“Good as Money,” proclaimed the ad for
Twenty Grand Cognac.
Being a beer drinker, and never having cashed in a Budweiser to pay for a
fill-up at the local gas station, I said to myself “Man, that must be
really good stuff!” Even in a financial meltdown I thought, you could
use it in place of cash, diamonds, gold or
Bitcoins! And if the Mongol hordes descend upon us during a future revolution, who wouldn’t prefer a few belts of
Twenty Grand on the way out, instead of some shiny rocks and a slingshot?
Well, not being inebriated at that moment I immediately shifted focus to a more serious topic. What
IS
money? A medium of exchange and a store of value is a rather succinct
definition, but we generally think of it as cash or perhaps checks that
reflect some balance of “ready” cash at a friendly bank. Yet as
technology and financial innovation have progressed over the past few
decades, and as central banks have tenuously validated the liquidity and
price of various forms of credit, it seems that the definition of money
has been extended; not perhaps to a bottle of
Twenty Grand Cognac,
but at least to some other rather liquid forms of near currency such as
money market funds, institutional “repo” and short-term Treasuries
“guaranteed” by the Fed to trade at par over the next few years.
All of the above are close to serving as a “medium of exchange”
because they presumably can be converted overnight at the holder’s whim
without loss and then transferred to a savings or checking account. It
has been the objective of the Fed over the past few years to make even
more innovative forms of money by supporting stock and bond prices at
cost on an ever ascending scale, thereby assuring holders via a “
Bernanke put” that they might just as well own stocks as the cash in their purses. Gosh, a decade or so ago a
house almost became a money substitute. MEW – or
mortgage equity withdrawal –
could be liquefied instantaneously based on a “never go down” housing
market. You could equitize your home and go sailing off into the sunset
on a new 28-foot skiff on any day but Sunday.
So as long as liquid assets can hold par/cost with an option to
increase in price, then these new forms of credit or equity might be
considered “money” or something better! They might therefore represent a
“store of value” in addition to serving as a convertible medium of
exchange. But then, that phrase “Good as Money” on the cognac bottle
kept coming back to haunt me. Is all this newfangled money actually
“money good?” Technology and Fed liquidity may have allowed them to
serve as modern “mediums of exchange,” but are they legitimate “stores
of value?” Well, the past decade has proved that houses were merely
homes and not ATM machines. They were not “good as money.” Likewise, the
Fed’s modern day liquid wealth creations such as bonds and stocks may
suffer a similar fate at a future bubbled price whether it be 1.50% for a
10-year Treasury or Dow 16,000.
But let’s not go there and speak of a bubble popping. Let’s perhaps more immediately speak about current and future
haircuts when we question the “goodness of money.”
Carmen Reinhart has
said with historical observation that we are in an environment where
politicians and central bankers are reluctant to allow write-offs:
limited entitlement cuts fiscally, no asset price sink holes monetarily.
Yet if there are no spending cuts or asset price write-offs,
then it’s hard to see how deficits and outstanding debt as a percentage
of GDP can ever be reduced. Granted, the ability of central
banks to avoid a debt deflation in recent years has been critical to
stabilizing global economies. And too, there
have been
write-offs, in home mortgages in the U.S., for example, and sovereign
debt in Greece. But the cost of these strategies, which avoid what I
simplistically call “haircuts,” has been high, and their ability to
reduce overall debt/GDP ratios is questionable. Chairman Bernanke has
admitted that the cost of zero-bound interest rates, for instance,
extracts a toll on pension funds and individual savers. Some of his Fed
colleagues have spoken out about the negative aspects of QE and future
difficulties of exit strategies should they ever take place. (They
won’t!) So current policies come with a cost even as they act to
magically float asset prices higher, making many of them to appear “good
as money” – shots of cognac notwithstanding.
But the point of this
Outlook is that even IF… even IF QEs
and near zero-bound yields are able to refloat global economies and
generate a semblance of old normal real growth, they will do so
utilizing historically tried and true “haircuts” that rather
surreptitiously “trim” an asset holder’s money without them really
knowing they had entered a barbershop.
These haircuts are hidden
forms of taxes that reduce an investor’s purchasing power as
manipulated interest rates lag inflation. In the process, governments
and their central banks theoretically reduce real debt levels as well as
the excessive liabilities of levered corporations and households. But
they represent a hidden wealth transfer that belies the vaunted phrase
“good as money.”
Before drinking up, let’s examine these haircuts to see why they do
not represent an authentic store of value even if their bubbly prices
never pop. I will give each haircut a symbolic name – I welcome your
suggestions as well via e-mail reply:
outlook@pimco.com
(1) Negative Real Interest Rates – “Trimming the Bangs”
During and after World War II most countries with high debt overloads
resorted to artificially capping interest rates below the rate of
inflation. They forced savers to accept negative real interest rates
which lowered the cost of government debt but prevented savers from
keeping up with the cost of living. Long Treasuries, for instance, were
capped at 2½% while inflation was soaring towards double-digits. The
resulting negative
real rates together with an accelerating
economy allowed the U.S. economy to lower its Depression-era debt/GDP
from 250% to a number almost half as much years later, but at a cost of
capital market distortions.
Today, central banks are doing the same thing with near zero-bound
yields and effective caps on higher rates via quantitative easing. The
Treasury’s average cost of money is steadily grinding lower than 2%. If
current policies continue to be enforced in future years it will
eventually be less than 1% because of the inclusion of T-bill and short
maturity financing.
The government’s gain, however, is the
saver’s loss. Investors are being haircutted by at least 200 basis
points judged by historical standards, which in the past offered no QE
and priced Fed Funds close to the level of inflation. Large
holders of U.S. government bonds, including China and Japan, will be
repaid, but in the interim they will be implicitly defaulted on or
haircutted via negative real interest rates.
Are Treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered. These rather innocuous seeming (-1%) and
(-2%)
real rate haircuts are not a bob or a mullet in hairstyle parlance.
More like a “trimming of the bangs.” But at the cut’s conclusion,
there’s a lot of hair left on the floor.
(2) Inflation / Currency Devaluation – “the “Don Draper”
Inflation’s sort of like your everyday “Mad Men – Don Draper” type of
haircut. It’s been around for a long time and we don’t really give it a
second thought except when it’s on top of a handsome head like Jon
Hamm’s. 2% ± a year – some say more – but what the heck, inflation’s
just like breathing air … you just gotta have it for a modern-day
levered economy to survive. Sometimes, though, it gets out of control,
and when it is unexpected, a decent size hit to your bond and stock
portfolio is a possibility. If our TV idol Don Draper lives another
decade or so on the airwaves, he’ll find out in the inflationary 70s.
Such was the example as well in the Weimar Republic in the 1920s and in
modern day
Zimbabwe
with its One Hundred Trillion Dollar bill shown below. As central banks
surreptitiously inflate, they also devalue their currency and
purchasing power relative to other “hard money” countries. Either way –
historical bouts of inflation or currency devaluation suggest that your
investment portfolio may not be “good as the money” you might be banking
on.
(3) Capital Controls – the “Uncle Sam Cut”
Uncle Sam with his rather dapper white hair and trimmed beard serves
as a good example for this type of haircut, if only to show that even
the U.S. can latch on to your money or capital. Back in the 1930s, FDR
instituted a rather blatant form of expropriation shown above. All
private ownership of gold was forbidden (and subject to a $10,000 fine
and 10 years in prison!) if it wasn’t turned into the government. Today
we have less obvious but similar forms of capital controls –
currency pegging
(China and many others), taxes on incoming capital (Brazil) and
outright taxation/embargos of bank deposits (Cyprus). Governments use
these methods to keep money out or to keep money in, the net result of
which is a haircut on your capital or your potential return on capital.
Future haircuts might even include a wealth tax. Are gold and/or AA+
sovereign bonds good as money? Usually, but capital controls can clip
you if you’re not careful.
(4) Outright Default – the “Dobbins”
Ah, here’s my favorite haircut, and I’ve named it the “Dobbins” in
honor of this 5-year bond issued in the 1920s with a beautiful gold seal
and payable, in dollars
or machine guns! Bond holders got
neither and so it represents the historical example of the ultimate
haircut – the buzz, the shaved head, the “Dobbins.” As suggested
earlier, the objective of central banks is to prevent your portfolio
from resembling a “Dobbins.” I have tweeted in the past that the Fed is
where all bad bonds go to die. That is half figurative and half literal,
because central banks are typically limited from purchasing bonds
payable in machine guns or subprime mortgages (there have been
exceptions and Bloomberg reported that nearly 25% of global central
banks are now buying stocks believe it or not)! But by purchasing
Treasuries and Agency mortgages they have rather successfully incented
the private sector to do their bidding. This behavior reflects the
admission that modern-day developed economies are asset-priced
supported. Unless prices can continuously be floated upward, defaults
and debt deflation may emerge. Don’t buy a Dobbins bond or a
Dobbins-like asset or a bond from a country whose central bank is buying
stocks. They probably aren’t “good as money!”
Investment Strategy
So it seems as if the barber has you cornered, doesn’t it? Sort of like Sweeney Todd!
Let’s acknowledge that possibility, along with the observation that all
of these haircuts imply lower-than-average future returns for bonds,
stocks, and other financial assets. If so, the rather mixed metaphor of
“money’s goodness” and “avoiding haircuts” is still the question of our
modern investment age. The easiest answer to the question of what to buy
is to simply take your ball and go home. If the rules aren’t fair,
don’t play. That endgame however, results in a Treasury bill rate of 10
basis points or a negative yield in Germany, France and Northern EU
markets. So a bond and equity investor can choose to play with
historically high risk to principal or quit the game and earn nothing.
PIMCO’s advice is to continue to participate in an obviously
central-bank-generated bubble but to gradually reduce risk positions in
2013 and perhaps beyond. While this
Outlook has indeed claimed
that Treasuries are money good but not “good money,” they are better
than the alternative (cash) as long as central banks and dollar reserve
countries (China, Japan) continue to participate.
The same conclusion applies to credit risk alternatives such as
corporate bonds and stocks. Granted, this sounds a little like Chuck
Prince and his dance floor metaphor does it not? His example proved that
dancing, and full heads of hair are not forever. So give your own
portfolio a trim as the year goes on. In doing so, you will give up some
higher returns upfront in order to avoid the swift hand of Sweeney
Todd. There
will be haircuts. Make sure your head doesn’t go with it.
Quick Read
1) Central banks and policymakers are acting like barbers. They
haircut your investments.
2) Negative real interest rates, inflation, currency devaluation,
capital controls and outright default are the barber’s scissors.
3) Gradually reduce duration, risk positions and “carry” as the year proceeds.
William H. Gross
Managing Director
