If there’s one thing that I’ve learned from my research on financial markets, it’s that you always have to expect the unexpected. Nothing is linear, everything works in cycles and what monetary policy makers say is usually wrong.
Last week when the FED raised interest rates, Janet Yellen said: “We’re in a synchronized expansion. This is the first time in many years we’ve seen this.”
That might be true, but the fact is that every economy today is a global economy and the global economy isn’t synchronized. At some point, it will crack somewhere as it always does. The important thing for us is to be prepared for something like that and to see how to best position our portfolios for the consequences that a financial shock might create.
Last week we discussed the fragility and strength of the Chinese financial system, so today we are going to focus on the other significant parts of the global economy: the U.S., Europe, Japan, and the UK.
The Stability Of The Financial System In The U.S.
Given that the FED just increased interest rates, it would lead most to believe that the situation in the U.S. is great. That is definitely true if you look at unemployment numbers, economic growth, and consumer confidence. However, there are also some risks in the U.S. economy that have to be assessed.
The above figure shows that the U.S. GDP has doubled since 1991, from $8 trillion to $17 trillion, while total debt has increased four times, from $14 trillion to $63 trillion. This also means that the total debt to GDP ratio has increased from below 2 to the current 3.7.
Now, increased debt also means higher risks. An economy based on debt will eventually have to deleverage as the debt burden is constantly increasing. As long as the unemployment rate is low, the economy is growing, and interest rates are relatively low, things should be fine. However, a significant increase in interest rates—let’s say up to 3.5%—would at least double the interest expense for the economy.
A 2% increase in interest rates would increase interest costs on $64 trillion in total debt by $1.28 trillion, or 7.5% of GDP. Of course, this would be rebalanced and higher inflation might help, but higher interest rates are definitely a risk for the U.S. as even in the past, soon after the FED significantly increased interest rates, a recession usually followed. Will that happen again?
European Financial Stability
Things might be going well in Europe, but the situation doesn’t look that good when compared to the U.S.
While the U.S. is slowly tightening its monetary policy, the European Central Bank is still printing money into the system to keep it stable.
The continuous monetary easing has created a distorted financial market where negative interest rates are the norm. A country like Italy that has a BBB credit rating, just a notch above junk status, has a two-year Treasury yield of -0.27% and the yield has been declining for the last 3 years.
To me, a situation where a central bank is forced to keep the yield in negative territory means that the real underlying situation is pretty bad. Even with negative yields, where the government has to pay back less money than it borrowed, the Italian debt to GDP ratio has been continually increasing for the past 10 years.
Any kind of interest rate increase in Europe would really put incredible pressure on Italy and other European countries that are in a similar position. Therefore, Europe is much riskier than the U.S. as there is no way Europe can increase interest rates if it wishes to keep the current political stability. The impossibility of increasing interest rates will make more quantitative easing the only option in the next global downturn which will lead to terrible consequences for the currency.
The United Kingdom
The pound has been battered due to BREXIT and shows how political instability can be extremely detrimental for a currency and for investors.
The currency situation has been improving in the last few months as BREXIT will take time to complete and the consequences haven’t been extreme yet. The debt to GDP ratio is 88% and the Bank of England still has control over its currency.
The Bank of Japan is in a similar situation as the ECB, it has greatly increased its share of GDP in the last few years.
The financial markets there are, like in Europe, extremely distorted as the Bank of Japan owns more than 66% of domestic ETFs. Japan is in a similar situation as Europe, but it doesn’t have the political risks a dividend economy like Europe has.
It Will Boil Down To Currencies
Given the huge intervention and importance central banks have created for themselves in the last 10 years, it looks like we can expect them to continue protecting financial markets and the respective economies at all costs. This means that we will see extreme currency fluctuations. The riskier environment to invest in is the one where global investors can lose faith and central banks lose control.
How To Invest In The Above Described Environments
How to invest really depends on where you are. If you are from the U.S., I would definitely look for some international diversification in the form of emerging markets and would definitely avoid Europe and Japan as the risks there are extremely high and the yields negative.
If you are from Europe, hedging yourself with U.S. investments might be a good idea, especially if your personal situation is strongly Euro dependent. A similar strategy should be applied if you are from Japan.
If you are from an emerging market, proper diversification is always key but remain highly exposed to your domestic markets, especially if the yields are satisfying.
The distortion central banks have created makes it really difficult to come up with investing ideas on how to take advantage of the above-mentioned imbalances because a negative effect can quickly become a positive after a change in monetary policies.
Keep reading Investiv Daily as I’ll try to find the best low risk high reward investment vehicles to help you sleep well for the current and the future highly leveraged and distorted financial environment.