Free Lunches can be real
The portfolio enjoyed another index-beating month with a gain of 0.9% versus 0.6%, so improving further the long term numbers. The MSCI ACWI has risen by 18.2% over the last 12 months, versus 10-year annualised returns of only 8.7%. Hence there is a broad consensus that a major correction is overdue, especially because the rate of global GDP growth is slowing. As noted in previous Bulletins, correlations between growth and equity market returns are low. Investors remain fixated otherwise, but some confusion is reasonable given that growth in earnings per share is also slowing. Yet strong equity markets can be justified by the Free Lunch Theory.
From preachers to the Walt Disney cartoon The Sorcerer’s Apprentice (with that ridiculous mouse whose ears never move), the message is that “something for nothing” does not exist: there will always be a payback. This belief is shared by treasurers and central bankers and drives policy, because throughout their careers the value of money has always been fixed to something: first gold, then the dollar, and later a basket of currencies. Meanwhile, all developed countries currently aspire to reduce national debt and create a primary budget surplus. This ignores the development of fiat money - a currency legislated as legal tender but with no intrinsic value and not backed by reserves. With fiat money there is no limit on the amount which can be printed.
America's recent default drama was partially about balancing the national books. Why? Government debt is approximately 102% of GDP, relatively low compared to other advanced countries with fewer advantages. Had the government failed to borrow more to support the system from 2008 onwards, there would have been a financial collapse of unique proportions. The problem with America's debt is not its size, but duration, averaging less than six years. If the Treasury were to increase it by a quarter, say by issuing $4 trillion of new 50-year bonds with a 4.0% coupon, debt to GDP would rise to c. 128%. Investors globally would trample each other in a buying frenzy. (Many countries, such as Mexico or France, already have 50-year bonds.) Spending these funds in areas such as infrastructure would create a large economic multiplier, yet repayment would be easy. Inflation would have so reduced the real cost that it would be a question of finding pennies down the back of the couch. This is the FreeLunch Theory in practice.
This matters because it has already commenced - by accident. America's economic recovery has been relatively weak and is fading. It was driven by printing money. The all-important housing market (Chart 1, page 4) is an example. Without continuous support, it will slump. Thus whatever Congress wants, it will be forced to continue borrowing heavily to maintain some economic growth. The eurozone is another example. In late 2011 a bank and sovereign debt crisis was imminent, halted only by Mr. Draghi making available €1 trillion of interest-free loans to EU banks for up to three years, later followed by a promise to “do whatever it takes”, i.e. print infinite amounts of money. These loans are due for repayment in the next eleven months. To date, Italy's banks have repaid approximately €5bn of the €200bn borrowed, or 2.5%; Portugal’s have repaid 3% of €50bn; Spain's 25% of €300bn. The odds of these countries meeting the deadline are molecule-sized. If this free money (officially Long Term Refinancing Obligations) is not extended by printing even more, many eurozone banks will implode, creating a domino effect. Mr. Draghi's decisions in 2014 have already been made for him.
It seems that the British government is stealthily following the Theory. As ever, the priority is to win the next election, to which end the government has commenced throwing subsidised loans to first time homebuyers. This is a return to pre-2007-crash policies, using short term bribes to encourage those with insufficient income to take out new, long-term mortgages. However, UK government debt is relatively long dated at fourteen years and confidence in its bonds is remarkably high. Over time, this policy might just work.
Japan's approach is a hybrid. The "Four Arrows" experiment introduced late last year by PM Shinzo Abe (quantitative easing relative to GDP the greatest ever) is breathtaking in the amount of new debt being issued. Multiple free lunches. The desired impact on the exchange rate, corporate earnings, housing starts and employment has been remarkably swift. After less than a year in power, however, his government stands accused of backtracking in the sensitive areas of looser employment laws and lower spending on pensioners. Maybe he will cut and run given an election in 2015, but the speed at which unpopular sales tax rises are being driven through (from 5% to 8%) suggest the government's determination is being underestimated. Yet it is also hoping to achieve a primary budget surplus by stimulatinggrowth(which increases tax receipts) whilst reducing expenditure. These trends have been in place since 2009, when expenditure peaked at over ¥100 trillion p.a.; revenue was below ¥40 trillion but has risen by over ¥6 trillion since.
Bedlam does not naïvely argue against the probability that these free lunches will fail one day, through hyperinflation, capital flight or a loss of confidence in paper money; but currently there are no signs of concern over the safety or value of fiat money in any developed country. Moreover, it might just work. Japan and the UK are interesting litmus tests. That one day is years away. Until then, free money and (as a consequence) suppressed interest rates will keep valuations high. When, or if, it ends, investors will still be better off holding businesses with tangible assets and increasing cash flow, rather than government bonds and bright coloured monopoly money. It's all about stock-picking.
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This document is not investment advice or a recommendation to purchase, hold or sell a security. Past performance is not a re liable indicator of future results.
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