A New Year - What I'm Watching

To be honest, I’ve been working and reworking this article for several weeks as I hoped to start the new year with something very erudite, very impactful, and memorable while also helping our readers to better manage their own finances. The truth is it seems like everybody has said whatever I want to say elsewhere and probably better. In fact, our clients have sometimes accused me of writing the same message over and over again but with different words. I guess consistency is good, but truthfully these periodic articles have become challenging to write after over two decades in this business. How many different, and interesting, ways can I send the message? Plan, execute, monitor and enjoy. Oh, and make sure you diversify, keep costs down, and don’t ever make emotional decisions about your finances.

While we are a financial planning firm, and I strongly believe in the need to plan comprehensively, my true passion has always been markets, economics, politics and their interaction. So, I’ve decided to use my columns to write about what I’m watching and thinking about at the moment in regards to the world’s various markets. I realize this more freeform approach likely will result in longer articles. Feel free to jump around to whatever (if any) topic interests you. So, in no particular order, here are some of the happenings drawing my attention at the moment.

Interest Rates Are Practically Unfathomable

In 1979, I graduated from college at a time that seems the polar opposite of today. Inflation was 10%; short-term interest rates were 20%; and long-term rates were 15%. Nobody had ever seen anything like it. Today, inflation has fallen to 1%, short-term rates are 0% and long-term rates are under 2%. Again, nobody has ever seen anything like it.

Housing affordability has immensely improved. In the early 1980s, with sky high interest rates, it took over 35% of average household income to cover mortgage payments. Today, it takes barely over 10% of income. While this is just an “average”, it does represent dramatic improvement.

The investing implications are stunning. When we purchase bonds, we are essentially lending money to get paid back over the term of the loan at a specific interest rate. In the early 80s, you couldn’t give away bonds. In retrospect, it is amazing that so many people missed the opportunity to lock in a government-backed return in the neighborhood of 15% for ten or more years. Today it is turned upside down. People are racing to buy bonds/lend money to the government, locking in the lowest rates in history. In fact, the biggest buyer in history – our Federal Reserve – has, over the past few years, purchased roughly $4,000,000,000,000 in bonds. (My mom always thought people would pay more attention if we actually wrote all the zeros in some of these exorbitant numbers)

In retrospect, buying bonds in the early 80s would have been one of history’s greatest purchases. As I write this, the 30-year U.S. Treasury yields a record low under 2.4%. I’ve got to believe when we look back in five or ten years, we will see these purchases as some of history’s all time worst.

Europe: Where the Real (Lack of) Action Is

I find the situation in Europe to be fascinating and a bit scary on many levels. Compared to the situation there, the United States seems almost uninteresting in terms of the economy and the markets, which is probably a good thing for U.S. investors.

The Euro Experiment

In 1999, Europe introduced a new currency, the Euro, which has now been adopted by 19 members of the 28 member European Union. The monetary policy is managed by the European Central Bank (ECB), Europe’s counterpart to our Federal Reserve. The impetus behind the Euro was, among other things, to develop a single market, facilitate trade, coordinate economies, etc. It was a furtherance of the continent’s desire to create more economic interrelationships with the hope of not only being economically beneficial, but also of finally breaking the centuries-old pattern of wars between the European states.

While I’m no expert on European institutions, (I obtained some of this background from Google/Wikipedia), I do know that after humming along seemingly successfully during its first few years, the Euro area’s harmony was upended with the 2008-09 worldwide financial crisis. Investors suddenly realized that it doesn’t make sense to lend money to (buy bonds from) such disparate countries as Germany and Greece at the same rates. Realizing the higher likelihood of default in some of the less financially sound countries, the bond yields suddenly diverged stunningly. While Germany’s rate fell to and stayed in the low single digit area, Greece’s exploded to nearly 30%! Many of the other peripheral European countries also saw their yields significantly increase, though typically only into the high single digit area. A new crisis enveloped the continent as the possibility of some of these countries defaulting on their debt and setting off a chain reaction gripped the markets. In fact, the possibility of the whole European Union unraveling became quite real. The ignoble moniker “PIIGS” was created to disparage those countries which were financially teetering – Portugal, Italy, Ireland, Greece, and Spain. Thankfully, I have not heard this epithet used in a long time.

“Whatever it takes”

As the collapse of the EU seemed quite possible and even likely in the summer of 2012, new ECB President, Mario Draghi, uttered this paradigm-shifting statement, “…the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough”. While it was not entirely clear what this would involve, nobody wanted to stand in the way of the ECB. The market reversed; the crisis subsided; the EU held together; and, interest rates fell across Europe. In fact, the ECB did not ever really have to do anything to save the Euro as the statement itself had the desired effect.

Today, interest rates in many European countries are at generational or record lows. In fact, Germany, France, Sweden, and the Netherlands all have ten-year bond rates of less than 1%! And, get this, German rates on their two-year and five-year bonds are negative while Switzerland, has negative rates all the way out to ten years! That’s right; investors are paying Germany and Switzerland to hold their money. (It sure would be nice to get a negative rate mortgage and actually get paid to borrow, wouldn’t it?) While the core European countries have had these unimaginably low rates, even many of the financially less sound countries such as Italy and Spain are borrowing for ten years at less than 2%. It boggles my mind.

In a nutshell, the reason for these negligible rates is that the European economy is stagnating and slipping into a period of falling prices, known as deflation. When prices decline, holding money safe and constant is a good bet. Over time, the same amount of Euros or Swiss Francs buys more.

“Whatever it takes” – Part 2

Unfortunately deflation can become a very serious problem if it gets entrenched. It perpetuates itself as people defer purchases today, knowing they will be cheaper tomorrow. This drives prices ever lower and grinds the economy down to snail-like growth. Japan’s cycles of alternating slow growth and recessions for the past 25 years still have not been broken. Worse still, deflation can cause collateral used for loans to depreciate while the amount owed does not. Borrowers can end up defaulting, possibly resulting in a systemic collapse such as was experienced in the Great Depression.

(Note, after this was written, the Swiss National Bank unexpectedly “unpegged” the Swiss Franc from the Euro, resulting in the Swiss Franc shooting up in value. Thus, overnight, any borrowers in Swiss Francs saw their debts grow unexpectedly. It bears watching to see if this might result in systemic defaulting.)

So, this brings us to where we are now with the ECB, driven by the core European mindset of fearing inflation, being very slow to take any action to reverse the falling prices. Yet, seeing the success the United States has had (to date) in staving off deflation and stagnation, the ECB has talked about mimicking our Fed by employing their own version of quantitative easing (QE). As I write this, the problem is they have talked about it but haven’t actually done anything. In fact, there are some very real roadblocks preventing them from moving forward aggressively. It will be interesting to see if they do take some action and if it will truly be “whatever it takes” to reverse the deflationary trend. They may be running out of time.

Quick Aside – How the United States and Europe have very different economic memories

My belief is that we both have been guided for decades to avoid repeating the nightmares of the 1920-30s. The thing is, however, we see these periods very differently. Europe most fears the possibility of a repeat of the post World War One hyperinflation that sowed the seeds for Hitler’s reign of terror. The U.S., on the other hand, has been guided to avoid the horror of the Great Depression. In essence, Europe, led by Germany has emphasized very tight, sound money out of fear of inflation while the U.S. reacted to the financial crisis by flooding the system with money to avoid a deflationary depression.

The Options are Dwindling – Is Currency Depreciation the Answer?

Many of the traditional tools policymakers have employed are no longer working as they have in the past. Some of the big ones include:

1. Interest rates. We are essentially in a zero interest rate world. Every major worldwide central bank has lowered their official interest rates to essentially zero. Traditionally, the central banks would lower interest rates as a tool to spur economic growth and get their economies out of slowdowns or recessions. In a world with 0% rates and negligible growth (except in the U.S.), this tool is no longer effective.
2. Quantitative Easing. This economic jargon describes the recently implemented strategy of central banks adding money to the economy through the purchase of government bonds. The hope is that the cash infusion will be spent, borrowed, and essentially put to use getting things going. The U.S. has been a leader in quantitative easing with the initial foray during the depths of the crisis in 2009, which has been credited with providing much needed confidence to our then teetering financial system. However, the next two legs, known as QE2 and QE3 have arguably had limited to negligible impact. Besides a confidence boost, the actual economic benefits are questionable though we may find out more if Europe does finally implement similar measures.
3. Fiscal Stimulus. Again, traditional measures such as government spending and/or tax cuts were the fiscal levers used to help spur growth. Yet, today with towering and growing government debt loads worldwide, major fiscal stimulus seems infeasible. In fact, for several years – particularly in Europe – fiscal austerity has been the focus in an attempt to tame the debt loads.

So with these traditional levers currently ineffective, policy makers are looking to depreciate their currencies as a final resort. The idea is that when a country (or the European region) makes their currency worth less, their goods sold internationally become cheaper thus spurring demand. The increase in demand for the products will hopefully spur self-sustaining growth. Furthermore, a “benefit” is that goods produced outside of the country/region become more expensive possibly generating inflation, thus reversing deflationary forces.

Some of the Issues with Currency Depreciation

1. Everybody is trying to depreciate at the same time. With a slow-growth world, most countries/regions are seemingly trying to depreciate at the same time, with the exception of the United States. In particular, both Japan and Europe seem intent on devaluing their currencies. While the U.S. is not actively trying to depreciate the dollar, if it continues to appreciate, we run the risk of falling into deflation ourselves. In a sense, we would be importing their deflation.
2. Benefits likely to be temporary. Unless the currency is continually depreciating, the benefits might be temporary as the market does a one-time adjustment.
3. Potential to worsen into a trade war. We are probably a long way from this point, but it is always a risk that more severe scenarios could be triggered.

Unprecedented Territory – Don’t Be Complacent

The current economic conditions and unorthodox policy actions are unprecedented. We are in the midst of a grand experiment with a growth-starved world desperately seeking to find an answer. The best hope, it seems to me, is that the United States growth can accelerate and be the engine that pulls the world out of this sluggishness. Nonetheless, after a nearly six year bull market with prices having more than tripled, I believe that it is paramount to avoid complacency and prepare for volatility. Nobody knows how this will play out. Be prepared.