Inflation is Taxation without Legislation or Representation

The Cash Crucible & the Acceleration of Financial Repression

“Cash is a Legitimate Asset Class for the First Time in Decades, Investors are piling into products that shield them from losses in a rising rate environment.”^[i] So said a recent article in Bloomberg. Any headline-hailing investors “piling” into anything should trigger instant paranoia.

Consistent with history, our research over 12 years has demonstrated that the crowd may be comfortable, but it is rarely the right place to be. Reading that the hot spot du jour is cash, with nominal rates of 3.25% and a -5% real yield, is a testament to the financial repression underway.^[ii] This paper builds on a 2015 study of the Financial Repression used to help liquidate government debts in the 35 years following World War II.

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Summary: the nominal comforts of cash may come at a steep price for investors’ newfound risk aversion.

Buyers of Treasuries are betting against history, the Fed’s playbook & the interests of the US government
Explaining the liquidation of government debts between 1945-1980, Reinhart and Sbrancia highlighted the re-emergence of policy tools that mechanically transfer wealth from savers to the government in a “policy tax” dubbed “Financial Repression”
Specifically: “…we document how in the post [Great Financial Crisis] debt-laden environment financial repression has once again resurfaced in its many forms among the advanced economies through a variety of regulatory changes, implicit (or explicit) nominal interest rate ceilings, and in some cases, capital controls, and “moral suasion” to induce domestic institutions to hold more government debt.”
2009 – 2020 was a period of severe financial repression that not only failed to liquidate government debts, as occurred in the post-WWII period, but actually left us more indebted than any time in history
History, recent policy, and the unsustainable current trajectory of US deficits suggest Treasuries will become a “comfortable” method of transferring your savings to the US government

KCR has been writing about these risks since June 2020 when we penned 60/40: Buying a Ticket on the Titanic. The recent return of nominal bond yields and the correction in equities has improved the optics of 60/40 strategies. Unfortunately, history suggests the risks could be accelerating rather than abating.

As usual, we will not be making forecasts here. Merely explaining where we are through the lens of financial history. Take a look at the quote below.

“…deficit reduction usually involves highly unpopular expenditure reductions and (or) tax increases … the relatively ‘stealthier’ financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts.”^[iii]

That is from a paper published by the IMF. Do you think the world’s developed economies, lumbering under the weight of wholly unpayable debts, is worried about your purchasing power? We think not.

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We encourage our readers to keep in mind that the policy initiatives explained over the next few pages are openly being endorsed as a means of reducing debt. There’s nothing subtle about this. The federal government’s incentives are diametrically opposed to investors. Act accordingly.

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SOURCES

[1] Longtime readers know our fierce objections to beta as a measure of risk, but in an environment like this we believe utilizing a common, easily understood, and widely accepted metric might be appropriate. We are open to other sorts, screens and ranking methods for those who, like us, frown on daily price movements as a measure of an underlying asset’s intrinsic value. Please know we’d love to hear from you!

[2] In selecting stocks for this screen, we used a 0.7 beta threshold which yielded a reasonably consistent 0.5 beta on average. Historically, portfolios of these type of stocks outperformed during the dot.com crash, the GFC crash and have done well since the market’s peak in 2021.

[3] 1m T-Bill

[4] Statistically, based on the beta we just knocked above!

END NOTES

^[i] Cash is a Legitimate Asset Class for the First Time in Decades, Investors are piling into products that shield them from losses in a rising rate environment. Bloomberg News, 09/30/2022, quoting the head of fixed income from a prominent money manager

^[ii] Fed Funds of 3.25% minus CPI YoY of 8.30%

^[iii] The Liquidation of Government Debt, Carmen M. Reinhart and M. Belen Sbrancia, IMF, Working Paper, January 2015, page 14 and page 15

^[iv] The Liquidation of Government Debt, Carmen M. Reinhart and M. Belen Sbrancia, IMF, Working Paper, January 2015, page 14 and page 5

^[v] The Liquidation of Government Debt, Carmen M. Reinhart and M. Belen Sbrancia, IMF, Working Paper, January 2015, page 14 and page 7

^[vi] The Liquidation of Government Debt, Carmen M. Reinhart and M. Belen Sbrancia, IMF, Working Paper, January 2015, sub-section “The Pillars of Financial Repression” pages 9-11

[vii] Consistent with the work of Reinhart and Sbrancia, Fig. 4 we use treasury bills

FAQ

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for a simple, concentrated, low turnover, and hard-hitting GARP investing strategy, we would like to talk with you. Similarly, if you are looking for a model portfolio of the most proven and durable dividend payers that is simple to implement, please let us know. KCR also offers a wide range of easy-to-use but sophisticated tools like our Equity Duration product, which allows you to estimate a given portfolio’s interest rate and inflation risk. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.

Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

SERVICES

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

Disclaimer

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