The Dam Has Broken

This article is excerpted from a letter by MOI Global instructor Daniel Gladiš, chief executive officer of Vltava Fund, based in the Czech Republic.

Ideological revolution

I don’t really care much for using grandiose words, because they often are spoken under emotional pressure and may prove exaggerated with hindsight. This time, however, they seem to fit the occasion. In my opinion, what we are living through just now is a time of ideological revolution insofar as monetary and fiscal policies of the world’s key countries are concerned. There are some things that one might perhaps have believed heretofore to be temporary but that will apparently become permanent aspects of the financial world while having great long-term impacts on the values of the main asset classes. Although for investors there is no escape, there nevertheless does exist a defence.

How did we get here?

If I were writing some kind of academic text, I would have to start much further back in history. I think that for our purpose it is quite enough to start with the last recession in 2008. Its epicentre was in the financial sector. At that time, the central banks came up with a rather innovative solution that involved two main steps: purchasing assets from bank portfolios and reducing interest rates to historically low levels. Their combined effect was very positive, and particularly so in the first few years. They provided liquidity to the markets, brought stability to the financial sector, and spurred economic growth. This did not come for free, of course. Part of the private sector debt was transferred to governments, and their debts grew substantially. The balance sheets of central banks swelled to unprecedented levels while artificially low interest rates distorted prices in financial markets and created the temptation to underestimate risk. Central bankers answered to their critics with the argument that these were only temporary measures, and as soon as the situation in the markets would normalise the central banks would begin to reduce their balance sheets again and interest rates would go back to normal, too. This never happened, however, and it probably never will.

The Fed’s balance sheet, which expanded from USD 900 billion in the autumn of 2008 to USD 4.5 trillion at the end of 2014, started to contract slowly from 2018. But this only lasted for a year and a half, until autumn 2019, when it totalled USD 3.7 trillion. Then, practically overnight, the Fed made an unexpected 180-degree turn and began once again to purchase treasury bonds. It turned out, in fact, that there were not enough buyers in the market who would soak up the newly issued sovereign debt. Foreign investors have not been buying American debt very much in the past five years, and capacity of domestic buyers is not unlimited either. Last year, however, the country ran a deficit of about USD 1 trillion, and this new debt had to be bought up by somebody. The only remaining buyer was the Fed. By February 2020 (and that was still before the virus pandemic), the Fed’s balance sheet had bloated to USD 4.20 trillion.

Then came the virus, and this year’s US budget deficit will be not USD 1 trillion but rather USD 4 trillion, and if there were not enough buyers for the new debt already last year, that is even more so the case this year. The Fed’s balance sheet hit USD 7.00 trillion at the end of June and is still growing. Practically all new debt is now being purchased by the Fed. I am using the USA here as an example, but the situation is similar in all the world’s key economies – in the large countries of the EU, in Britain, Japan, as well as in China. This is a global problem.

What to do about the debt?

There are only three possibilities for settling sovereign debt. The first and best one is rapid economic growth. If an economy grows fast enough and is not burdened by a too-large debt, that debt may decrease as a percentage of GDP. For most of the big countries, however, this solution is outside the realm of reality. Their combination of slow growth and large debt practically excludes this, regardless of what politicians and central banks might say.

The second way of reducing the debt is to cancel it. This is a very common way of resolving the issue, and some countries having their own currencies will continue to use it. The latest big such case is the recent default by Argentina. This, however, is quite a drastic solution that is accompanied by great costs and difficulties and is politically unpopular.

The third way to diminish the debt is to let inflation wipe it away or, generally speaking, to repay it in depreciated currency. History knows many such examples dating back to Ancient Rome. This is and will remain the preferred manner of resolving debts in many high debt countries having their own currencies. This is nothing new, but the extent to which this solution is applied will probably accelerate.

The dam has broken

National budgets are in the hands of politicians. If we take a cynical point of view (or maybe not even a cynical but a realistic one), we can say that the main interest of politicians is to be re-elected. The best path to winning election leads through bribing voters using state budget outlays. There is one unpleasant complication associated with this, and that is that if we want to give something to somebody we must first take it from somebody else. People are pleased to receive things, but they tend to get defensive when we want to take something away from them. What is happening now, however, changes the situation completely. Politicians see that it is possible to scatter money around without the need to take it from somebody else first, because the entire debt is financed by having the central banks print new money. This is nirvana to them. Now, they will shed even the last of their scruples. The result will be that large budget deficits will be predominantly financed by printing new money. “Helicopter money” is here in full strength. The dam has broken, and there is nothing that could stop the flood of new money.

In everyday life, scarcely anybody will raise objections against this. When you boost taxes on people, when they lose their jobs or when debts are cancelled, they protest. They are happy, however, when newly printed money is given away to them. They see only their own immediate benefit. The costs of this entire operation are too distant, abstract, and incomprehensible for them to recognise. It would be naïve, however, to think that these costs do not exist.

The whole thing works thusly: The government runs up large debt over the long term, the debt is underwritten by the central bank, and interest rates paid to the central bank by the government are returned by the central bank to the budget. Who would have any motivation to change this state of affairs? Reductio ad absurdum, the question arises as to whether it makes any sense to collect taxes at all when all the expenses may be paid by printing new money? I think it will not be too long before somebody comes up with this perpetual-motion machine.

And what about the economy?

I have ever greater difficulties with economic theories. When I began enthusiastically to study economics in 1991, I considered it to be a science. Today, I seriously doubt that. An exact natural science for me is physics, for instance. When we reduce water’s temperature towards zero and below, we know what happens with water. It changes its state, volume, and other characteristics. It works the same every time and we all can agree on that. When we decrease interest rates towards zero and below, however, we do not know what will happen. Some economists consider negative interest rates to be very beneficial, some consider it very harmful. There is probably no real proof for either one. So, how can economics be a science?

Economics is right about one thing, though. The saying “There ain’t no such thing as a free lunch” declares that it is not possible to get something for nothing. Financing debt by printing new money truly has its real costs. They may be various – social, political, relating to ownership rights, and so forth. We are most interested in those that may involve financial markets.

The key to further investment considerations in my opinion comes down to two things. First, financing budget deficits by printing new money is now a permanent state of affairs. Second, a great part of this money will go directly to consumers because of the purposes for which the budget deficits are run, and over time this may have a considerable inflationary effect. It used to be that central banks were buying financial assets from institutional market participants, but today, a large part of newly printed money is directed to financing everyday outlays.

How might this influence the markets?

It is thus probable that we will continue to invest in an environment accompanied by negative real interest rates, with nominal interest rates held artificially low, fiscal expansion, rapidly growing money supply, and inflating of central bank balance sheets. There does not occur to me any way how this may greatly change for the better any time soon. We’ve been working in this environment for some time already, but investors should change their thinking in the sense that this environment is not temporary but permanent. This whole trend will tend to accelerate with the speed of change in politicians’ and central bankers’ thinking. I believe it is no exaggeration to speak of an ideological revolution in finance.

The greatest threat to investors

All the worlds’ main currencies have nearly flawless history insofar as their own depreciation is concerned. This trend will very probably even accelerate, and that is the main problem investors need to contend with. When I speak about currency depreciation, I do not mean exchange rates of currencies against one another. This is not a debate about whether it is better to own dollars, euro, pounds or francs. This is a discussion about the fact that all currencies lose value in relation to real assets.

Holding cash has historically been a bad investment choice because its real value is always sinking. Today the situation is even a bit worse, and holding a great part of one’s assets in cash over the long term makes practically no sense. And it may get even worse. Some economists are very seriously recommending to introduce substantially negative interest rates – to start with on the level of −3%. (From the future speech of the Great Economist to the nation: “Dear ordinary people, it gives me great joy to announce that from tomorrow we are introducing negative interest rates in the amount of 3%. Our economic theory clearly demonstrates that this step will bring you enormous benefit. It is true that we will take 3% of your savings each year, but do not forget the most important thing – that at least something will still remain for you. After 20 years, it still will be a bit more than a half.”)

It is a bit depressing to think that a person can work, earn money, and then instead of having and enjoying that money in peace, he or she has to continue investing just to protect the value of the money he had earned. This necessity is becoming ever more urgent even as there are fewer investment opportunities. The majority of debt assets are today essentially out of the game. Their real returns are either very low or they are inadequate relative to the credit risk taken on.

Essentially, the only way of preserving at least the real value of money over the long term remains ownership assets, and particularly shares in companies. Ownership of company shares (stock) should continuously bring greater returns than other investments, and that is for two main reasons: Shares represent the creation of value by human work, and there is opportunity to reinvest capital at higher rates of return.

I perceive every company as a living organism wherein people endeavour to create value by their work – contributing their ideas, efforts, creativity and common everyday labours. It may not succeed every time, but, on average and over the long term, this influence is very positive and, most of all, it is not eroded by the decreasing value of money.

Just about everybody will recognise, for instance, that the influence of Jeff Bezos on the value of Amazon is huge. The same could be said about the influence of Steve Jobs on the value of Apple. Both of them, together with other people in these companies, contributed crucially to the fact that the value of each of these companies exceeds USD 1 trillion today. We need not go so far to find examples of creating value by human work. Great creators of value in our Czech homeland, for example, were Tomáš Baťa, Emil Škoda, František Křižík and Emil Kolben. The names of great Czech value creators from the present need not be mentioned here, we all know them, even though in fact only one of these companies (Avast) is today publicly traded. It is one of the best examples of how people create value. Initially, the main creators of value were probably its founders Pavel Baudiš and Eduard Kučera, today they are almost two thousand employees.

People are simply the main instigators of value in a company, and so it is at all levels. These need not be gigantic corporations, either, not at all. People create value also on a smaller scale, in small firms, services and trade, for example. Every one of us either knows these examples from our own surroundings or is striving to do it himself or herself.

The influence of human activity on the value of a company is absolutely fundamental. People cannot by their work influence the value of other asset classes, like cash or gold or bonds, or they may be limited by the possibilities offered by such assets, as in the case of land or real estate, for example. In the case of companies, they have the greatest room, flexibility, and largest opportunity to adapt to changing conditions. This is the first and main reason why ownership of shares brings – and over the long term must bring – higher returns than can ownership of other asset classes. Nothing should change this in the future.

The second main reason why ownership of stocks should bring greater returns than ownership of other asset classes lies in the higher returns obtained from reinvestment of earned capital. Companies function over the long term by striving to reinvest earned capital into further growth and expansion. Reinvested capital increases the total sum of capital a company has at its disposal for doing business, and this should also bring increase in absolute returns. Capital reinvestment is of course possible also in cases of owning bonds, land or real estate, but in the case of companies the returns are much higher and the opportunities broader. For example, the average return on equity in the case of American publicly traded companies is around 12%. The companies may, on average, reinvest their own earned capital for that same rate of return. We scarcely can expect to attain such high returns when reinvesting into bonds, land or real estate. In long-term investing, when it is important how quickly the compounding returns accumulate, the difference between reinvested returns from stocks and reinvested returns from other asset classes is decisive.

None of these ideas is new or surprising. What has changed is the environment within which we invest. Some barriers that have existed up to now have been broken, and the degree of urgency to direct investments into ownership assets has increased. If you were to ask me if I like the hand that has been dealt, I would be very critical of many things and developments, but this has no influence on our investing. It is not important whether or not we like how things are developing. It is necessary to take things as they are, accommodate to them, and think about which stocks will benefit most in such an environment.

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