Inflation, Interest Rates & Financial Represion

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giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Inflation, Interest Rates & Financial Represion

Post by giskard »

I wanted to start a discussion about these topics because of the era we are living in and the actions that it looks like governments around the world will need to take. I'll start by defining some terms, giving some official stats, state some assumptions and lay out a couple of arguments to see if people agree with my research or not.

Inflation

- CPI inflation is a measure of consumer price inflation based on a basket of goods with "hedonic adjustments". Current CPI: 1.6%
- Asset Price Inflation - inflation in financial assets such as stocks and bonds. 15% return on SPY in 2020, 29% return in 2019.
- CPI is widely believed to be slightly under-reported for various reasons. I personally believe it could be more like 3-5% based on things like the Big Mac Index and my own experiences with actual price increases in the US.
- Some economists believe true inflation should be measured and looked for only in commodity prices and that it can take years to filter down into measured CPI.

Interest Rates

- The federal funds rate is the rate at which institutions lend to each other overnight. Current rate: 0.09% (basically zero)
- USA 10 year treasury bonds (UST 10 YR) currently sits at 1.22%
- JPN 10 year government bonds - yield is 0.027%
- German Bund 10 year rate - yield is -0.477% (yes it is negative)

Real Rates

In the USA these are negative (same with Germany). That means you get paid back less in purchasing power for the dollars you lend.

- The actual rate accounting for inflation
- US CPI is 1.6%, and US Treasuries are 1.22% so that would be a negative 0.38% rate of return in real purchasing power
- German inflation is -0.3%. German 10yr treasuries are -0.477%, so they have a negative 0.177% rate of real return in purchasing power.
- It looks like Japan is basically flat or has slightly positive real rates depending on where you look.

Debt / GDP Ratios

- Current US Debt to GDP ratio: 127% (https://fred.stlouisfed.org/series/GFDEGDQ188S)
- Current Japanese Debt to GDP Ratio: 236%
- Germany: 73%
- UK: 100.9%

Financial Repression

These would be measures where governments channel funds from private industry to pay down public debt. Article: https://www.investopedia.com/terms/f/fi ... ession.asp

Features of financial repression
- caps on interest rates (these create negative real yields on assets like bonds)
- government intervention with banks
- direct government lending to specific industries

Where this ends up going

I've been reading a lot of articles and listening to a lot of podcasts put out by folks like Russel Napier, Grant Williams, Brent Johnson and Erik Townsend. It seems that people are having a hard time agreeing on whether or not we are going to have a deflationary or inflation environment in the near term (in terms of CPI), but I believe that most of them agree we will probably get negative real rates and financial repression for some years to come.

One era folks are comparing this to is the post WWII era where there was a lot of inflation, and very negative real rates (nominal interest rates were pegged lower) and the very high public debts were effectively inflated away. This came at the expense of bond holders in terms of purchasing power.

The fed appears to be doing what it can to both hold rates down and foster some inflation. They seem to be accommodative to "helicopter money" in the form of stimulus checks and direct grants to businesses. They seem to be doing QE aggressively and expanding their balance sheets to prop up asset prices, keep bond yields low, and credit flowing freely.

Russel Napier is predicting we get 4% measured CPI inflation sometime this year and deeply negative real rates. I believe he was also expecting both yield curve control (central banks buy long dated bonds to suppress rates) and possibly even US treasury bonds going negative.
https://themarket.ch/interview/russell- ... nt-ld.2323

Portfolio constructions

It goes without saying you want to own no bonds in this environment. You want things that do well with negative rates like precious metals, and you want stocks that will do well with mild inflation. Here is my personal portfolio construction:

- 20% precious metals & miners
- 20% bitcoin
- 10% cash
- 50% equity (pretty evenly split between US, emerging markets, and developed markets, some REITs, some mining stocks, tech stocks, etc)

What do you think?

Do you see any problems with this scenario? What moves are you making? Is my portfolio totally stupid? What do you think the world will look like 2 years from now, 5 years from now, and 10 years from now?

One difference we have today is that private corporations and consumer debt is also very high. Another difference we have is that pension systems are heavily invested in bonds and our current demographics mean there are many older savers depending on yields on e.g. bonds. We also seem to be in an "everything bubble". Also, if inflation is under-reported that means real rates are even more negative right now.

How does this all play out?

IlliniDave
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Joined: Wed Apr 02, 2014 7:46 pm

Re: Inflation, Interest Rates & Financial Represion

Post by IlliniDave »

What I think is that being driven by human actors means the future will be chaotic (in the layman's sense) and I'm leery of betting too highly on predictions underwritten by appeal to authority. I don't know how it will play out. There's a pretty good chance it won't be good.

Regarding your portfolio, only you can judge whether it suits you--the older I get the more convinced I am that emotion and temperament are the things which define the playing field one must navigate. Portfolios have to be suitable for that terrain and part of a holistic life strategy. For the sake of discussion 40% total in bitcoin and PM&M is more than I could stomach, despite the famous story of the man who spent something like $4.2B (today's valuation) in bitcoin on pizza in 2009.

There is a lot going on alongside the tricky economic situation, and economics are not my chief worry at this time. I'm gearing up for a rearguard campaign with preservation being the focus. I'm down to being just months away from pulling the plug, and proximity to that juncture is a big driver in my current and short-term future actions.

My thoughts on equity are similar to yours. I seem to have settled at 50% +/- 10%, pretty far down from brash and youthful iDave, and lower than my "official plan" which would have me up around 75% at this time. The rest is bonds and cash. Not sure of the split at this moment.

The one area I'm developing a plan to change is real estate. Currently real estate is about 16-18% of my net worth, and only about a tenth of that is above what's dedicated to where I'll be residing. I'll be expanding my real estate holdings modestly as my family dies off, but I'll probably also be a buyer. At this time I have no desire to manage rental properties, actively or passively. So I'll be looking for farmland or possibly undeveloped property. With the former it would probably have to be rented out to offset taxes, but the idea isn't income generation, it's just an alternate way to park wealth with modest probability it won't vaporize. I would like to get it up to about a third of my net worth.

ertyu
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Joined: Sun Nov 13, 2016 2:31 am

Re: Inflation, Interest Rates & Financial Represion

Post by ertyu »

giskard wrote:
Wed Jan 13, 2021 1:17 am
deflationary or inflation environment in the near term
yes

>> to elaborate, in my opinion thinking about "inflationary or deflationary environment" is misguided, even if we were to just focus on the cpi. it is very clear certain categories of goods and services are experiencing strong inflation whereas others are experiencing deflation. conflating only muddles one's understanding. so when we think of "where this is going," in my opinion it is best to think in terms of sectors and their interplay relative to each other rather than in terms of aggregates ("CPI", "stocks", "bonds", etc.)

Campitor
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Re: Inflation, Interest Rates & Financial Represion

Post by Campitor »

World wide the age demographic is flipping; more old people than young people. This means that the price of labor will go up (who knows for how long) because of human capital shortages - not enough replacement workers. This also means economies will contract globally. As everyone's economy shrinks, supply chains will also shrink which will cause some global instability and perhaps regional cold/hot wars.

Supplies chains will shrink not only as a result of a depressed economy but the secondary effects of diminished US military spending on foots and fleets which means the EU will need to spend more on their defense while increasing their military conscription to stopgap the US diminished NATO presence. Since there are few EU countries than can project power to safeguard supply chains, existing supplies chains may be taken over by bad actors/hostile nations. Future saber rattling/military skirmishes will add to the economic miasma.

The US and some South American countries have a better economic impact mitigation profile than Europe/China because of easier trade access to Atlantic/Pacific rim economies, intra-continental trade, and easier access to domestic raw materials.

In this scenario I imagine that emerging markets investments will need to be heavily scrutinized. For example Mexico is a better position to endure this economic downturn because of it's proximity to the US, easier access to Atlantic/Pacific shipping, and its reliance on US military protection of common shipping lanes.
Last edited by Campitor on Tue Jan 19, 2021 6:19 pm, edited 2 times in total.

7Wannabe5
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Joined: Fri Oct 18, 2013 9:03 am

Re: Inflation, Interest Rates & Financial Represion

Post by 7Wannabe5 »

The U.S. also still has the room to open up immigration.

ertyu
Posts: 1586
Joined: Sun Nov 13, 2016 2:31 am

Re: Inflation, Interest Rates & Financial Represion

Post by ertyu »

@giskard, as for portfolio construction, chris cole + dragon makes a compelling case, also mike greene + straddles. you sound like a quantitatively solid guy, you could probably diy (some part of) these strategies. obv. tinker with the "bonds" category 'cause i think dragon suggests a quarter in bonds :D

nomadscientist
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Re: Inflation, Interest Rates & Financial Represion

Post by nomadscientist »

Are "everything bubble" and "underreported inflation" logically distinct concepts

The Old Man
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Joined: Sat Jun 30, 2012 5:55 pm

Re: Inflation, Interest Rates & Financial Represion

Post by The Old Man »

USA real growth in the first two decades of the 21st century averaged 2% a year. Real growth in the 20th century, with the exception of the 1930s, averaged 3% a year. The Fed implemented quantitative easing to support the economy and the subpar economic growth is the likely root cause. It should be noted that financial engineering cannot compensate for economic decline – only economic fluctuations. Quantitative easing has led to major asset price inflation and low/negative real interest rates; however, the economy has been temporarily supported.

The Long Depression of 1873-1879 (or 1893) was a worldwide price and economic recession driven by the side-effects of the industrial revolution. We can consider the current economic environment to be suffering the side-effects of the Internet revolution. It seems apparent that the Internet (and affiliated technologies) has vastly improved efficiency, but overall demand seems to have declined (or rather the rate of increase of demand has declined from 3% to 2%).

How will it end? Will overall real growth return to its long-term average of 3%? The rate of 3% seems to be arbitrary, so 2% may be the new normal. If growth returns to its long-term average of 3%, then the current issues will eventually subside; although, we should see low investment returns in the interim. If 2% is the new normal, then quantitative easing will fail in a major way. The side effects of quantitative easing will lead to economic crisis and high inflation. In the 1960s-1970s the government attempted to smooth the business cycle, but the end result by 1980 was persistent inflation and unemployment.

TL/DR: Low/negative interest rates are driven by sub-par economic growth. If economic weakness is temporary, then low investment returns in the interim. If economic weakness is permanent, then because of the side effects of financial engineering the economy will be in crisis and endure high inflation.
Last edited by The Old Man on Fri Jan 15, 2021 10:01 am, edited 1 time in total.

Lucky C
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Re: Inflation, Interest Rates & Financial Represion

Post by Lucky C »

Since you asked if your portfolio is "totally stupid," I would say no except the 20% Bitcoin part. Not to go off on a tangent outside the Bitcoin thread, but I would not even consider that an investment, so 20% seems crazy to me.

Assets are already pricing in the aggregate expectation of inflation from all of the best investors of the world. By tilting your portfolio toward inflation, you are betting that these assets, which are already getting more expensive due to the expectation of higher inflation, are actually underestimating the amount of inflation we'll be seeing. So if the market is pricing in that we go from 1.4% to 4% inflation and it turns out we only go to 3% inflation, I would not expect those assets to "beat the market" and they may decline instead. Sorry to be Efficient Markety but inflation rate (or rather the difference between the market's expected inflation rate and the actual subsequent inflation rate), as well as changes in bond yields, are extremely hard to predict if you're not a full time professional with that kind of specialty.

Having said that, I know that some of the greatest investors in the world did buy gold mining stocks last year, so there's that. You could look up 13F forms to see the composition of their active picks, though that involves a delay between when they purchased and when the 13F form listing the purchase was made public.

Lastly, Hussman recently wrote about the option value of cash. Sometimes it makes sense to hold a higher portion of cash, like when it's hard to find bargains currently but you anticipate being able to find assets with better expected returns in the somewhat near future (before inflation takes too much of a bite). It seems like right now is a great time to have a higher allocation to cash. After all, if this is an everything bubble, we can expect an everything crash with bargains galore to follow.
https://www.hussmanfunds.com/comment/mc201201/

ertyu
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Joined: Sun Nov 13, 2016 2:31 am

Re: Inflation, Interest Rates & Financial Represion

Post by ertyu »

@giskard, luke gromen says you're fine :lol:. He says he's holding miners, gold, btc, and equities.

the problem with this portfolio is the possibility that rates go up, which almost everyone agrees they're unlikely to except in the immediate short term.

giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Re: Inflation, Interest Rates & Financial Represion

Post by giskard »

IlliniDave wrote:
Wed Jan 13, 2021 6:59 am
My thoughts on equity are similar to yours. I seem to have settled at 50% +/- 10%, pretty far down from brash and youthful iDave, and lower than my "official plan" which would have me up around 75% at this time. The rest is bonds and cash. Not sure of the split at this moment.

The one area I'm developing a plan to change is real estate. Currently real estate is about 16-18% of my net worth, and only about a tenth of that is above what's dedicated to where I'll be residing. I'll be expanding my real estate holdings modestly as my family dies off, but I'll probably also be a buyer. At this time I have no desire to manage rental properties, actively or passively. So I'll be looking for farmland or possibly undeveloped property. With the former it would probably have to be rented out to offset taxes, but the idea isn't income generation, it's just an alternate way to park wealth with modest probability it won't vaporize. I would like to get it up to about a third of my net worth.

With 50% in bonds and cash and looking towards preservation, do you feel comfortable with the bond allocation? Interest rates are a 5000 year low and real rates are negative.

I think expanding into real estate makes a lot of sense at the current time as a preservation tactic, what will you de-allocate from to do this?

giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Re: Inflation, Interest Rates & Financial Represion

Post by giskard »

Campitor wrote:
Wed Jan 13, 2021 1:50 pm
The US and some South American countries have a better economic impact mitigation profile than Europe/China because of easier trade access to Atlantic/Pacific rim economies, intra-continental trade, and easier access to domestic raw materials.

In this scenario I imagine that emerging markets investments will need to be heavily scrutinized. For example Mexico is a better position to endure this economic downturn because of it's proximity to the US, easier access to Atlantic/Pacific shipping, and its reliance on US military protection of common shipping lanes.
This is an interesting thing to think about. I think it makes a lot of sense in terms of security and likelihood of conflicts, etc.

giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Re: Inflation, Interest Rates & Financial Represion

Post by giskard »

ertyu wrote:
Thu Jan 14, 2021 2:28 am
@giskard, as for portfolio construction, chris cole + dragon makes a compelling case, also mike greene + straddles. you sound like a quantitatively solid guy, you could probably diy (some part of) these strategies. obv. tinker with the "bonds" category 'cause i think dragon suggests a quarter in bonds :D
I've read about the dragon portfolio and I like the idea. It is:

- Domestic Equity (24%)
- Fixed Income/Bonds (18%)
- Active Long Volatility (21%)
- Commodity Trend Following (18%)
- Physical Gold (19%)

Long vol is tricky in my opinion. This past year it has been incredibly profitable to sell at the money puts on just about anything because of the high vol all year. You could make 5 to 10% a month for a while after the March crash. This captures the volatility profit but selling an option makes you short vol from the time you do it. Interesting to think about. Strategically buying LEAPs when vol is low is an obvious long vol option which I am doing a little a bit, hard to actually do well in practice though.

Is bitcoin a long vol asset? In my opinion it is and I'm long vol because of this.

Commodity trend following is also something I'm looking to try to allocate to, just trying to find the right fund to buy into because it's very hard to do this yourself without a lot of time + capital. I think being long some emerging markets & mining equities gives you long side exposure to commodities, but getting that short side you need to use a CTA fund.

I also think the permanent portfolio system is interesting to look at but I think making discretionary decisions like de-allocating bonds and cash is important in the face of historically outlying timeperiods like the one we are currently in.

Ultimately, I've read through these different strategies and I'm saying I'm discarding bonds and reducing cash allocation and basically just going long the equity + previous metals + vol. I just don't see a good argument to not discard the bond portion, it opens you to deflation but everyone is united against allowing deflation to actually happen!

giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Re: Inflation, Interest Rates & Financial Represion

Post by giskard »

The Old Man wrote:
Thu Jan 14, 2021 11:53 pm
USA real growth in the first two decades of the 21st century averaged 2% a year. Real growth in the 20th century, with the exception of the 1930s, averaged 3% a year. The Fed implemented quantitative easing to support the economy and the subpar economic growth is the likely root cause. It should be noted that financial engineering cannot compensate for economic decline – only economic fluctuations. Quantitative easing has led to major asset price inflation and low/negative real interest rates; however, the economy has been temporarily supported.

The Long Depression of 1873-1879 (or 1893) was a worldwide price and economic recession driven by the side-effects of the industrial revolution. We can consider the current economic environment to be suffering the side-effects of the Internet revolution. It seems apparent that the Internet (and affiliated technologies) has vastly improved efficiency, but overall demand seems to have declined (or rather the rate of increase of demand has declined from 3% to 2%).

How will it end? Will overall real growth return to its long-term average of 3%? The rate of 3% seems to be arbitrary, so 2% may be the new normal. If growth returns to its long-term average of 3%, then the current issues will eventually subside; although, we should see low investment returns in the interim. If 2% is the new normal, then quantitative easing will fail in a major way. The side effects of quantitative easing will lead to economic crisis and high inflation. In the 1960s-1970s the government attempted to smooth the business cycle, but the end result by 1980 was persistent inflation and unemployment.

TL/DR: Low/negative interest rates are driven by sub-par economic growth. If economic weakness is temporary, then low investment returns in the interim. If economic weakness is permanent, then because of the side effects of financial engineering the economy will be in crisis and endure high inflation.
Excellent comment, you gave me more stuff to read about. The internet / industrial revolution being analogous is something to think about. Especially due to age demographic realities across the developed world it appears that that low economic growth could be the future for a while and the results (high inflation for one, and probably more negative real rates) seem like they the most likely outcome.

One thing to think about is what if economic growth is not just weak / flat... What if it is mildly negative for years?

giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Re: Inflation, Interest Rates & Financial Represion

Post by giskard »

Lucky C wrote:
Fri Jan 15, 2021 4:11 am
Since you asked if your portfolio is "totally stupid," I would say no except the 20% Bitcoin part. Not to go off on a tangent outside the Bitcoin thread, but I would not even consider that an investment, so 20% seems crazy to me.
Well to be fair it started out as a much smaller allocation and I just let it grow and have not rebalanced. My plan is to rebalance away from it into emerging markets and real estate during this year to some degree.

giskard
Posts: 212
Joined: Sat Apr 30, 2016 12:07 pm

Re: Inflation, Interest Rates & Financial Represion

Post by giskard »

Lucky C wrote:
Fri Jan 15, 2021 4:11 am
Assets are already pricing in the aggregate expectation of inflation from all of the best investors of the world. By tilting your portfolio toward inflation, you are betting that these assets, which are already getting more expensive due to the expectation of higher inflation, are actually underestimating the amount of inflation we'll be seeing. So if the market is pricing in that we go from 1.4% to 4% inflation and it turns out we only go to 3% inflation, I would not expect those assets to "beat the market" and they may decline instead. Sorry to be Efficient Markety but inflation rate (or rather the difference between the market's expected inflation rate and the actual subsequent inflation rate), as well as changes in bond yields, are extremely hard to predict if you're not a full time professional with that kind of specialty.
It's a fair point to consider if increasing inflation is priced in now.

I believe things like copper are breaking out because of stimulus expectations not necessarily inflation. Inflation expectations in mainstream financial press are still very low from what I read.

I think the consensus view is immediate concern about deflation and maybe some slowly increasing expectations of inflation over the past 2 months.

As far as precious metals, I don't think they went up because of inflation expectations. I think they went up because of negative real rates and increasing M2. I don't believe PMs are as tied to CPI inflation as they are to M2 inflation and negative real rates.

7Wannabe5
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Re: Inflation, Interest Rates & Financial Represion

Post by 7Wannabe5 »

One reason 3% is held as long term fairly conservative growth rate is that it represents the average annual growth rate of timber. Might be interesting to compare with solar acreage production of photovoltaics these days.

ertyu
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Joined: Sun Nov 13, 2016 2:31 am

Re: Inflation, Interest Rates & Financial Represion

Post by ertyu »

giskard wrote:
Tue Jan 19, 2021 1:54 pm


Is bitcoin a long vol asset?
I guess it's a call option on the upside tail? It does go to zero on the lower tail as we saw in March; a sell-off in equities triggered a sell-off in btc and only a prayer and the exchanges slamming down voluntary breakers prevented it from actually crashing even further down.

Is it the best call option on the upside tail? debatable... I guess you don't burn theta when you hold it??

IlliniDave
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Re: Inflation, Interest Rates & Financial Represion

Post by IlliniDave »

giskard wrote:
Tue Jan 19, 2021 1:29 pm
With 50% in bonds and cash and looking towards preservation, do you feel comfortable with the bond allocation? Interest rates are a 5000 year low and real rates are negative.
I'm not real excited with it, but reasonably comfortable (else I'd change it). Not a whole lot of options inside my 401k any way, just stocks or bonds.

white belt
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Joined: Sat May 21, 2011 12:15 am

Re: Inflation, Interest Rates & Financial Represion

Post by white belt »

giskard wrote:
Tue Jan 19, 2021 1:54 pm

Long vol is tricky in my opinion. This past year it has been incredibly profitable to sell at the money puts on just about anything because of the high vol all year. You could make 5 to 10% a month for a while after the March crash. This captures the volatility profit but selling an option makes you short vol from the time you do it. Interesting to think about. Strategically buying LEAPs when vol is low is an obvious long vol option which I am doing a little a bit, hard to actually do well in practice though.

Is bitcoin a long vol asset? In my opinion it is and I'm long vol because of this.

Commodity trend following is also something I'm looking to try to allocate to, just trying to find the right fund to buy into because it's very hard to do this yourself without a lot of time + capital. I think being long some emerging markets & mining equities gives you long side exposure to commodities, but getting that short side you need to use a CTA fund.
I went down the same rabbit hole a few months ago. Right now I'm basically doing a Permanent Portfolio allocation because I don't feel comfortable with long vol and CTF yet (need to understand options better). I think the Dragon Portfolio is sound, but as you mentioned Long Vol and Commodity Trend Following are more sophisticated strategies.

CTF is actually not that difficult if you set automatic alerts for whatever criteria you are using to follow trend and match them to how often you want to trade (e.g. don't pick a trend measurement that changes weekly if you want to be less active). There's some debate over the best way to trade CTF. You could go with an oil fund or oil producer ETF, since oil is the largest share of the commodity market and it generally tracks the larger market. Or you can make a basket of different commodity ETFs that you prefer.

As for as I know, the only way for the retail investor to implement long vol strategies is to do it with options trading. I wouldn't call BTC a long vol asset. There are no buy and hold long vol assets because any volatility index will have a negative carry over the long run. Check out Patrick Ceresna's video on youtube about ways to implement long vol with options (I think he has one on CTF too).

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