James Montier, the investment strategist at GMO, published a long piece on financial repression in Advisor Perspectives in November 2012. It’s taken me almost that long to read it—and I’m still not sure I completely understand its implications. Financial repression itself is pretty easy to understand though. Along with a humorous description of Fed policy, Montier describes it like this:
Put another way, QE sets the short-term rate to zero, and then tries to persuade everyone to spend rather than save by driving down the rates of return on all other assets (by direct purchase and indirect effects) towards zero, until there is nothing left to hold savings in. Essentially, Bernanke’s first commandment to investors goes something like this: Go forth and speculate. I don’t care what you do as long as you do something irresponsible.
Not all of Bernanke’s predecessors would have necessarily shared his enthusiasm for recklessness. William McChesney Martin was the longest-serving Federal Reserve Governor of all time. He seriously considered training as a Presbyterian minister before deciding that his vocation lay elsewhere, a trait that earned him the beautifully oxymoronic moniker of “the happy puritan.” He is probably most famous for his observation that the central bank’s role was to “take away the punch bowl just when the party is getting started.” In contrast, Bernanke’s Fed is acting like teenage boys on prom night: spiking the punch, handing out free drinks, hoping to get lucky, and encouraging everyone to view the market through beer goggles.
So why is the Fed pursuing this policy? The answer, I think, is that the Fed is worried about the “initial condition” or starting point (if you prefer) of the economy, a position of over-indebtedness. When one starts from this position there are really only four ways out:
i. Growth is obviously the most “popular” but hardest route.
ii. Austerity is pretty much doomed to failure as it tends to lead to falling tax revenues, wider deficits, and public unrest. 2
iii. Abrogation runs the spectrum from default (entirely at the borrower’s discretion) to restructuring (a combination of borrower and lender) right out to the oft-forgotten forgiveness (entirely at the lender’s discretion).
iv. Inflation erodes the real value of the debt and transfers wealth from savers to borrowers. Inflating away debt can be delivered by two different routes: (a) sudden bursts of inflation, which catch participants off guard, or (b) financial repression.
Financial repression can be defined (somewhat loosely, admittedly) as a policy that results in consistent negative real interest rates. Keynes poetically called this the “euthanasia of the rentier.”3 The tools available to engineer this outcome are many and varied, ranging from explicit (or implicit) caps on interest rates to directed lending to the government by captive domestic audiences (think the postal saving system in Japan over the last two decades) to capital controls (favoured by emerging markets in days gone by).
The effects of financial repression are easy to see: very low yields in debt instruments, and the consequent temptation to reach for yield elsewhere. Advisors see the effects in clients every day.
If you are feeling jovial, I highly recommend reading Montier’s whole piece as an antidote to your good mood. His forecast is rather bleak—poor long-term returns in most all asset classes for a long period of time. My take-away was a little different.
Let’s assume for a moment that Montier is correct and long-term (they use seven years) equity real returns are approximately equivalent to zero. In fact, that’s pretty much exactly what we’ve seen during the last decade! The broad market has made very little progress since 1998, a period going on 15 years now. Buy-and-hold (we prefer the terminology “sit-and-take-it”) clearly didn’t work in that environment, but tactical asset allocation certainly did. Using relative strength to drive the process, tactical asset allocation steered you toward asset classes, sectors, and individual securities that were strong (for however long) and then pushed you out of them when they became weak.
I have no idea whether Montier’s forecast will pan out or not, but if it does, tactical asset allocation might end up being one of the few ways to survive. There’s almost always enough fluctuation around the trend—even if the trend is flat—to get a little traction with tactical asset allocation.
Source: Monty Python/Youtube
[In fact, might I suggest the Arrow DWA Balanced Fund and the Arrow DWA Tactical Fund as considerations? You can find more information at www.arrowfunds.com.]
