The stability of the financial system

Time and risk

The financial world is about two interrelated things: time and risk. The moment a pension fund has an obligation over thirty years and there is no longer a bond than one with a ten-year maturity, that can theoretically be offset by a larger position in a ten-year loan. Suppose the yield on that loan was originally 5 percent and drops to zero percent. The duration (the weighted average life of the distributions) of a 30-year loan then increases from 15.4 years to 30 years, while that of a 10-year loan increases from 7.7 years to 10 years. Whereas previously two 10-year loans were sufficient to cover the risk of a 30-year bond, the fall in interest rates increases that to three 10-year loans. The fall in interest rates alone, therefore, means that more bonds have to be bought, creating a self-perpetuating downward spiral in which ‘safe’ government bonds become more and more expensive, with the result that savers and bond investors are deprived of all returns. 

Interest rates are too low

This drop-in interest rates to zero is the result of central banks keeping interest rates much lower than they need to be. In the ideal situation, the interest rate is more or less equal to the nominal growth rate of the economy. Those who can make just a little more return than the average (the nominal growth rate) can pay the interest on the debt. Such a situation automatically creates innovation. Old and uncompetitive companies lose out to new, innovative, and more profitable companies, if only because those old companies can no longer pay the interest. In the case of governments that are over-indebted, an ever-increasing portion of the budget goes to interest payments, eventually leading them into a debt trap. The job of the central bank is to keep interest rates in line with the nominal growth rate of the economy. There are periods when this has worked wonderfully, such as from the early 1980s to the beginning of this century. This ensures economic growth, falling unemployment and is also good for financial markets. This century, in particular, interest rates are much lower than the nominal growth rate. Borrowing money is interesting because the rate of return (the nominal growth rate) is much higher. More and more borrowing is done to buy existing assets and less and less to invest in innovation. The side effect is that existing poorly performing companies do not go bust thanks to the excessively low-interest rates, and therefore impede innovation by new competitors. This development is crippling for economic growth, but financial markets are decoupling themselves from the real economy through constantly rising valuations due to cheap credit. 

Monetary madness post-Corona

Post-Corona is a new world. In large parts of the developed world (United States, United Kingdom, and the Eurozone), the government dictates how much money is created. This flows into the real economy thanks to government guarantees. This form of blanket credit has minimized the chance of things going wrong somewhere because a company is over-financed. There is no longer any link between the amount of money and the growth of the economy. The creation of money has been nationalized, central banks are de facto part of the ministries of finance. It is not the private sector that determines how much money is needed, from now on the government determines it. Governments have a lot of debt, but it is easy to carry thanks to low-interest rates. Unfortunately, governments have an unlimited need for money, which may result in an unlimited growth of the money supply. The result is lower economic growth, higher prices, and a lower standard of living. The moment there is too much money in an economy, it is important to distinguish between real assets (stocks, commodities, real estate) and contracts (loans, bonds, savings accounts). Real assets are by definition limited and therefore retain their value. Contracts are infinite, as paper is patient. Savers are punished, but unprofitable companies are allowed to continue to exist and therefore put pressure on the returns of healthy companies. This stands in the way of innovation and productivity, which would ultimately benefit everyone. 

Consequences for investors

In this situation, it is important for central bankers and governments that the value of financial assets remains the same or rises, only then the debts that are covered by these financial assets are sustainable. The central bank’s put option is stronger than ever. Ultimately the assets with the longest duration benefit from this, and that is equities, especially growth stocks. After all, the value of a stock is determined by the present value of its future cash flows, and with low or even negative interest rates, cash flows in the distant future have become increasingly important. This new post-Corona monetary system has only just begun, with the risk of blowing bubbles again. If we draw a parallel with historical bubbles, we are only halfway there. This bull market does not stop until the economy goes into recession or stocks have become more expensive than bonds. A recession is unlikely because of the coming Keynesian investment wave, and the risk premium on equities is at about the highest point of this century. Inflation is rising, but in the long run, companies are perfectly capable of passing on that inflation, while for savers and bond investors inflation is the biggest enemy. Because of these developments, especially because of the accumulated debt, many fear a new systemic crisis. The likelihood of that is not so great. Any country with its own currency can and will always pay off its debts in full; the big question is only what the value of that repayment still is at that time. So the big outlet for this financial problem is through the value development of the currency. Now, the aforementioned Western central banks seem to be caught in a race to the bottom in this regard. The solution probably has to come from Asia, through a revaluation of the Chinese renminbi. Hedging the currency risk to a currency where monetary madness has struck is then unwise. For those who want to escape this wealth trap, a well-diversified equity portfolio is the best alternative.