45 years ago, almost to the day, Richard Nixon rocked the global financial system by abandoning the fixed exchange convertibility of gold and the United States dollar. The president justified his 1971 action by telling the world he had been “converted” to Keynesian economics. In reality, quick action was required on his part to protect existing U.S. gold reserves and continue the fiscal policy expansion designed by previous government technocrats to concurrently fund a war and social spending. The price of gold quadrupled over the next 3 years.
Today, global regulations and negative interest rate policies, designed by a younger group of policy makers and implemented by monetary authorities at the Swiss National Bank, Nordic Central Banks, and the European Central Bank have “converted” traditionally safety-seeking European investors into market timing speculators.
Life insurance companies and pension funds no longer invest in European government bonds for safety and yield. They invest in these guaranteed to loose (when held to maturity) securities either due to regulatory requirements or in the hope of selling them at a higher price to central bankers unconstrained by the formalities of profit and loss calculations.
The markets functioned in a different fashion not that long ago. Bonds were the safest investment. They promised full return of principal plus interest. Next down the risk spectrum came commercial real estate, offering rental yield, like a bond, but were subject to an indeterminate sale price in the future with the potential for capital appreciation. Equities offered the potential for capital appreciation with a reduced dividend yield, or none at all, and an indeterminate terminal price. Lastly, commodities and precious metals, viewed, as the riskiest investments of all offered no yield, an indeterminate terminal price, only the potential for speculative price appreciation.
Gold is often quoted by Keynesians as a “barbarous relic” because it does not generate a positive yield like bonds once did. Before central bank negative interest rate policies, investors bought bonds for yield and equities for capital gains. Now investors buy equities for yield in the form of dividends and buy bonds for capital gains to compensate for the performance drag from the negative yield. Over 13 US$ trillion worth of government bonds currently trade at a negative yield on speculation that they will appreciate further in the future. Negative yielding bonds bought for capital appreciation will naturally gravitate along the risk spectrum and trade like the riskiest asset.
In his latest investment letter from Janus Capital, Bill Gross makes a very valid point that central bank negative interest rate policies have turned trillions of dollars worth of bonds from assets into liabilities. As such, in keeping with generally accepted accounting standards and reflective of economic reality, insurance companies and pension funds should move the loss due to these securities from the left hand side of their balance sheet to the right side; an unlikely act that would significantly impair both industries.
A fixed income portfolio constructed for safety and yield no longer capable of providing either should be remodeled with the one asset that is bought for safety and offers no yield. It’s doesn’t have any counterparty credit risk, it’s shiny, and yellow.
by Eric Schreiber, Investment Asset Manager at EMS Capital