Against the overall backdrop of an economic recovery, along with a series of unusual conditions
that I described in our last issue of FinancialMuscle.com, I believe these are on the short list of
issues of which to remain aware when building a sound financial strategy. Each has a large
component of government intervention and each is very large. The goal here is not
recommending a strategy. Instead, it is educating on issues that are real and should have weight
in any personal financial strategy.
Japan: Japan has suffered since the 1990s what we are suffering now. They haven’t been able to
cease propping up banks and real estate developers, even now over 20 years later. According to
the International Monetary Fund, from a 2010 estimate for 2012, Japan’s gross government debt
as a percentage of its GDP was 236%. The United States number was 107%. According to one
researcher Japan has been able to keep their economy from tragic contraction because private
citizens funded government debt at low interest rates. This is changing because Japan’s
population is aging. The quote I recall is “last year, they sold more adult than baby diapers.” The
aging population is cashing in bonds for retirement, rather than remaining a net buyer because so
many are in retirement. Now Japan has to go out to the international marketplace to issue new
debt at higher costs. Interest expense will rise. Average government bond yields of 2% or higher
means their interest expense is not covered by tax revenue. They would be forced to respond by
printing even more money while going further into debt.
US Entitlements, and Pensions: Entitlements are obviously out of control and un-affordable.
The only way to come up with the money is to raise tax at the risk of lowering private sector
growth even more. This is not a good option, but it is happening.
US Housing and Commercial Real Estate Markets: It is very obvious that these marketplaces
are being propped up by artificially low interest rates. Our risk is that interest rates increase
making housing and commercial real estate, far less affordable. A hypothetical 3 ½% 30 year
mortgage for $200,000 generates about a $900 monthly payment. Raise the rate to closer to a
long-term average of about 6% and that payment jumps to about $1,200. That’s a 33% increase.
Raising interest rates can have a bad effect on the stock and bond markets also. We saw this in
May of this year when Fed Chairman Bernanke indicated that his organization was on course to
allow interest rates to move up about a year and a half from then. Within a couple of days the
stock market was down by almost 6% (S&P 500 high on June 19, 2013: 1652.45 and low of 1560.33 on June 24, 2013).
Complex systems: What I am going to write here is a bit complex. If your eyes glaze over a bit,
just skip to the emboldened sentence below. Recent research writings by Rubino [2013]
explained that there are complicated mechanisms in finance as well as complex systems. A
complicated mechanism is like a car engine or a wristwatch. It has many moving parts that don’t
talk to each other. They simply move around doing what they’re supposed to do. A complex
system is more like a weather front. It has parts too, but they communicate with each other and
can respond by growing and shrinking. He refers to an “epic feedback loop” that turns a tropical
depression into a category five hurricane. As one component speaks to another within the system
exponential growth can occur. Double the size of one component and perhaps the entire system
grows 50 fold. The component here that can increase leverage many fold is bank balance sheets.
Long and short leveraged asset positions result in what appear to be moderate risk positions.
They actually represent far more risk than appears for a key reason. Consider that in year 2000,
volatile leverage positions approximated $30 trillion. Today they are about $596 trillion.
The way they are structured indicates the system is growing in a nonlinear fashion while the net
risk position appears to be moderate. This is exacerbated by the fact that everyone is everyone
else’s counter-party. Essentially, systematic risk is not priced into the value of these volatile
leverage positions. An International Monetary Fund working paper from 2012 essentially says it
like this: “The network topology where the very high percentage of exposures is concentrated
among a few highly interconnected banks implies that they will stand and fall together.” They go
on to further explain that one of the benefits of such a small, clustered group of banks
maintaining the lion share of [leverage] makes regulation far easier than it was in 2008”.
As always, please feel free to contact me at 952-230-1340. If you have any questions or would
like to discuss what is written here.
Warm regards,
Christopher Gerber, CFA
Stock investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Stock investing involves risk including loss of principal.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
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