Tuesday, September 18, 2012

Rothschild Wealth Management: "Investing in an era of financial repression"

Following up on:
Rabobank on Financial Repression and What Bernanke is Up To
Crestmont Research on Inflation, P/E's and Market Returns
Markets Appear to Expect 5% Inflation and IMF: "Inflation Hedging for Long-Term Investors"

As a very sharp (and deranged) analyst said to me when looking at the Philip Morris chart sometime in the late nineties: "A pattern appears to be emerging"*

From Rothschild Wealth Management & Trust:.
Heavily-indebted governments have a clear incentive to depress interest rates and lock-in demand for their bonds. This financial repression has major implications for the economic outlook and future investment returns.

Excessive debt continues to dominate the investment landscape. Since the financial crisis struck in 2007, private debt has been reduced slightly in the advanced economies after thirty years of excess, but remains very high as a percentage of national income. Government debt continues to grow across the developed world, in many cases to dangerously high levels (see figure 1).

For investors, recognising the scale of the debt problem is important, because of its implications for government and central bank policies, particularly the incentives it creates for financial repression.

In the pages below, we set out what we mean by financial repression, what it looks like today, and why we expect it to continue for at least several years. We then assess the economic and investment implications, outlining how we are positioning ourselves to achieve positive real returns.

A broad policy approach
The term financial repression was first coined in the 1970s and applied to developing economies that, at the time, hadn’t embraced economic liberalisation. Over the past 18 months, the concept has been resurrected, with economists such as Carmen Reinhart, Maria Belen Sbrancia and Jacob Kirkegaard re-examining government policies in previous periods of high public debt.

In our usage, financial repression describes a situation where interest rates are kept artificially depressed. This works through governments intervening directly in the market for public debt, and via the knock-on effects of their actions on the monetary authorities. It takes a wide range of forms, including central banks directly buying government bonds (which pushes yields and borrowing costs lower), restrictions on cross-border capital flows (to create a captive home market for bonds), new regulations for banks and insurance companies (to raise the amount of government debt they own) and interference in the management of pension funds’ assets. More extreme forms of financial repression have included punitive taxes on buying and selling securities, the nationalisation of banks and bans on the private ownership of gold.

Financial repression works best when combined with modestly elevated rates of inflation that persist for a number of years. This means headline inflation rates around 1% to 3% above official targets (inflation rates much higher than this tend to be very disruptive to economic and financial activity). Higher inflation makes interest rates negative in real terms, favouring debtors at the expense of creditors: while the nominal stock or face value of outstanding debt may be unchanged, its real value (i.e. its actual purchasing power) is steadily eroded. This liquidation effect can be quite substantial over time and acts as a tax levied on holders of domestic debt....

...The investment implications
In this environment, many investors will need to fundamentally rethink their investment strategies if they are to achieve returns that, at the very least, keep pace with inflation and preserve their purchasing power.

In our view, most traditional ‘low risk’ portfolios – those that are heavily invested in cash and bonds – will produce poor and often negative real returns over the next five years. For example, government bonds issued by countries such as the US, Germany and the UK typically form the backbone of conservative portfolios. Yet these securities no longer offer enough of a premium above cash rates to compensate for the associated risks, even if financial repression succeeds in keeping yields depressed.

What can be done? As a first step, investors need to be prepared to embrace riskier assets, and to tolerate more short-term fluctuations in the value of their portfolios than they would have done before the financial crisis. For conservative investors, more volatility is the price that has to be paid for maintaining positive real returns....MUCH MORE (15 page PDF)
Here's the 42-year chart for MO:
Chart forAltria Group Inc. (MO)

Splits: Jun 3, 1974 [2:1], Jun 1, 1979 [2:1], Apr 11, 1986 [2:1], Oct 11, 1989 [4:1], Apr 11, 1997 [3:1]

The move is approximately a split adjusted 2 cents to today's $33.32