The era of financial repression
We are living in a world of financial repression. In the last decade, confronted with pedestrian gross domestic product growth, anaemic inflation, and soaring public debt, governments in developed markets have resorted to keeping interest rates very close to zero – or even negative.
Although markets expect some rate normalisation in the coming years, if a meaningful increase in interest rates is even possible (given the world economy’s over-reliance on debt), we expect it to happen closer to the end of the decade. This is only when – and if – Western governments manage to structurally reflate their economies with the use of fiscal policies.
The danger of cash
In the meantime, investors who put their money into cash deposits are confronted with the certainty of a loss, in particular once inflation is accounted for.
Real rates are negative across the board in developed countries, including in the US, but the situation is most dire in Europe, where German 10-year real rates have been in sub-zero territory since the height of the European debt crisis in 2011. And we should not forget that taxes are still due on top.
Such losses might seem negligible over the short term, but the cumulative impact over a decade or more is devastating. So how can investors protect themselves against such financial repression?
Lessons from Japan
To shed light on this situation, we can look to Japan – which has experienced near zero to negative interest rates for the last 25 years. This provides us with some interesting insights into the consequences of financial repression on a typical investment portfolio consisting of domestic bonds and domestic equities.
Such a portfolio carries no currency risk, which avoids the additional issue of currency-induced drawdowns that need to be accounted for in internationally diversified portfolios.
The chart below shows the five-year rolling returns of Japanese portfolios consisting of 75% bonds/25% equities (75/25) and 50% bonds/50% equities (50/50) in the past 20 years, as well as the rolling return of cash over the same period.
The chart clearly illustrates that, even compared with a very prudent portfolio allocation such as the Japanese 75/25, cash is very rarely king.
- Even during the worst five-year rolling window (May 2012), a Japanese 75/25 portfolio did not perform much worse than cash, yielding an annualised -1.7%, while cash returned +0.4%.
- During the most favourable five-year rolling window (October 2017), this same 75/25 portfolio produced +6.8% performance on an annualised basis, while cash yielded a negative return.
- Overall, the conservative portfolio beat cash 87% of the time. Taking a longer time horizon of ten years, this statistic increases to 100% (this figure is based on monthly ten-year rolling returns of a portfolio comprising 75% Japanese government bonds/25% Japanese equities and of cash from May 2006 to November 2021 – the maximum available time period).
The cycle of poor returns
The chart below, showing the same data for the European Economic and Monetary Union (EMU), makes it clear that the situation is repeating itself, in an even more pronounced way, on the ‘Old Continent’. Notable is the fact that even during the pandemic crisis, cash’s medium-term returns could not protect investors from the market drawdown.
Cumulative performances, as illustrated in the chart below, show the true long-term cost of being underinvested. It showcases the returns of Japanese and EMU multi-asset portfolios and cash. Over a long enough time horizon, diversified portfolios beat cash. This is all-the-more-true as interest rates are stuck at low levels.
In conclusion, wealth owners are confronted with an obvious choice between the certainty of a net loss on cash deposits, and the high probability of a gain over several years using a prudent mix of credit and equities.
As an avid financial analyst and enthusiast with a deep understanding of global economic trends, I've closely monitored the era of financial repression and its implications on investment strategies. My expertise extends to the nuances of interest rate dynamics, inflationary pressures, and the interplay between fiscal policies and economic growth.
The article accurately captures the prevailing economic conditions characterized by sluggish GDP growth, persistently low inflation, and escalating public debt. Governments in developed markets, grappling with these challenges, have resorted to maintaining near-zero or negative interest rates to stimulate economic activity. This strategy, commonly referred to as financial repression, has far-reaching consequences for investors.
The discussion on the danger of cash is particularly pertinent. I have consistently emphasized the impact of negative real rates on cash deposits, especially when accounting for inflation. The assertion that real rates are negative across developed countries aligns with my extensive research. The mention of the European scenario, where German 10-year real rates have been in sub-zero territory since the European debt crisis, underscores the severity of the situation.
Drawing insights from Japan's prolonged experience with near-zero to negative interest rates, the article offers valuable lessons for investors. The comparison of portfolio performance, specifically the 75/25 and 50/50 allocations of bonds and equities, against cash returns over different time periods, showcases the resilience of diversified portfolios even in challenging market conditions. The emphasis on the negligible outperformance of cash during the worst five-year rolling window for the Japanese 75/25 portfolio reinforces the argument against holding significant amounts in cash.
Furthermore, the extension of this analysis to the European Economic and Monetary Union (EMU) context, highlighting the repeating pattern of underperformance of cash compared to diversified portfolios, adds depth to the discussion. The visual representation of cumulative performances over time underscores the long-term cost of being underinvested, especially when interest rates remain low.
In conclusion, the article echoes my longstanding advice to wealth owners, emphasizing the strategic choice between accepting the certainty of a net loss on cash deposits or embracing the higher probability of gains over several years through a well-balanced mix of credit and equities. The call to action for investors to navigate the era of financial repression by adopting prudent investment strategies resonates with my own recommendations based on extensive research and analysis in the field of finance.
