Tipping Point?

The next crisis we face may be much worse than the housing crisis. It’s what I’ve talked about in the space before: sovereign subprime or too much government debt.

This may seem like a problem facing far-off Greece or Hungary, but it’s bigger and more problematic in the developed economies. Here, I’m talking about the big economies we typically associate with stability: Japan, Germany, France, Britain and the United States.

The issue is that such developed economies have borrowed too much money, like subprime borrowers, to live high on the hog today. This borrowing is going and has gone to generous social programs, defense, and, most insidiously, growing interest payments.

When the burden of paying debt, both interest and principal payments, get too high relative to incoming money (taxes) or an economy’s size (GDP), you get to a tipping point where there’s no where to go but down.

This problem is exacerbated by two additional issues: who did you borrow from and when do you owe them principal.

If you borrow from your own citizens, you’re in a better situation than when you borrow from foreigners, especially when those foreigners aren’t your best friend (hello, China).

If you borrow the money short instead of long term, you face the same problem as paying off a credit card versus a home loan–no credit card will give you wiggle room while you get your financial house in order.

Japan and Britain borrowed mostly from their own citizens. The U.S. borrowed mostly from Japan and China. Japan and Britain predominantly borrowed long term, the U.S. borrowed short term and must roll over most of its debt over the next several years.

The U.S. has an advantage over Japan, Britain, France and Germany, though: our economy grows faster and so does our population (both organically and from immigration). This gives us some wiggle room they don’t have.

Back to the tipping point issue. When interest payments get too high relative to economic production or tax revenues, those who lent you money want a higher interest rate. Guess what a higher interest rate does to those interest payments? Yep, higher and higher.

You can see why there’s a tipping point–once you reach a certain threshold, people start to doubt you can pay and want higher interest payments (or won’t lend you money), which creates a vicious cycle.

The developed economies of the world are entering that vicious cycle over the coming years. We stand on a knife’s edge and can chose, now, to stay on the good side or go to the dark side. And, we don’t have much time to chose.

If you tip to the dark side, what do you have to do? Theoretically, you can grow your way out of trouble, lower your interest payments, get bailed out by someone else, cut spending and jack up taxes, print money (inflation) to pay back loans, or default (also known as restructuring, repudiation, rescheduling, etc.).

The U.S. has been growing its way out of trouble for over 200 years. Unfortunately, when government spending grows to a certain percentage of the economy, your growth rate slows dramatically. We’re reaching that point, so we need to allow a lot of immigration, cut government spending, and reduce taxes to increase growth. I’m guessing the chance of any of those three happening is as great as finding a snowball near the sun’s core.

Is there any way we could lower the interest rate on our debt? You’ll have to ask Japan and China on that one, but don’t count on it.

Is it possible that any country in the world is capable of bailing out the U.S.? Please see snowball reference above.

Can we cut our spending and raise additional taxes? We could, but in a populist environment like we’re in, that will probably work as well as it has in Greece (please see riot footage as reference).

Can we inflate? This is the most likely outcome, and it won’t be a lot of fun for those who lent us money or for those on a fixed income here in the U.S.–and, by the way, that’s a lot of people!

Can we default? Like inflation, we can do it, but it won’t be pretty and will likely be a disaster for many.

Standing on the knife’s edge and looking at those six options, I would chose to knuckle down now, so we don’t have to go down the path of the six. I’m not optimistic that will happen in a democracy, so I’m planning on inflation.

So should you.

(I think we’ll still experience slight inflation/deflation over the next couple of years, but the turning point is hard to predict because our lenders will get to chose the timing).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds aren’t as safe as they may seem

When stock markets tank, most people think, “boy do I wish I owned bonds.”

Let me make this clear–bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn’t mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you’d have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward–but those are profits you can’t eat.

So, what are the risks for bonds. The first risk is the same as for stocks–what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business’s assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what’s left, but that doesn’t mean they will get paid back in full, and it doesn’t mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn’t have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can’t go down like stocks, think again!

The price declines I referred to above would happen quickly, but you’d still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That’s true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you’d receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970’s, and they’ll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business’s assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren’t riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it’s a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.