09 January 2015

Shavers and Borrowers 

Article by Kevin Doran, Chief Investment Officer at Brown Shipley

Today’s heavily leveraged governments are discouraging saving.

Since 2008, central banks have been cutting interest rates to nearly zero and engaging in quantitative easing (purchasing securities in order to lower interest rates and increase the money supply).

The impetus for such actions is to encourage savers to put their capital to work, including through riskier assets, thus spurring investments that are more productive for national economies than piles of cash gathering dust in an account.

Take the example of Europe, where interest rates fell sharply as the global financial crisis began, recovered slightly in 2010, then declined even further – finally tumbling to today’s record lows. The cost of that decline in interest rates is real and calculable, country by country.

Individuals in those nations that have relatively high savings rates, such as Germany, have been heavily penalized. On average, between 2010-14, Germans paid an unofficial “savings tax” of nearly €300 per capita. Over the same period, Spaniards – who are major borrowers – received an unofficial “borrowing bonus” of almost €1,150 per capita.

This ongoing redistribution of wealth is taking place across most of the developed world. The trend is not unprecedented but, throughout history, it was usually considered illegal. Sometimes, it was seen as such a serious crime that it carried the potential penalty of death.

In the late 17th century, at a time when wealth was represented in the form of precious metals such as gold and silver coins, unscrupulous traders literally “shaved” the edges of such currency. Traders would then melt down the leftover “clippings” in order to create new currency out of thin air.

This process – known as “debasement” – frequently led to inflation. Even worse, it undermined confidence in the general money supply. Consequently, coin shaving and other forms of debasement were often considered acts of treason, a capital crime that could see the perpetrator hanged, drawn and, no pun intended, quartered.

Step forth Sir Isaac Newton, the English physicist and mathematician. As the greatest mind of his day, living during a period when roughly 20% of all coins were counterfeit, Newton was appointed to the UK Royal Mint to solve the problem of debasement.

Newton’s simple solution was to create a process known as “reeding,” carving tiny ridges into the edges of coins so that the holder of the currency could be sure that the metal had not been tampered with.

Though the problem of coin clipping has been eradicated, the concept of creating money out of thin air has not. Indeed, this is exactly what today’s heavily indebted governments are doing when they engage in quantitative easing.

In very real terms, savers are once again having their coins clipped. Since 2009, the rate of return on a savings account has not kept pace with the rate of inflation, as mentioned earlier through the example of Germany.

Today, governments that are metaphorically shaving the accounts of savers are not gathering up the clippings to use themselves. Instead, they seek to use these ill-gotten gains to rebalance their national economies … a rebalancing that sees wealth transferred from savers to borrowers.

There are nevertheless a range of investment strategies that can be employed to minimize the pain and maximize the potential gain.

First, it is important to keep in mind that central banks are now wholly intent on avoiding the harddefault scenario that would occur in a deflationary environment, and will do whatever it takes to create inflation in the real world.

Let’s then consider bonds, which, just like savings accounts, provide a fixed rate of return. With inflation running the risk of punching above the rate of interest on these asset classes, savers in these areas may well “make money” on their investments.

However, in real terms, holding such assets will result in the inevitable loss of purchasing power. It’s simply default by another name.

That is why investors must now hold real asset classes. (In this case, a “real” asset is any asset from which the cash flow generated on that investment grows at least in line with the rate of inflation.)

By that definition, hard commodities such as gold and silver do not represent “real” assets; holding such commodities yields no cash flow at all, other than future sales proceeds. And cash flows are important, as is the fact that the gold standard was abolished in 1933.

Today, the real asset classes of choice are equities (particularly those with pricing power and growing dividend streams) and property (where landlords have the ability to raise rents).

To supercharge this return, investors should not only be strategically selective in identifying assetclass opportunities; they should also step back and see the forest for the trees.

In other words, at a time when individuals can choose between paying a “savings tax” and receiving a “borrowing bonus,” long-term investors should also consider utilizing credit to finance investments in real assets.

If that advice – skip the tax and take the bonus – sounds too obvious to be right, consider a final piece of wisdom from our friend Sir Isaac, who remarked: “Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things.”