How To Invest With Coming Debt Crisis – Don’t Be The Turkey

Three extremely important pieces of information released over the last weeks for investors are:

  • The increase in US budged spending and consequently deficits.
  • The ECB’s public stance that they are going to print money, buy assets and do whatever it takes to prevent a recession.
  • The FED is ready to lower rates to keep economic growth stable.

My main concern is that we are in a Thanksgiving turkey situation and have a real turkey problem. What is the turkey problem?

The turkey is born, and fed more and more each day. The turkey thinks everything is perfect, food is coming in larger and larger quantities and there is absolutely no risk. As the days go by, the turkey’s wellbeing constantly increases. You can read more about Black Swans and turkeys in my Nassim Taleb articles.

1 turkey problem

Similarly, governments think they can spend money and not care about deficits. The central bank heads will do whatever it takes to keep things going well by printing more money and we, governments, corporations etc. all feel like turkeys. Think about it, aren’t you feeling good like a well-fed turkey and your wellbeing is constantly increasing?

There is only one minor issue, at some point in time, the butcher feeding the turkey, decides to prepare it for Thanksgiving. Similarly, the money printing game will end, it has happened a thousand times in history and currencies always debase, i.e. lose their value.

2 turkey problem

The key here for investors is not to be the turkey. Let’s start by explaining the economic fundamentals, the financial engineering provided by central banks and then conclude with how to invest so that your portfolio doesn’t end up like a Thanksgiving turkey.

Content:

Economy and monetary policy:

  • US budged deficits
  • Lower interest rates, money printing

How to invest:

  • Be like a government – have debt, but smart, good debt
  • S&P 500 to 5,000 points in 2030 but index fund investors will not be happy
  • Buy value like Buffett did in the last 50 years

US Budged Deficits

For me, one of the most important pieces of information over the last weeks was the ballooning of the US budged deficit.

3 us budged deficit

Source: Bloomberg

If we look at what the Congressional Budget Office has to say, The Budget and Economic Outlook publication shows how the US budged deficit will be larger than $1 trillion per year very soon.

4 budged defitic

Source: CBO

This means that the US total public debt will continue to grow at extremely fast rates.

5 total public debt

Source: FRED

The public debt is now 22 times higher than what it was in 1981. From my point of view, spending more than what you make can only last for a while, but sooner or later the butcher will come. Now, I know interest rates are lower and the debt cost servicing isn’t high, but interest rates can change if central banks lose control and history teaches us; sooner or later, central banks always lose control.

  • Lower rates, monetary easing and stimulus

Given what is going on with governments debt levels, corporate debt levels and even household debt levels, central banks have no other option to keep interest rates low, practically at zero, and promise to print as much money as necessary when necessary.

So, we have the FED saying how it will cut rates to sustain economic growth.

6 fed rate cuts

Source: WSJ

And we have Mario Draghi practically saying how the ECB will do whatever it takes to stimulate the economy.

7 draghi

Source: Bloomberg

My conclusion is that over the longer term, money will be printed and currencies debased or better to say sacrificed. Economies and businesses will be stimulated but sooner or later this too will pass. We have to be very careful, not to be the turkey.

How to invest to not end up like a turkey before Thanksgiving

If everybody has a lot of debt, especially governments, it means all policies will help the majority, i.e. those with debt. So, let’s say you have a 30-year mortgage with a fixed interest rate of 3.5% like I have and let’s say currencies lose 50% of their value over the next decade due to inflation. This would mean that the value of your house would go up 50%, your salary too, while your mortgage payment would remain the same.

8 inflation

You are practically playing the same game as governments.

Secondly, the ECB and the FED say they will buy assets, which means the value of financial assets will continue to go up as it did in the last ten years. I would not be surprised to see the S&P 500 at 5,000 points with index fund investors not happy about it.

If we see inflation, which is very likely to escalate somewhere in the future because it is never linear and the FED and ECB will lose control, especially the ECB that doesn’t have any kind of coherence within. Everybody is happy to get free money from money printing, but when things get ugly, we will see for how long will Europe last.

In 1961 it looked like there will be no inflation to worry about given that inflation was at 1.2%. However, over the following two decades, inflation was often above 5% and peaked at 13.5% in 1980.

9 inflation us

Source: FRED

My point is that by focusing on value investing, like Warren Buffett did over the last 50 years that have had significant inflation, you can do better than what the S&P 500 offers even if it doubles in the next decade.

The S&P 500 did go up 28 times since 1981, but Berkshire did just a bit better.

12 berkshire

The difference comes from the focus on businesses, that have moats, have pricing power and can consequently adapt to inflation. Therefore, when investing, and you have to be invested because currencies will be worthless, focus on buying value, businesses that will do good no matter what. Thus focus on risk and reward, exactly what value investing is.

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Trying to Explain Nassim Taleb’s Views on the Economy and Markets

Nassim Taleb just had an interview on Bloomberg discussing the latest topics in finance:

1 nassim Taleb

Modern Monetary Policy – Monetary Policy 3

Trade wars

Budged deficits

Market risk

How to invest

It is a great interview but as often with such interviews, things are not explained in depth. I’ll try to add facts to Taleb’s thinking and you will see how that affects your investing!

The biggest risk for Taleb – Deficits and no skin in the game

Let’s start with deficits, from the Wall Street Journal:

2 budged deficit

In an environment with full employment, thus with the economy doing great, budged deficits are increasing!

3 unemployment

Unemployment rate US, Source: FRED

With a strong economy, the logical thing should be to have budget surpluses so that when a recession or slowdown eventually comes, you have the room to increase government spending. If you check below, during the late 1990s, the budget had surpluses but it seems now most politicians think that debt is something not to worry about now.

4 budged deficitis

Source: FRED

Accumulating deficits mean higher government debt. Total public debt in the US had doubled in the last 10 years, DOUBLED.

5 public debt

Source: FRED

Higher debt, leads to higher interest payments. Despite historically low interest rates on government lending, interest payments have skyrocketed due to the large amount of debt.

6 interest payments

Source: FRED

The US government has to pay $550 billion in interest per year, and to do that, it simply borrows more as the deficits are now at almost $800 billion and expected to hit $1 trillion soon.

7 budget deficit

Source: FRED

Such a situation is unsustainable and for Taleb, and probably for every other rational being, a huge risk that is piling up and will at some point in time blow up. If you borrow just to pay interest on your debt, you are close to a Ponzi scheme and we know how those things usually end up.

In the next recession, budget deficits will explode that will probably increase the borrowing rate and create a spiral of trouble as raising rates will cripple debt servicing. To solve such issues, government tend to print more money and you soon have hyperinflation.

Further, if you increase interest rates, the cost of debt for the government exacerbates. So, a normal option to cool the economy is something the FED can’t use at this point in time.

9 treasury

Source: FRED

A longer term increase in rates where the US borrowing cost go to 5%, where those were in 2007, would double interest payments on the debt, further increasing budget deficits.

The main problem for Taleb is that those who make decisions, like politicians have no skin in the game. What harm will Trump have from current budget deficits if those create havoc in 2029? The main problem for Taleb is that there is no accountability in the current capitalistic system.

The plausible solution to the above problems creates another huge risk.

Taleb on Modern Monetary Policy – Monetary Policy 3

We recently discussed Ray Dalio’s views on the plausible next monetary policy moves that involve helicopter money and a coordination between government spending and money printing. Taleb is against such things because of the risks that pile up where the main risk is hyperinflation.

Even if inflation has been really low over the past years and contained between 1.5% and 2.5%, Taleb mentions how inflation doesn’t work linearly and how just because it hasn’t materialized, it doesn’t mean the risk isn’t there.

8 inflation

Source: FRED

At some point inflation will ramp up, that will make things not manageable; think of Venezuela, Argentina, Zimbabwe. Taleb really agrees with Charlie Munger on this issue.

Don’t own equities

On market risk, Taleb discusses how people should not even own equities and should focus on their jobs as source of income and invest only for capital protection. He says that if you must hold equities, you have to do that and be hedged in a proper way against long tail risks. The problem is that few know how to do that, i.e. buying some puts is not the strategy because of the large cost attached to it.

But, he is clear that what is going on will at some point crash and that we should be ready for it. He also says that if there is a crisis, he will be the first to buy.

How to invest

On how to invest, he advises to avoid the middle, thus the zone where most people invest chasing income and yield and how you should invest in a barbell way where you hold most of your money in safe, wealth protective assets where he excludes equity and especially bonds.

10 barbel investing

Source: Seekingalpha

He mentions how public pensions funds need to hedge properly because if not those are doomed as they promise 7% returns and a crash would require them to reach much higher returns in the long term.

His message is that if you don’t know how to hedge for tail risk protection, you should not hold equities.

He owns some gold, land, some other financial instruments(derivatives) and avoids stocks, long term bonds – hold short term. Tail risk hedging if you know how to do it.

Morale of the story, risks are piling in the form of higher debts, hyperinflation is the probable solution and one should be hedged against tail risks. More about what are tail risks and how to possibly hedge, if we can do that in future videos.

Trade Wars

Oh, on the hot topic, I almost forgot, Taleb says how he loves to chat about things that took him 20 years of thinking to get to have something to say, so he really has nothing to say on trade wars, next year there will be something else people will chit chat about.

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Nassim Taleb is warnings us – situation worse than in 2007

  • The US government has $21 trillion of debt, but few know and think about the $49 trillion in hidden debt.
  • The global economy is not stable because the core is cracking already, think Italy.
  • Taleb compares this debt environment with a Ponzi or Maddoff scheme.
  • The main message is to be protected (gold, real assets, puts).

In a recent Bloomberg video, Nassim Taleb, the author of Black Swan and probably one of the best estimators of risk, is warning us that the financial situation is worse than it was in 2007.

As Taleb doesn’t share much data in his interview, I have researched each of his statements and attached a few facts to them.

The topics he discusses and I dig deeper into are:

  • (0:00) Introduction
  • (1:23) The bigger debt pile that has just been transferred from housing to governments.
  • (4:16) The hidden debt few are taking into account.
  • (5:48) How the economy is already cracking in some places.
  • (6:32) The high probability of a global currency collapse.
  • (8:01) What will happen and how will it pan out? Inflation.
  • (9:36) 4 ways to protect yourself.

Enjoy the video.