The End of Money: From Paper to Things

History repeats itself, but in such cunning disguise that we never detect the resemblance until the damage is done.” –Sydney J Harris

Those who cannot remember the past are condemned to repeat it.” –George Santayana

This year marks my 40th year in the business. During these past four decades, I have seen fads and cycles come and go. When I began my career, the inflation of the late 60s and 70s was coming to an end along with a peak in interest rates. As shown in the graph below, interest rates peaked in August 1981, the result of Fed Chairman Paul Volker’s efforts to conquer inflation which reached as high as 14.5%.

interest rate inflation
Source: Bloomberg, Financial Sense Wealth Management

Since the peak in 1981, interest rates have steadily fallen to where they are today. The rate of inflation has also fallen but the value of money has depreciated. The dollars you hold in your wallet buy less goods and services every year. I would like to demonstrate financial inflation in a way that impacts you personally, as an investor, as shown below. I begin with a million dollars and show what income it would produce for you each year over the past five decades if invested in 10-year US Treasury bonds.

$1,000,000 investment (annual income per year in each decade)

  • 1980s: $140,000
  • 1990s: $80,000
  • 2000s: $50,000
  • 2010s: $40,000
  • 2020s: $7,000

While the inflation rate has steadily fallen each decade, the purchasing value of money and its return has also fallen dramatically. This is because the Fed has implemented QE and other methods—as it is doing today—to suppress the rate of interest for borrowing money. Why are they doing this? Because of the massive amount of debt held across the entire U.S. economy from government, municipal, corporate, to the consumer as shown below.

total us debt
U.S. Department of the Treasury. Fiscal Service, Federal Debt: Total Public Debt [GFDEBTN], retrieved from FRED, Federal Reserve Bank of St. Louis;, June 26, 2020.

The Fed is once again implementing a program to keep interest rates suppressed through massive interventions into the bond market to the tune of $1 trillion per month. This time they are actively intervening in the corporate bond market by financing new corporate debt ($500 B) and buying existing debt ($250 B).

Normally, in a business cycle, as the economy heads into a recession, credit spreads between Treasury debt and corporate debt start to widen as the risk of default rises on lower-quality debt. This is the result of an economic recession. Company debt on lower-quality issues can get downgraded as firms experience lower sales and profits as a result of the recession. Interest rates start to rise as the risk of default increases. Then investors start to demand higher interest rates to compensate for the increased risk of default or a debt downgrade.

This is exactly what was happening in February as the U.S. economy headed into a recession from government shutdowns. Corporate bond yields began to rise reflecting the increased risk to bondholders as a result of the recession. You can see this in the precipitous drop in the price of the popular junk bond ETF, HYG.

The bond fund lost 23% of its value in a matter of weeks. But then, magically, things turned around as the Fed announced a new program of intervention, whereby they would buy bonds, bond ETFs, both high quality and low quality.

hyg high yield index
Source: Bloomberg, Financial Sense Wealth Management. Note: Past performance does not guarantee future results.

The interest rates on corporate debt started to rise posing a financial risk to the markets, so the Fed expanded its mandate to support the corporate debt markets. Credit spreads, which had been widening, suddenly began to contract.

For a brief period, we were taking advantage of the higher interest rates and were able to lock in high short-term yields. That opportunity came to an end as bonds rallied thanks to massive bond purchases by the Fed, which lowered yields and raised prices.

Why did the Fed do this when in the past they stuck to Treasuries and mortgage bonds? The reason is simple. There was too much corporate debt, half of which was rated BBB. There was a risk of those BBB bonds downgrading to BB or lower, dropping them into the junk bond category. That would trigger a selling deluge by investment-grade bond and bond ETFs, which would have been forced to sell, triggering a financial crisis in the bond markets.

There is simply too much debt, so they intervened to keep the bond market from imploding, which is why they are expanding their bond-buying efforts to include corporate as well as Treasury debt. The Fed’s balance sheet will go from $4 trillion at the start of the crisis to $10 trillion by year-end and beyond.

Where is all of this leading us? As the government borrows massive amounts of money and as deficits become multi-trillion, it will be the Fed’s role to artificially suppress interest rates. This is good news if you are a debtor. Mortgage rates have never been this low and if you are a corporation you can borrow money at next to nothing. It is not good news if you are an investor, a pension fund, or a retiree. Cash yields next to nothing, money markets are at 0.0%, and even short-term treasury yields are below inflation rates. This means, as an investor, you are losing money after taxes and inflation on cash investments.

We anticipated this coming last year when we gave seminars in the fall to clients called “Zero Bound”. That is why we launched our income fund which is strategically a long-term investment account created to take advantage of the inflationary wave that is coming this decade (more about this later).

I want to discuss the rationale for what the government is doing and where we are heading in the years ahead and the remainder of this decade. The government strategy is being driven by MMT (Modern Monetary Theory). Simply stated, MMT is a macroeconomic framework that says sovereign countries like the U.S., U.K., Japan, or Canada are not operationally constrained by revenues when it comes to federal government spending. They don’t need taxes or borrowing for spending since they can print as much money as they need as they have a monopoly on issuing currency.

Translation: they can deficit spend as much as necessary. They can simply print the money to pay for it as they are now doing. Deficits no longer matter nor does debt according to this “new” economic theory.

There is a new book explaining this philosophy that just hit the bookshelves this month. It is titled The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy by Stephanie Kelton. Kelton is an economics professor at Stony Brook and was an economic advisor to the Bernie Sanders campaign. She was also the chief economist for the Democratic staff on the U.S. Senate Budget Committee. The bad news is that her arguments are very readable and will strike the reader of her book as reasoned, plausible, persuasive, and intelligent.

Her argument boils down to a few simple points. Because the government has the legal capability to print unlimited dollars there is no need to worry about spending money or the deficits they create. Thus making it possible to provide funds for any government program the people demand. The government simply prints money to pay for anything the voters or politicians want to provide. MONEY IS SIMPLY FREE. The government doesn’t have to worry about saving or earning money through taxes in the same way as ordinary businesses or households do.

Her arguments are persuasive and give the illusion that sovereign governments are different than you and me. They aren’t confined by the same constraints of money as the corporate and household sector. It is because they have a monopoly on money and the ability to print as much of it as they need.

This philosophy now permeates the country’s elites from government, Wall Street, to academia. Everyone is on board the easy money train which has now left the station. Wall Street loves the idea of free money as it inflates investment markets. Politicians of both parties endorse it as it gives them a license to spend as much money as the public demands. It is also a favorite of academics as is supports the progressive ideas of socialism.

The problem: no one is paying any attention to history and the financial disasters of the past. It is the oldest political trick in the book. Everyone from kings, dictators, prime ministers, and American presidents have tried this approach before. They have all ended in disaster. This was tried in the 70s under Nixon and Carter which led to double-digit inflation and interest rates. Back then there wasn’t the level of debt that now exists in our economy.

This brings me to the end game under this new monetary regime which will be the devaluation of the US dollar. It will be sudden and come out of nowhere, but the only way out of our mounting debt will be a devaluation. Overnight, tens of trillions of government debt will be wiped out and become worthless to those who hold this debt, be it foreign governments, pensions, companies, or individuals. History is repeating itself or rhyming as Mark Twain once said. There is a lot of rhyming in the decade ahead of us.

Investment Crossroads

We are at a key pivot point in investment history. The monetary environment is going to change the investment landscape going forward. I have found there are very few investment cycles in an investor’s lifetime. These are periods or cycles where the rules of the investment game are altered. The vast majority of investors continue to play by the old rules and end up losing out, or worse, losing money or missing opportunities.

Investors have been following the deflationary trend of the last decade. This was a period when paper assets such as stocks and bonds did well. This led to the index bubble and the proliferation of passive investment strategies. It didn’t matter if you owned stocks or bonds, both made money over the last decade. Simply invest in an index fund, sit back, and enjoy the ride.

Indexing led to extreme market valuations as the index favored large-cap stocks which drove the indexes higher and higher. The result was most of the index returns were concentrated in a handful of stocks as shown in the graph below (chart of S&P 500 sector and member weights).

spx sector weights
Source: Bloomberg, Financial Sense Wealth Management. Indexes are unmanaged and cannot be invested into directly. Note: Past performance does not guarantee future results.

That trend is still present today with the market’s rebound driven by a handful of large-cap stocks shown above. Most stocks within the S&P 500 are still selling at below book value.

The strategy worked until it didn’t. The investment allocation of 60/40 stocks vs. bonds did not protect investors in the fast and furious downturn of February and March 2020. Bonds and stocks lost money. There was only cash and gold.

In my humble opinion, a new trend is rising to take its place as paper money depreciates and loses its value. This will foster a trend towards natural resources, things, and hard assets. In future articles, I will lay out the fundamental shift from paper back to things. I wrote a similar article at the beginning of the 2000s called The Next Big Thing, outlining the merging bull market in commodities (see here:

This article explains as much of my philosophy and my thinking then as it is does now. I have found throughout my long investment career that an investor needs to make very few investment decisions in their lifetime. The key is to identify a long-term trend as it begins to emerge, invest in that trend, ride it until it ends and another trend replaces it. As an example, U.S. stocks in the 50s and 60s, commodities in the 70s, Japanese stocks in the 80s, tech stocks in the 90s, commodities in 2000s, and tech and paper assets in the 2010s.

The next trend that is emerging will favor things or hard assets. This is what the gold markets are telegraphing now. This trend will be inflationary driven by resource shortages and a tsunami of money printing. There are two things the markets aren’t ready for right now which are the return of high oil prices and inflation.

I recently wrote about why I think another oil shock is ahead of us. The drop in the rig count and low prices driving this reassures me higher oil prices lie directly ahead of us. The markets have bought into the idea that we have reached peak oil demand as a result of COVID-19 and that we are entering a new green economy where electric cars will replace the gasoline combustion engine. This is utter nonsense and wishful thinking. Electric cars make up only 0.3% of the global car fleet. Green driven cars are heavily subsidized by the government. Without those subsidies, they wouldn’t be able to stand on their own. We will be driving combustion driven cars or hybrids for decades to come.

We are looking at investing in the next big thing, which I believe will be another cycle of hard assets. Commodity prices have never been this cheap as they have been relative to financial assets. That is why in our income fund we own gold, oil, natural resources, and high dividend-paying monopolies and oligopolies. This is the opportunity that very few investors see or expect. The trend in paper assets has been broken. Once a long-term trend is broken, another one replaces it. As the wise King Solomon wrote, there is a time and season for everything. This is one of those times.

Full disclosure: I am long gold, oil, natural resources, and high dividend-paying companies.

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Copyright © 2020 Jim Puplava

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