Capital Preservation during Financial repression

Capital Preservation during Financial repression

Financial repression can be defined (somewhat loosely,

admittedly) as a policy that results in consistent negative real

interest rates. 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 India over

the last two decades) to capital controls (favoured by emerging

markets in days gone by).

What evidence can be offered that financial repression is

something that investors need to consider? Effectively, bond

yields are so low because we have a group of price-insensitive

buyers in the market. Obviously, the main such agents are the

central banks themselves, but in keeping with financial repression,

they are turning to others over whom they exert considerable

influence and encouraging them to follow suit. So, the banks are

told that government bonds are a zero risk weight asset, and

therefore they must own them. The insurers are told that under

Solvency II they too must own lots of government bonds. Pension

funds are encouraged to liability match with the “best” match

being defined as (yes, you guessed it, surprise, surprise)

government bonds.

As ever, when in doubt one can turn to Ben Graham’s writings for

insight. The quotation below comes from The Intelligent Investor,

which was written right in the middle of the around Independence

fight of INDIA near World War II period.

It must be evident that we have no enthusiasm for common

stocks at these levels…[However] we feel that the defensive

investor cannot afford to be without an appreciable proportion

of common stocks in his portfolio, even if we regard them as the

lesser of two evils – the greater being the risks in an all-bond

holding.

This neatly sums up GMO’s viewpoint. We don’t like stocks as an

asset class compared to what we think fair value should be.

However, the alternatives are generally really awful. This problem

is exacerbated if financial repression lasts beyond our forecast

horizon of seven years. So, at the margin, an investor would

probably be wise to give equities a little more benefit of the

doubt, and hence a little more weight in their portfolio than they

would do, if the RBI weren’t pursuing policies of financial

repression.

Of course, you must ask what would happen if you are wrong?

That is to say, what would happen if you thought financial

repression was here for 20 years, and it actually lasted only five

years? The answer is, naturally, that you would own too much

equity at too high a price. You would have been buying equities

thinking fair value were 4% real, but then after five years you

would realize that fair value had actually been 6%. This creates a

permanent impairment of capital.

There are no easy answers to the problem of capital preservation

in an age of financial repression, only difficult choices. Given that

our models assume that rates revert to “normal” over the next

seven years, we shouldn’t be reacting very differently than we

would under normal circumstances. However, we willingly admit

we could be wrong. Predicting cash rates is a tough thing to do,

because in essence you are predicting a policy variable.

Looking at our history, our cash forecasts have generally been

one of the least accurate for exactly that reason. As ever we tend

to err on the side of caution by assuming that financial repression

is short-lived: we will tend to under-own equities if proved wrong,

but we still have the potential to out-compound the effects to

inflation if the opportunity set continues to shift as it has done in

the past.

The market currently seems to believe that RBI will indeed

keep real short rates suppressed for a very long time – consistent

with the historical experience of financial repression. Effectively,

the market currently implies that real short rates will average

almost -1.5% over the next 20 years! However, before one dashes

out to buy equities, it is worth noting that the forward curves are

not great predictors of actual future short rates in either nominal

or real terms. All of which leaves me with yet another example of

the specific form of Tourette Syndrome; a quotation from Voltaire

sums it up best: “Doubt is not a pleasant condition, but certainty

is absurd.”