Protect yourself from inflation these three ways

Monday, 11 July 2022 — Albert Park

[6 min read]

Dear Reader,

Fund manager Tim Davies was one of the first guests on my Fat Tail Investment Podcast. He just popped up unexpectedly at my Saturday breakfast — in The Weekend Australian.

Tim wrote a cracking piece explaining why the central banks will be very quickly walking back the interest rate rises and tough talk on inflation.

It’s an easy case to understand too. There’s simply too much sovereign debt in the world to tolerate higher rates.

Central bankers have a choice: crashing the asset markets and the economy with higher rates or find some other way to deal with the current situation.

They’ll find another way, which will involve financial repression in some form.

Here’s the problem no one wants to address…

We all like to live in a collective fantasy where asset prices rise, and wages are good, but the government can run financial deficits endlessly to pay for everything from healthcare to Ukraine handouts, to first home buyer grants, to subsidising the arts during COVID, to transgender studies.

All these things need to be paid for. But they aren’t, really. They are merely financed with borrowed money.

You only need to look at Sri Lanka to see where that can lead a country. It barely has enough foreign exchange to pay for crude oil or medical imports.

The government in turn prints money to pay for the public service staff, which is driving the basics of rice and cooking oil through the roof.

Australia is not immune to this basic dynamic. Almost all our foreign exchange is earnt through the sale of iron ore, coal, and natural gas — three sectors that are hardly going to be the driving force of the 21st century.

The times are good now, but we are on a borrowed bounty. And we still have a trillion-dollar deficit and more to come!

Each government, Liberal or Labor, craps on about getting the budget back in balance, and then proceeds to meet the reality that voters like their free lunch and don’t want it taken away from them.

And even if the federal government could get a handle on it all, the state governments run their own shambolic finances.

It’s absurd.

But it’s OK! We now have Modern Monetary Theory to justify all this! ‘Deficits don’t matter’, they say. They also add that as an accounting exercise, public debt is a private asset. One wonders what those holding Sir Lankan debt think about that point.

To be fair, some of their basic tenets are true. A sovereign nation can use its currency created at will to finance whatever it likes. A government bond is a private asset.

But most government spending is squandered on non-productive behaviour, not investment for the future.

The MMT crowd also love to point to Japan, too, as an example of how a government can run endless financial deficits and not generate inflation.

They ignore the collapse in Japanese bank credit creation simultaneously that allowed this to happen.

Japanese debt-to-GDP is well over 200%. The central bank owns a staggering 50% of the entire government bond market.
They do this to pin down interest rates. The Japanese Government cannot pay all the interest on such debt at normal market rates.

That’s the future of the West too.

The Japanese yen is down quite badly this year. And no wonder. Japan has a printing press, but it doesn’t have natural resources, and they’re scarce right now and at a high cost.

Japan can print as much yen as it likes, but markets aren’t stupid. They’ll demand more of them for each hard barrel of oil or tonne of wheat.

The net result is a higher cost of living for the Japanese people as the yen declines. Compare that to the Russian ruble, which is up this year, because Russia at least has huge reserves of natural resources.

This hidden asset backing also underpins the US dollar via the petrodollar. The question is: what happens when hydrocarbons are undercut from the world economy via the oncoming freight train of renewable energy?

The US Government has an equally ridiculous US$30 trillion in debt and deficits.

Suffice to say, the fiat currencies of the West can’t hold the system together without further central bank intervention.

We’re going to get — at least in my book — negative real interest rates as they pin down rates and allow inflation to run higher.

This is one reason I find the notion of a real estate collapse absurd right now. Property is a hedge against this dynamic.

Once this situation becomes apparent, the overarching investment goal will be to get out of cash and into hard assets.

It’s also why I don’t think you should give up on physical gold or Bitcoin [BTC] yet either.

And why corporates that rely on commodities for their inputs — like carmakers — can use underpriced debt to acquire real assets inflating in value. For more on that, go here.

Regards,

Callum Newman,
Editor, The Daily Reckoning Australia

Dear Reader,

Our hoary president was in the news the other day. This from CBSNews: ‘Biden promotes plan to protect millions of workers’ pensions’:

‘President Joe Biden on Wednesday traveled [sic] to Ohio to highlight his administration’s work to prevent cuts to millions of workers’ pensions as his approval rating continues to sag ahead of the midterm elections.

‘Biden’s visit was tied to the launch of a program launch of a program created under the American Rescue Plan that provides assistance to struggling multi-company pension plans, ensuring that as many as 3 million workers and retirees will receive their full benefits.’

This morning, the Wall Street Journal (WSJ) adds that pension funds will be able to use up to a third of the US$90 billion in free money to gamble in the stock market.

Republicans allegedly maligned these pension bailouts as ‘rat holes’. Of course, they were right. But the rats vote, and Joe will take votes from wherever he can get them.

And here’s an earlier WSJ note showing us what a big hole the rats dug for themselves. In Pasadena, California:

‘The local police and fire pension plan has been closed for nearly 50 years. Pension recipients have dwindled to fewer than 180. But the city still owes about $135 million in bond debt on the plan. Payments on it are expected to be about $6 million in 2022.’

Local governments made pension commitments that they couldn’t afford. Employees must have known it. So did fund managers. But such was the connivance between them that neither wanted to ask questions. They hoped for the best…and waited for the bailout.

Our pen pal, MN Gordon, adds this:

‘According to a Municipal Market Analytics analysis of Bloomberg data, more than 100 city, county, state, and other governments borrowed for their pension funds last year. This is twice the highest number that did so in any prior year.

‘Standing behind these pension funds are state and local taxpayers — that’s you, acting as the ATM. Moreover, when the investment returns of public pension funds fall short, governments are primarily responsible for filling the void. This means cutting other spending and services or increasing taxes.’

Behind the local pensions stand the local governments. And behind the local governments stand the state governments. And behind them all stands the US Federal Government. And the US Government is us.

So where do the citizens of Dubuque get the money to pay the pensions of garbage collectors in Baton Rouge? The question is rarely asked because the money was…until recently…almost free and unlimited. Governments could borrow…and then rollover their debt at an even lower rate.

But now, bonds are falling, consumer prices are rising, and the question marks are coming out. We have an answer that will delight the wokesters. They won’t have to worry about defunding the police…or the trash collectors. All current services will be defunded in order to fund past ones.

And by the way, that is the way of all debt. The money must be taken from the future to make good on yesterday’s promises. Or the promises must be broken.

We will not dwell on the coming disaster in the pension world. It’s the debt disaster in the larger world that interests us.

So far…

We have the worst inflation in 41 years.

The worst stock market in 52 years.

The worst bond market in 224 years.

The worst consumer sentiment…and the worst performance for a balanced 60–40 portfolio…since record keeping began.

So what gives?

We’re glad you asked. And hope you don’t expect a short answer.

A full accounting of ‘what is going on’ would take more time and space than we have available. You can go as deep as you care to — all the way to the Big Bang, if you want. After all, had Adam not gotten together with Eve, there would be no Jerome Powell today. And had not the naked lady eaten the forbidden fruit — thus bringing evil into the world — there would be no US Federal Reserve.

But we’ll spare you the Original Sin interpretation and just give you the Dummies Guide version. And in the spirit of ‘diversity, access and inclusion’, we will begin at the ‘functioning moron’ level and head down on the freight elevator from there.

Here at the Letter, we usually stop at the ‘smoked-too-much-weed-in-college’ explanation; it’s about all we can handle. Exceptionally, we will keep going down…examining the sedimentary layers as we go…and let you decide where to get off.

What’s going on? The simplest answer is it’s a stock market sell-off.

Stocks go up. Then they go down. They went up, with brief interruptions, for 39 years…from August 1982 to November 2021. Since then, the Dow has lost about 5,000 points. If recent history is anything to go on, it will lose another 7,000 points before it hits bottom.

We doubt that recent history will do us much good, however. Something very important has changed. Inflation: we haven’t seen so much of it since Rod Stewart was singing, ‘Da Ya Think I’m Sexy’. So, we will go down another level and take a look…

Bonds go up and down too — typically in very long cycles. The 10-year T-bond yield, the basic brick of the entire capital structure, hit a low in August 2020. Before that, the previous low came around the time we were born — in the late 1940s. Bottom to bottom took more than seven decades.

So it’s a big deal when these things turn around. And that’s what appears to be happening now. After 42 years of rising prices, bonds just suffered their worst loss since George Washington was president.

But what does that mean? Why is it so important? Tomorrow, we head down further…closer to bedrock…to see if we can figure it out.

Regards,

Bill Bonner,
For The Daily Reckoning Australia