Returns over the last decade have been amongst the lowest on record. Buy-the-dip has persistently failed. Despite enormous monetary and fiscal stimulus, the major OECD economies have not managed to generate adequate economic growth. Governments have been in this spot before. Academic research shows that, typically, the policy prescription that is adopted is one called “financial repression,” where interest rates are kept persistently below inflation rates. Financial repression is nothing new. Throughout history, governments have used the technique to transfer wealth from the prudent saver to the balance-sheet constrained and reckless borrower. The biggest culprit in this latter category is usually government itself.
The current scenario, however, is unlike any faced before for three reasons. Each of these reasons will place a unique stress on the ability of financial repression to “heal” the damaged balance sheets of the OECD bloc.
1) For the first time in history, the OECD bloc as a whole stands to face a sharp inflection point on age dependency. In 1990, the old-age dependency ratio for the developed economies stood at 19%. This edged up to 24% by 2011. By 2030 it is predicted to rise to 36%. Unlike economics, demographics can be predicted with accuracy. Given the highly age-skewed nature of health care spending, this demographic profile suggests that there will be upwards pressure on public spending on age-related benefits and healthcare, while at the same time the tax base from income earners will be shrinking. This will result in more and more intractable budget deficits. It will also act as a potentially big drag on economic growth.
2) According to a study entitled “Growth in a Time of Debt” by Reinhart and Rogoff, once an economy’s government debt/GDP ratio rises above 90%, the economic growth rate of that economy becomes severely impeded. The study suggests a lowering of GDP growth by 1.5-2.0% per annum. In the past, this would have been an interesting but not especially relevant issue to consider when evaluating the bigger economic picture. In today’s environment it has become central to thinking. In the early 1980s, not one OECD economy had a debt ratio over 100%. Throughout the 1980s and 1990s, the proportion of economies with excessive debt varied between 0-15%, averaging 10%. So, out of 28 economies, one might have expected up to four economies with excess debt problems. According to the OECD, almost one-third of OECD economies will have debt burdens over 100% of GDP in 2012. So, rather than being an isolated problem, the debt drag is now hurting a material number of OECD economies, making it much harder for healthier economies to provide an engine of growth. If Reinhart and Rogoff’s debt buffers at 90% do prove to be an impediment to growth, then the level of debt that currently prevails in the OECD will make it very hard for governments to reduce their budget deficits through economic growth. Indeed, this is one of the conclusions from the Reinhart and Rogoff study: “The sharp run-up in public sector debt will likely prove one of the most enduring legacies of the 2007-2009 financial crisis….seldom do countries grow their way out of debts.”
3) Emerging economies just do not suffer from the same demographic or debt dynamics as the developed bloc. As Jim O’Neill will tell you, the growth outlook for the BRIC economies is much healthier. I think he is right. However, the one disadvantage that the BRICs will face that the developed OECD did not is the ability to industrialise against a backdrop of cheap raw material prices. The EM economies are growing rapidly. The energy intensity of these faster growing economies is, unsurprisingly, high. This suggests that peak supply constraints on key commodities may well keep commodity prices high. This may be a modest problem for the emerging bloc, but it is another nail in the growth coffin for an ageing and debt-ridden OECD.
Had one of these structural events been taking place, then the impact would have been important for economic forecasting. However, when three such potent structural factors come together at the same time, the confluence has the potential to so radically change the economic outlook for advanced economies as to make an examination ofhistorical precedent impossible. The advanced economies have never been in this position. Against this backdrop, the need for intense financial repression will be clear to governments. In other words, expect more and more money printing as economic growth keeps failing to gain traction. Government response has been exactly that with record low interest rates and wave after wave of various forms of quantitative easing and money printing. If only one could invest in a product that mimicked the money supply! Since 1925, US and UK equities have produced annualised returns of around 5.5%, with a standard deviation of 20%. The US money supply, M2 has recorded an annualised return of 6.3% with about one quarter of the volatility. Of course, nothing can match that lack of volatility, but over time there are certain types of assets that can mimic money printing that do not carry the same risks as fiat money. Economics has a defined list of traits that help it define “money”. I have taken that list and amended it to produce a set of traits, or DNA, of a new form of hard money. The list goes as follows:
1) Physical assets with longevity
2) Ready market of exchange; multinational demand
3) No incumbent debt associated with the asset
4) Transportable and easy to store
5) Scarcity – finite supply
6) Relative uniformity of product
7) No income stream – so no tax liability
8) Relatively uncorrelated to equities
9) A sovereign debt default would not alter any of the above traits
10) No specific currency of denomination
No asset conforms perfectly, but some assets tick more boxes than most. Fiat money no longer ticks enough of my 10 DNA profiles to make it a valid store of value. SWAG stands for Silver, Wine, Art and Gold and the acronym came to life when I looked at the performance of various asset classes over the last decade. SWAG returns have knocked the spots off traditional investment assets. Furthermore, numerous academic studies have shown that this performance is not just a recent phenomenon. Indeed, it seems that SWAG assets have substantial academic research backing their inclusion in a portfolio.
The inherent risk of more and more money printing as governments face the need for intense financial repression will provide an investment arena that may well see traditional assets continue to struggle as indeed they have over the last decade. Yet, this type of environment has suited SWAG assets very well. I believe that no asset class, in itself, is too risky. Risk is all about the size of allocation to an asset. In this sense, an allocation of 20% to SWAG assets would likely provide greater robustness and enhanced diversification for any portfolio.
Joe Roseman joined Greenwells in 1987 as an Economist. He subsequently worked at SEB, being responsible for fixed income proprietary trading. Joining Moore Capital Management in 1994, he took over as Head of Economics in 1998, retiring from Moore in 2010 and now runs swaginvestor.co.uk.
Silver, Wine, Art and Gold
Alternative investments for the coming decade
Originally published in the July 2012 issue