jurisdictions”.
Over in Germany, more than 100 companies have signed up to pledge €735bn (£640bn) of investments by 2028 through the “Made for Germany” initiative launched last summer.
Through capex and R&D spending, big players like Siemens (DE:SIE) and Deutsche Bank (DE:DBK) have stated their opposition to the outflow of German capital: “we are committed to Germany; we are not withdrawing capital but actively investing and shaping the country’s future”.
Napier called the scheme “an incredible thing with profound long term impacts for the whole of the EU and not good ones”. It could have major implications for European bond markets, in his view.
Across the Atlantic, the US administration is busy taking stakes in rare earth miners and forcing companies like Apple (US:AAPL) to invest domestically, displaying the solid link between national capitalism and financial repression. Meanwhile, JPMorgan (US:JPM) is directly investing billions of dollars in companies “essential for our national security” through its Security and Resiliency Initiative.
Amid concerns about the US dollar’s loss of ‘safe haven’ status, foreign central banks have reduced US Treasuries holdings. Henry Paulson, former US treasury secretary, called this week for an “emergency break-the-glass plan” to address a potential crisis in the US public debt market.
There are, of course, two sides to the financial repression story. These policies may be bad for savers and bondholders, but on the other side of the equation sit debtors and blue-collar workers.
But this all begs the question: for investors worried about financial repression, what should they actually do? As well as getting completely out of bonds (or holding as few as possible), Napier is reticent about pension and life funds. He pointed to value stocks, gold and cash as means of fighting back against financial repression, with equities exposure to the companies that could gain from the capex of national capitalism drives (the Investors’ Chronicle cover feature this week looks at how to gain from the state race for resource supremacy).
This is, clearly, a risky and niche approach. That doesn’t mean it is necessarily wrong. Napier, founder of Edinburgh’s Library of Mistakes (which aims to explore how “professionals and the investing public can avoid the mistakes of the past”), takes the long view.