how stocks would fare: the Carmen Reinhart cookbook (II)

financial repression

Yesterday, I wrote about the scholarly outline Carmen Reinhart gives in “The Liquidation of Government Debt” about how the US government, or any government of a heavily indebted country, could work to decrease the real value of its outstanding obligations–and thereby reduce them relatively quickly.

The attack has several prongs:

–set interest rates lower than inflation,

–encourage at least gentle rises in the price level,

–force financial companies and institutional investors to buy bonds–by saying it’s for their own safety and that of customers,

–establish controls to prevent capital flight.

The “beauty” of the Reinhart plan, which is all developed nations did after World War II, is that citizens won’t really “get” what’s going on.  Therefore, the legislators who enact it have a good chance to stay in office–which they might not if they vote to increase taxes or decrease public services instead.

The overall result is that bondholders have the same miserable investing experience that characterized the US or European fixed income markets from the 1950s through the 1970s–and the opposite of what they’ve enjoyed in the decades since.

What about stocks?

I think there are two main caveats to consider:

1.  capital controls.  Would locals be expressly barred from removing funds from the country to buy  equities in foreign markets–either directly or through mutual funds/ETFs?

This may not be quite as big an issue as it seems at first.  Foreign stocks could easily be regarded as too risky for financial institutions, like banks, insurance companies, and pension funds.  So strict limits on the percentage of assets that they invest abroad–or even a total ban–might not raise too many eyebrows.  As to individual investors, their appetite for foreign equities might not be that large.

Also, since most advanced countries might be adopting the same strategies, the only refuge might be emerging markets, a category that contains substantial risks of its own.

2.  explicit taxes on stocks.  An implicit argument Reinhart makes is that legislators have their reelection as their number-one goal and will not advocate any tax that might raise voter ire.  It might be, however, that removing the tax preference for long-term capital gains in the US would be pitched as making the wealthy elite pay their fair share.  Higher capital gains taxes than that?   …my guess is that wouldn’t happen.

It seems to me that these variables would affect the extent of stock outperformance of bonds, not the high probability of relative gains, and that there are some general rules that would apply in all Reinhart-like situations.  We have only to look at the behavior of the Mexican stock market after the borders were closed in the early Eighties, or that of the US stock market in the late Seventies, to get a good sense of what those rules would be.

winners and losers

In particular,

on the plus side

1. tangible assets would likely do well, on the idea that they have a good chance to hold their real value.  This means natural resource and real estate owners.

2. since the real value of debt would be falling, highly financially leveraged firms might come back into vogue.  Companies might borrow aggressively to acquire tangible assets, creating a kind of asset arbitrage.

3.  domestic companies with large streams of foreign earnings should trade at a premium.  In this arena, firms might also borrow heavily in the domestic market to acquire foreign assets, especially in emerging markets.

4.  stocks based in foreign countries not subject to ” financial repression” would be especially attractive.  If domestic investors are somehow barred from buying them directly, the companies could easily seek listings here.

5.  because the combination of low interest rates + inflation would likely weaken the currency, export-oriented and import-competing firms would probably do well.  So too would businesses that cater to foreign tourists.

on the minus side

1.  slow-growing, domestic-only, high dividend-paying firms–the ones that look the most like bonds–would likely be underperformers.

2.  financial firms might well be hurt the most, since they would be the principal owners of unattractive government bonds.  People might regard this as a rough sort of justice, however, given those firms’ major role in creating the financial crisis.


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