In September, 2019, I put out an article titled “The Monetary Death Spiral” attempting to explain why interest rates, inflation, productivity, and economic growth have been sliding downward over the past 35 years.
To understand the theory, one must first understand the two competing theories of what causes economic growth. The standard theory, to which most economists adhere in one form or another, emphasizes the demand side of the economy. Since consumer spending makes up ~70% of GDP, economic growth can be generated by policies that boost aggregate demand.
Higher consumer spending > higher business profits > more investment > more productivity > higher wages > more consumer spending > a growing economy
It’s a simple and intuitive process. The alternative view, which I believe comes closer to reality, may seem only slightly different on the surface but has profoundly different implications. It emphasizes the supply side of the economy: private savings, investment, and capital formation.
Higher savings > increased investment > more capital formation > higher productivity > higher wages > more consumer spending > even more investment > even more capital formation > a growing economy
It’s almost the same flow of events, but a lot changes depending on where one begins. What sets the process in motion? If it’s more consumer spending, then it won’t matter if private savings are sacrificed in the short term in order to get the process going. But if private savings initiates the progression of economic growth, then sacrificing it for spending will throw a wrench in the cogs and prevent the growth sequence from functioning properly.
The Monetary Death Spiral (or “MDS”) is what happens when government policies continuously and unsuccessfully try to initiate economic growth by boosting aggregate demand, even when it comes at the cost of ever-higher debt loads and shrinking private savings.
In what follows, I review the MDS theory, discuss the endgame of this process, and highlight a few takeaways for investors.
The Seven (or Eight) Steps of the Monetary Death Spiral
In the original piece, I outlined seven steps in the Monetary Death Spiral. These seven steps take an otherwise healthy and growing economy and transform it into a sluggish, stagnant, overindebted, low-growth, low-rates, low-inflation, dysfunctional, politically and financially polarized society. But there is actually another step that precedes and facilitates the others. We’ll call it “Step Zero.”
0. The Abandonment of a Stabilizing Monetary “Anchor”
By “monetary anchor” I mean some sort of rule that externally imposes restraint and limits on fiscal and monetary policymakers. Most people’s minds will immediately jump to the gold standard. That is certainly one form of monetary anchor. It was in place during what’s called the “classical gold standard” period from the end of the Civil War to the beginning of World War 1. During this period, the federal budget balanced more often than not and the United States saw some of the fastest economic growth of its history.
But gold is not the only kind of monetary anchor. Some countries around the world peg their currencies to the US dollar, which limits authorities from devaluing against the dollar. If Congress passed legislation restricting the Fed from certain monetary policy tools, this would act as an external anchor limiting the ability to distort or manipulate the currency. Likewise, if Congress passed a balanced budget amendment limiting deficit spending beyond a certain percentage of GDP only to officially declared wars and recessions, this would act as an anchor.
Not even a gold coin standard per se is necessarily a monetary anchor if the governing authorities don’t abide by it. In the first century Roman Empire, Emperor Nero was the first to debase the currency (to help pay for his extravagant spending) by mixing the precious metal with a common metal (copper) and by making a new and smaller coin that contained less silver. After a few hundred years of successive emperors doing this, the Roman currency lost 98.8% of its precious metal content.
After World War 2, the Bretton Woods system, in which various nations of the world pegged their currencies to the dollar while the dollar remained pegged to gold, also acted as a monetary anchor. But in the 1960s, the US lacked adequate gold reserves to match the amount of dollars in the world because of deficits that were ran during the Vietnam War. And since the US dollar was pegged to gold, the scarcity of gold in US coffers led to an overvaluation of the dollar. Fears of a legal devaluation of the USD caused fluctuations in value in the foreign exchange markets.
In 1971, President Nixon closed the gold window, thus causing currencies around the world (including the USD) to become free-floating against each other. Then, in 1977, Congress updated the Fed’s mandate to promote maximum employment and stable prices (i.e. low but positive inflation), which opened the door to monetary activism during Alan Greenspan’s term as Fed chairman, continuing with each chairperson thereafter.
This step — the abandonment of all monetary anchors — did not directly cause the seven steps that followed but rather facilitated them. A sharp inflationary period in the 1970s, along with the associated spike in interest rates, set the stage for a globally coordinated regime of competitive currency expansion, interest rate suppression, and debt buildup in the following 40 years.
1. Unsustainable Debt Expansion
Without any monetary anchor in place, governments’ fiscal largesse and markets’ cyclical exuberance could be met with monetary easing, which blunted the negative effects of both.
Excessive government spending, especially for non-investment purposes such as entitlement programs or the maintenance of a large standing army, eventually results in a rise in interest expenses. But the coordinated suppression of interest rates by central banks during downturns, when debt and interest costs historically tended to rise, prevented the need to reign in spending once the recession abated. Likewise, the sustained deleveraging that normally takes place in households and businesses following a crisis was repeatedly stopped short. Instead of crises exposing risks that lead to a demand for higher rates, thus spurring the need to deleverage, central banks kept rates artificially low for long enough to allow businesses and consumers to further lever up their balance sheets.
Progressively lower rates had the effect of encouraging debt-financed spending (by governments, businesses, and consumers alike) at the expense of saving.
Debt is basically the pulling forward of future consumption to today, unless that debt is taken out to invest in an asset that produces income greater than the costs of servicing and repaying the debt.
In a highly over-indebted nation, a little bit of monetary tightening (higher rates and less liquidity inflows from the central bank) goes a long way toward cooling off the economy. But, in contrast, when debt (especially consumption/unproductive debt) is already high, it takes a large amount of monetary easing (lower rates and more liquidity inflows) in order to produce any noticeable effect. The closer rates get to zero across the curve, the less impact monetary policy has on economic expansion.
A debt load that grows slower than the rate of economic growth may be sustainable, but when debt grows faster than the economy, it becomes unsustainable, building on itself in a destructive spiral.
Numerous studies, such as the famous one conducted by Kenneth Rogoff and Carmen Reinhart in 2010, demonstrate that national debt loads above a certain threshold weigh on economic growth. The Rogoff and Reinhart study found the threshold at around 90% of GDP, but a 2013 study of Euro-area countries by different researchers found the threshold much lower at around 67%. Another 2013 study of 155 countries found an even lower threshold of 59%. Meanwhile, a 2010 study found the tipping point into negatively correlative territory occurred at 77% of GDP for advanced economies and 64% for developing economies. A 2011 study put the threshold at around 85% of GDP and posited that similar thresholds exist for corporate and household debt. Yet another study from 2015 found a strongly negative correlation between large public debt loads and economic growth but no common threshold between nations.
In my estimation, seeking out an exact threshold after which higher debt-to-GDP becomes a burden on economic growth is futile. It could change from country to country and from time period to time period. In general, there is more than enough evidence to conclude that increasing debt loads provide diminishing returns for economic growth and eventually suppress potential future growth. Reinhart and Rogoff, in a paper from 2012 studying public debt overhangs in advanced economies going back to 1800, found that the growth-reducing effects of high debt often last multiple decades and frequently result in lower, rather than higher, real interest rates.
Hence we find the diminishing GDP productivity of the debt in advanced economies across the world over the last twenty years:
Source: Hoisington Investment Management Company
Notice the rapidly diminishing productivity of Chinese debt, which has expanded at a faster rate than any other advanced nation in the history of the world. In 2019, the Chinese economy grew at its slowest rate in 27 years.
2. De Facto Debt Monetization
Obviously, when central banks lower the ultra-short term interest rate by about five percentage points at every recession and are unable to raise them back to previous levels (which has been the historical pattern), simply lowering interest rates as a tool to soften the blow of economic shocks or cyclical downturns can only be done so many times. Eventually, interest rates approach zero.
At that point, central banks resort to a policy tool called “quantitative easing.” Instead of using digitally created dollars to confine the ultra-short term interbank lending rate (i.e. the “Fed Funds rate”) within a certain 25 basis point range, the Fed uses digitally created dollars to purchase government-backed debt securities held by commercial banks and hold them on its balance sheet. Historically, the Fed has returned the interest payments back to the Treasury Department on an annual basis, making that portion of federal spending virtually costless.
This is effectively a form of debt monetization, which is the transferral of debt into newly created currency. This form of debt monetization is not necessarily inflationary because it is being purchased from Federal Reserve member banks rather than retail investors. As such, it becomes bank reserves rather than going directly into the pockets (or bank accounts) of consumers. Even if the Fed did purchase assets directly from retail investors, however, the inflationary effect would be minimal since the wealthy (top 10% of income earners) own the vast majority of assets. In 2019, the top 1% of earners owned about half of the stock market. Obviously, these individuals scarcely increase their consumer spending with each additional dollar of wealth/income.
Up until recently, one might have objected that it would not be debt monetization if the central bank eventually sold its balance sheet assets back into the market rather than rolling them over as the debt matured. But now it is obvious that QE is a permanent policy. As with interest rates, it will take an ever larger amount of QE to spur any economic effect, but even a little bit of “quantitative tightening” (reducing the central bank balance sheet) has an outsized negative economic effect because total debt-to-GDP keeps rising.
As I wrote in The Monetary Death Spiral:
Sovereign debt monetization allows governments to continue running fiscal deficits while also preventing interest expenses from spiraling out of control. Effectively, it has enabled a relatively painless continuation of excessive government spending beyond what private savings would have allowed.
This process began in Japan after the bursting of its asset bubble in 1989, was later picked up in the US after the Great Financial Crisis, and subsequently emulated by the Eurozone in the early 2010s.
3. Yield Chasing
The huge Baby Boomer generation, which owns most of the world’s wealth, has tremendous difficulty finding yield in an ultra-low interest rate environment. Of course, those who have held stocks or long-duration Treasuries for a very long period of time have performed phenomenally well. But most folks can’t afford to save much for retirement, and those that can only begin meaningfully saving for retirement in their late 40s or 50s, leaving 10 or 20 years before needing to tap into savings.
When the safest yields available (federal debt securities) fall to very low levels, individual and institutional investors venture further out on the risk spectrum in order to attain higher yields. Pension funds and insurance companies, which have traditionally relied on safe debt securities to fund their obligations, are forced to seek out higher returns elsewhere. What’s more, foreign investors, especially from Japan, the Eurozone, and China, have sought out US Treasuries, equities, and real estate in order to generate higher yields than what are achievable in their home countries.
Source: Bloomberg, via Legg Mason
Lower Treasury yields lead to lower investment-grade corporate bond yields. Lower IG yields lead to lower junk bond yields. Lower Treasury yields also lead to lower real estate cap rates (property cash yields) and stock dividend yields. The prices of these assets are bid up as a corollary to the fall in Treasury yields.
Rather than merely saving more as interest rates fall, as the “paradox of thrift” would suggest, most investors simply shift their investment dollars into higher-risk assets.
4. Market Distortions
Quoting my previous article:
What happens when corporate debt becomes cheaper?
Well, according to standard economic theory, what happens when anything becomes cheaper? Demand for it rises. Indeed, that is what we’ve seen with corporate debt. Companies have taken advantage of their ability to obtain cheaper debt by loading up on it:
That was back in September, 2019. Today, corporate debt has surely exploded much higher as the Fed has flooded the financial markets with liquidity. Both IG and junk bond corporates have received Fed support, which has tamped down on rate spikes and led to a surge in new debt issuance.
You would think this massive corporate debt expansion would lead to an investment boom that would then translate into faster economic growth. But that isn’t what has happened.
Look at gross capital formation — the total production of new physical capital goods like machinery, equipment, tools, commercial vehicles, and hardware/software. On average, the economic expansion of the 2010s saw the weakest gross capital formation of any expansion going back to the 1950s, and it has been weakening steadily during the “booming” tax cut economy from late 2018 to today.
But gross capital formation doesn’t tell the whole story. A lot of the formation of new capital is done to replace old capital that has reached the end of its useful life. Net capital formation looks at the new capital produced for growth purposes, stripping out that produced to replaced depreciated assets. When we look at net capital formation as a percentage of GDP, we find a fairly strong recovery following the Great Recession through 2014, largely due to the fracking boom. But with the oil price collapse in 2015, net capital formation never recovered.
Why has business investment been so weak in recent decades despite the massive buildup of corporate debt? Where is that money going? In short: share buybacks, dividends, mergers & acquisitions, leveraged buyouts, and the sustenance of corporate zombies.
Source: Federal Reserve
To quote my previous article again:
The levels of interest rates and corporate share buybacks, for instance, have proven to be inversely correlated: when rates fall, share buybacks skyrocket. I wrote about this in The Good, The Bad, and the Ugly of Share Buybacks. I wrote about the increase in mergers & acquisitions due to low rates in How Low Interest Rates Have Led To Increased Market Concentration. I also wrote about how low interest rates are sustaining unprofitable and unproductive (zombie) companies in Central Banks Are Spawning A Zombie Apocalypse.
And while I have not written on how low interest rates increase leveraged buyouts by private equity firms, see this article from Investopedia for a brief primer on the subject.
There are two competing theories for why an elevated amount of corporate dollars have gone into mostly unproductive financial investments rather than productive capital formation. Joseph Gruber and Steven Kamin of the Federal Reserve write:
One possibility… is that corporations are actively reducing investment in order to finance share repurchases and dividend payments. Another interpretation, though, is that pessimism about future demand and economic growth is leading corporations to defer capital spending, and companies are simply returning cash to their shareholders for want of attractive investment opportunities.
Gruber and Kamin cite several academic studies showing that corporate decisions to engage in buybacks coincide with reduced investment. And that reduced investment has contributed to a reduction in GDP growth.
Hence we find that while GDP growth from 2000 to 2020 roughly halved the average from 1950 to 2000, S&P 500 EPS growth has been around 50% higher than its average from 1950 through 2000. And that includes the 80% EPS growth during the 1990s! Excluding the 1990s, EPS growth from 2000 to 2020 was a startling 3.6x higher than the average from 1950 to 1990.
See my article, “The Pernicious Effects of Low Interest Rates,” for more on this subject. My conclusion in that piece is this:
While trying to sustain consumer spending growth and asset prices, the Fed has inadvertently promoted the financialization of the economy. It has encouraged an abundance of investment in debt and financial products, and it has crowded out long-term investment in productivity- and wage-enhancing capital that would benefit the real economy.
But the two explanations given by Gruber and Kamin for corporations choosing financial investments over capital spending are not incompatible. The fundamental weakening of the economy, neglect of productivity growth, and lack of meaningful wage growth resulting from previous financial engineering endeavors naturally diminishes the number of attractive investment opportunities in the present.
The Fed, via its interbank lending rate as well as QE, drove the risk free rate (and by correlation the hurdle rate for investments) so low that it became more attractive for corporate managers to repurchase stock rather than hold cash in short-term investments or invest in relatively more risky capital goods.
For these corporate executives, buybacks had the positive effect of translating stagnant net income into rising EPS, which also helped them hit certain thresholds to earn higher bonuses. And then, of course, there is competition to think about. Just like there is competition for market share of customers, there is also competition for investor dollars. If one company is raising its EPS via share buybacks, that puts pressure on the company’s peers to do the same. Apple (AAPL) famously resisted calls for share buybacks for quite some time but eventually gave in. And after resisting buybacks for years, Warren Buffett’s Berkshire Hatthaway (BRK.A, BRK.B) finally gave in to shareholder demand and began repurchasing shares ($2.2 billion in the last quarter of 2019 alone).
I find it interesting that the impressively high spikes in capital formation growth ended around the mid to late 1980s, around the time that Fed chairman Alan Greenspan first swooped in to cushion the fall of financial asset prices with monetary easing. That is around the same time that buybacks first spiked as a percentage of GDP.
5. Social Distortions & Expansion of Inequality
Considering that the wealthy own the vast majority of financial assets, the rocketing asset prices resulting from all of the above has dramatically boosted their total wealth. On the other hand, it has suppressed the interest earnings of the lower and middle class savers who prefer savings accounts to stocks or real estate. It has also lured the non-wealthy into taking on more consumer debt in order to continue enjoying a rising standard of living despite stagnant real wages. What’s more, the lack of robust real investment has lowered productivity growth, which has in turn dampened real wage growth.
Nobel laureate Michael Spence and former Fed governor Kevin Warsh wrote in 2015: “Productivity — key to raising wages and living standards — rose less than half of 1% annually in 2011-14, the weakest four-year run in productivity outside of a recession since World War II.” In the five years from 2015 through 2019, labor productivity rose to a 1.52% average annual rate, which explains the brief rise in wages in 2018 and 2019. But even this was historically weak productivity growth.
The result of these combined factors is widening wealth and income inequality. I wrote about this in Blame (Or Thank) The Fed For the Meteoric Rise In Wealth Inequality and Here Is How Central Banks Have Compounded Wealth Inequality.
This expansion of inequality then affects the broader society in profound ways.
There is ample evidence to suggest that widening inequality contributes significantly to rising political populism on both the left and the right. A 2018 paper demonstrates that “[c]ountries with more inequality, higher financial development, and trade deficits are more vulnerable to populism.” A 2019 paper draws the link between far right populism and inequality by suggesting that inequality weakens social cohesion, and populist leaders rise to power by uniting a divided populace against foreigners. A similar argument was made in a 2017 study that far left populists rise to power by convincing voters that a self-serving and corrupt “elite” has usurped the democratic process from “the people.”
Moreover, a study published in Psychological Science pulling data from 28 countries across the globe found that “the growth in support for populist leaders who are happy to abandon democratic principles to achieve particular outcomes may partly be due to increasing levels of economic inequality.” Their data showed that “people in countries with high levels of economic inequality, both real and felt, were more supportive of a strong leader.”
“This strengthens our reasoning that economic inequality perceptions enhance the feeling that society is breaking down … fueling a desire for a leader who will restore order (by whatever means necessary),” the authors conclude.
Some research has argued that the success of populism in a given country leads to increased financial instability and asset price volatility. Although some specific brands of populism can be beneficial to markets.
But there are other social side effects of the Monetary Death Spiral.
Think about the falling birth rate. Now, surely there are numerous non-financial reasons that the birth rate has fallen dramatically since the 1950s, including changing religious, cultural, and social norms. But there is some evidence that the buildup of debt resulting from the Monetary Death Spiral has exacerbated this trend.
For one, the number of women who want children but aren’t having them is growing. Put differently, women are having fewer children than they say they want. In fact, the average number of children that Americans think is ideal to have — 2.7 — has remained roughly the same since the 1970s, despite the continued falling of the birth rate.
Why? Stagnant wage growth due largely to weak investment is one reason. People whose standard of living is not improving are more reluctant to have babies.
Another reason is that younger people are straddled with $1.68 trillion in student debt, and that number continues to grow quarter after quarter. Add in young people’s share of the $1.19 trillion in auto loans as well as credit card debt that peaked in February, 2020 at $1.09 trillion and you have very unfavorable circumstances for most people of child-bearing age to bring children into the world. The Great Recession didn’t help. The St. Louis Fed found in a 2018 study that Millennials in particular accumulated 34% less wealth than they otherwise would have if the crisis hadn’t happened. Older generations that owned more financial assets and had more established jobs fared significantly better.
What about immigration? Haven’t immigrants made up for the slowdown in the birth rate? Partially. But the net migration rate (immigrants coming into the country minus those leaving) peaked in the late 1990s and has been in a downtrend since then.
Recently released Department of Homeland Security data shows that legal immigration declined by 7.3% from FY 2016 to FY 2018. Excluding refugees, the decline would have been 11.5%.
The recent sharp decline in the immigration rate is surely due to the current administration’s restrictionist policies, but it is merely the exacerbation of a trend that has been in place since the late-2000s. In my estimation, the slow decline of American economic dynamism along with stagnant wages (including for illegal/undocumented workers) is the root cause of the slipping net migration rate.
Increased populism, a falling birth rate, and lower net migration are three social distortions of the MDS that likely weigh on growth.
6. Rinse And Repeat
To summarize the line of reasoning up to this point (quoting myself)…
… artificially low rates (and especially the ultra-low rates since the Great Recession) have spurred a massive rise in unproductive debt, both in the private and public sectors. Since productivity growth tends to lead to wage growth, this diminished productivity growth has played a significant role in wage stagnation, as well as slower economic output.
With less consumption (from lower wage growth) has come disinflation (i.e. lower rates of growth in consumer prices), despite the low unemployment rate. Though most of those who want jobs have them, employers have not felt the need to invest much in the productivity of their workers (following the lead of the corporate sector) or in their output capacity.
How do central banks respond to the economic sluggishness that follows from their policies?
Following the clichè definition of insanity (“doing the same thing over and over again and expecting a different result”), they lower interest rates again and engage in more debt monetization in order to “provide stimulus” and “support the expansion.”
Following the law of diminishing returns, these increasingly large rounds of monetary easing show less and less positive effects, and what effects that manifest are temporary and fleeting. Meanwhile, the economy becomes increasingly indebted in every corner, governments spend more on unproductive programs, buybacks rise, investors continue yield-chasing, pension funds and insurance companies become increasingly unstable, the banking system weakens, bank lending retreats, corporations enjoy fewer and fewer loan covenants, and unproductive zombie companies stay afloat via low borrowing costs.
This, then, leads to even slower productivity growth, wage growth, consumer spending growth, and GDP growth. Eventually, it leads central banks to think that they have not done enough stimulus — that more is needed to sustain the economic expansion.
7. Negative Interest Rates
Looking at a chart of interest rates of any duration from the 1980s to today, one can’t help but notice the inexorable downward pull toward zero. For many advanced economies such as Japan, Western Europe, and Scandinavia, rates plunged right through the so-called “zero lower bound” into negative territory. Even some very long duration government debt, such as the 30-year German bund, trades at negative yields. And recently, the United Kingdom issued negative-yielding debt for the first time ever.
Despite Fed Chairman Jerome Powell’s resistance to negative interest rates thus far, economists at the Wharton School of Business argued in 2019 that the United States will likely experience negative interest rates sooner or later. A note from Goldman Sachs put out on May 20th, 2020, is perhaps the most recent voice in support of negative rates.
As I wrote in the original MDS piece back in September, 2019:
Ignore for a moment the fact that Fed Chairman Jay Powell recently suggested that the central bank probably wouldn’t look at negative rates in the future. Look at the Fed’s past actions and compare them to the past actions of other central banks that eventually succumbed to negative rates. Consider also that the prevailing economic theory that led other central banks to push rates into negative territory still predominates at the Fed.
Even if Powell holds firm against negative rates, his term as Chairman of the Fed won’t last forever. How likely is it that the next chairman will also be staunchly against negative interest rates, even as more central banks across the world give in to them? I find it unlikely.
That isn’t to say that negative rates are necessarily coming during the current crisis. They may not manifest until the next downturn. But it is crucial to realize that nothing has changed that would result in an outcome besides continued low-growth and disinflation (or mild deflation). If the low-growth, disinflationary environment does persist, then central banks will do more monetary easing, and the only tool they will have left is negative rates.
What about buying equity ETFs? That decision, if the Fed does make it at some point, will have very little economic impact. It will be just one more gift to the already wealthy by boosting stock prices. It will not have any more positive effect on the underlying economy than corporate share buybacks do. So, even if buying equity ETFs is initiated as the next big central bank plan to bolster the economic expansion, economic growth will remain sluggish, and central bankers will reconsider whatever lingering skepticism of negative rates they have.
The problem is that interest rates no longer act the way they normally do when they fall into negative territory. Or, rather, market actors don’t act the same way around negative rates as they would with positive interest rates.
Banks in particular are put into a tight spot. Competitive forces ensure that the yields on their loans will remain low, but savers are highly resistant to leaving their money in accounts that slowly diminish in nominal (rather than just real or inflation-adjusted) value. Higher fees can be charged on some services, but these fees cannot make up the lost income from a shrinking net interest margin. As a result of falling bank profitability, these institutions extend fewer loans. This leads to less capital formation, slower productivity growth, slower wage growth, slower consumption growth, and (you guessed it) slower economic growth.
“Once the policy rate turns negative, the usual transmission mechanism of monetary policy through the bank sector breaks down,” a team of economists concluded in a 2019 paper. “Moreover, because a negative policy rate reduces bank profits, the total effect on aggregate output can be contractionary.”
What happens next depends, in my estimation, on whether the purchasing power of money is rising or falling.
If consumer inflation remains muted but positive, then the Monetary Death Spiral continues. Various market actors continue to gorge on debt. Wealth inequality continues expanding. Investment and capital formation continues to lag. Central banks continue the same old, same old policies.
If inflation hovers around zero, perhaps skirting back and forth between mild deflation and mild inflation, then, again, the MDS will continue. European corporates have already demonstrated their ability to borrow at negative rates. On July 31st, 2019, 42% of the European corporate bond market was already trading at negative rates. German industrial conglomerate Siemens was able to borrow $1.6 billion for zero coupon, and investors were willing to buy these debt issues above par — i.e. at negative rates. Siemens’ two-year note was issued at an effective rate of -0.315%. In October, 2019, Toyota Motor Corp (TM) became the first Japanese private firm to sell negative-yielding debt.
If you think negative-yielding corporate bonds can’t happen in the United States, you should reconsider. It is a strange world we live in. We are trapped in the final stages of the Monetary Death Spiral, and we have long since passed the point of no return. Fundamental forces continue to push rates lower, and central bankers press on with the same policies that got us here.
Central banks will need to bail out failing pension funds, states (in America), small nations (in Europe), and perhaps even certain types of corporations such as insurance companies. But that will not stop the MDS from progressing.
The endgame is and necessarily must be deflation. There is no plausible mechanism by which the Monetary Death Spiral as described above would result in a highly inflationary or hyperinflationary environment on its own.
The numerous articles that worry about a new uptrend in inflation coming as a result of the Fed’s massive money creation fundamentally misunderstand the causes of inflation. As I explained in a recent piece, there are several megatrends weighing on money velocity (the rate of turnover of a given unit of currency) and consumer prices. This leads to disinflation and will eventually lead to mild deflation. Inflation is caused by natural or artificial bottlenecks or shortages such that supply cannot keep up with demand.
Meanwhile, deflation can be caused by either increased efficiency in the delivery of those goods and services (allowing sellers to lower their prices in order to capture greater market share) or by a drop in demand (due, for instance, to a recession) that forces sellers to lower prices in order to generate sales.
I once thought that inflation is always and everywhere a monetary phenomenon, as Milton Friedman taught. That notion animates nearly every outcry from writers and pundits that all this central bank money creation will eventually lead to a sharp rise in inflation or perhaps even hyperinflation. What each one fails to do is demonstrate how all this central bank liquidity maneuvers its way into the pockets of a large swathe of consumers. Consumers, after all, are the only ones that can generate demand in excess of businesses’ ability to generate supply, which would then produce inflation.
But the Federal Reserve has no legal mechanism, according to its mandate from Congress, to create money and inject it directly into the pockets or bank accounts of consumers. It can only purchase debt securities (formerly only government-backed ones, but now through some legal gymnastics also corporate ones), and it can only purchase those from certain banks and brokerages.
What do the banks do with the cash? By and large, they hold it as excess reserves. No one can force them to make loans that they don’t want to make. As rates fall and net interest margins are squeezed, banks become increasingly likely to keep the excess reserves on their books or lend only to preferred borrowers. In Europe, negative interest rates also caused banks to lose depositor money to American banks, which still offered positive (if minimally so) interest rates.
Recently, the ECB began lending to Euro area banks at a negative rate in order to incentivize them to make loans. Whether this has a small, temporary positive effect on economic dynamism remains to be seen, but it will not alter the fundamental momentum of the MDS. I suspect the main effect it will have is to give confidence to Eurozone debt investors so as to tamp down on yields. Also, it will make central banks the “lender of first resort” for commercial banks.
The only way inflation will return in force is if/when deflation becomes sufficiently severe and economically disruptive that governments print money and distribute it directly to consumers.
Whether this printed money comes from the Treasury Department or somewhat indirectly by the Fed sending printed money to the Treasury (similar to a policy the Bank of England initiated recently). Once politicians are given the ability to engage in money printing for the purpose of fiscal largesse, they will inevitably abuse it in an attempt to satisfy an angry and heavily indebted populace. This largesse could take the form of a universal basic income, or perhaps the funding of all entitlement program obligations, or an assortment of new transfer programs, or even a massive infrastructure spending package.
This, and only this, will cause a new uptrend in inflation. It will create a strong, new source of demand for consumer goods and services that will overwhelm supply, leading to price hikes. At first, it will seem harmless, but this will only encourage fiscal policymakers to spend more printed dollars on their programs. Once inflation rises, life will quickly become miserable for everyone, as the value of money will rapidly erode, prices will rise for the first time in most people’s lifetimes, and it will be politically impossible to cut fiscal spending or raise taxes.
Before we get to that point, however, we will go through many more years of MDS-induced asset inflation and stagnant economic growth.
The Only Way Out: Austerity And A New Monetary Anchor
There is a way out, but it is extremely politically unpopular.
The massive overhang of unproductive debt will need to be shrunk down to a manageable level, which will require fiscal austerity. And interest rates will need to be allowed to float without as much central bank manipulation, which will require a new monetary anchor.
According to a study by the McKinsey Global Institute, the most common type of deleveraging in the last hundred years has been austerity, making up roughly half the instances. Interestingly, from a certain perspective, World War 2 and the years that followed can be seen as something of an austerity period.
The reason why real GDP growth rapidly took off after the massive leverage taken on during WWII was not the government spending but rather the very high private savings rate that began during the war combined with massive government spending reductions following the war. The result was a boom in investment and capital formation for productive (non-military) purposes.
In their 2019 book, Austerity: When It Works And When It Doesn’t, two Italian economists and an Italian-American economist examine hundreds of multi-year austerity measures taken by 16 different advanced economies since 1970. Their data demonstrates that austerity policies based on tax increases have strongly negative effects in economies with already high tax rates. They cause deep recessions, and the resulting declines in GDP ensure that the debt-to-GDP ratio does not fall.
But austerity based on spending cuts, however, has the opposite effect:
… spending cuts, particularly those that reduce the rate of growth of automatic entitlement programs, have a more permanent effect on deficits than tax hikes do. This is because taxes will eventually need to catch up with the automatic increases of various spending programs, if the latter are not tackled. If taxes keep rising they will slow down GDP growth, thus affecting the denominator of the debt over GDP ratio; if they do not the numerator will increase because spending goes up and taxes do not. [p. 4]
“The popular anti-austerity argument is that tax increases, and especially expenditure cuts, reduce aggregate demand and cause deep and long-lasting recessions,” the authors write (p. 17). Contrary to this argument, they find that austerity based on spending cuts is often expansionary. Specifically, meaningful spending cuts are often associated with increases in private investment. They theorize that spending cuts give investors a newfound confidence in the economy’s prospects and reduce expectations for future tax increases.
I would add that government spending cuts lower deficits and free up private savings to find more productive uses, which naturally leads to increased investment and capital formation.
In order to escape the Monetary Death Spiral, something will need to happen to cause the private savings rate to rise relative to government deficit spending. This would spur a new investment boom, just as it did after WWII.
But how would it even be possible to cause a significant rise in private savings and/or a fall in public spending as long as monetary authorities continue their pro-debt policies? I do not think any sustained progress can be made toward this positive scenario unless a new monetary anchor is introduced.
What would that monetary anchor be? A gold standard? A widely accepted and used cryptocurrency? A new Bretton-Woods-type arrangement between nations? A new Congressional mandate for the Federal Reserve that severely restricts its available tools? There is no telling what it would be or what it would look like. But I can’t envision a scenario in which we escape the MDS without it.
Takeaway For Investors
The above chain of reasoning sounds rather dour and pessimistic. But from an investment perspective, nothing is either pessimistic or optimistic, because rarely, if ever, is it impossible to make money. It’s just a matter of what to invest in.
The first point to highlight is that being indebted becomes increasingly painful in a deflationary scenario because one needs to repay the debt in increasingly valuable dollars. If Company X holds $100 in debt with fixed interest of 2%, then they will need to pay $2 in interest each year. But in a deflationary scenario, they likely need to lower their prices, which could reduce revenue and EBITDA and cause interest coverage to fall. Even if the debt is zero interest, it can’t be repaid in “deflation-adjusted” dollars; the nominal amount, which doesn’t take into account the need to lower prices at a later date, is the amount that must be repaid. Only the strongest, highest credit-rated companies that are able to borrow at sub-zero rates will be spared the pain of repaying debt in stronger dollars.
In a highly indebted economy, moderate deflation would be very painful, but I don’t think that fiscal policymakers would allow such a scenario to persist for long.
Low to no debt stocks that also have strong business models are one way to remain long equities. Some of my favorites are asset manager Franklin Resources (BEN), self-storage REIT Public Storage (PSA), multi-tenant industrial REIT PS Business Parks (PSB), travel website owner Expedia (EXPE), technology consultant Cognizant Technology Solutions (CTSH), international logistics stalwart Expeditors International of Washington (EXPD), semiconductor manufacturer Xilinx, Inc. (XLNX), fellow semiconductor producer Lam Research (LRCX), tech products producer Maxim Integrated Products (MXIM), and high-end toolmaker Snap-On Inc. (SNA). Each of these companies also pays a dividend, which would be very valuable in a deflationary scenario.
On the flip side, any business model that borrows short and lends long is likely to suffer in this environment. As proven by the European example, banks will find it tremendously difficult to remain profitable. I have begun selling my bank stocks, and I am considering what to do with my insurance company stocks on a case-by-case basis. What’s more, in my Roth IRA, I am trying to veer away from dividend ETFs that have large allocations to the financials sector. I like the WisdomTree Dividend ex-Financials ETF (DTN) as well as the WisdomTree Int’l Dividend ex-Financials ETF (DOO).
Another investment theme that should work well in this environment is business models that utilize long, contractually fixed revenue streams. Two examples of such businesses are net lease REITs, my personal favorite type of investment for this scenario, and natural gas pipeline & storage companies. Net leases require the tenant to pay for all property-level expenses, such as taxes, insurance, and maintenance, and have long initial lease terms of 10-20 years. And midstream natural gas companies often use long-term take-or-pay contracts with their counterparties, ensuring stable cash flows that aren’t reliant on a certain volume or commodity price.
One can buy a few dozen net lease REITs in one click through the NETLease Corporate Real Estate ETF (NETL), and one can buy a basket of mostly natural gas-focused midstream companies through the Global X MLP & Energy Infrastructure ETF (MLPX).
And, of course, perhaps the most obvious pick for a zero (or negative) interest rate and mildly deflationary environment is long duration Treasury bonds. These can be purchased via the Vanguard Extended Duration Treasury ETF (EDV) or the iShares 20+ Year Treasury Bond ETF (TLT).
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Disclosure: I am/we are long PSA, SNA, BEN, NETL, MLPX, DTN, DOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
Originally published on Seeking Alpha