New world order: How to invest under financial repression

Post-World War 2 globalisation brought wealth and prosperity to many nations. But the path the world has followed for the past three and a half decades has also created imbalances, which many countries are now moving to address.

While capital was cheap and mobile under globalisation, this also allowed debt to climb. Countries that ran high trade deficits became reliant on recycled foreign savings.

Globalisation also redrew the manufacturing map and a global supply chain was created with many manufacturing hubs moving to cheaper markets offshore, rewarding asset owners over workers, contributing to a rise in populism and economic nationalism.

The political response to these imbalances, such as Trump's tariffs or the even earlier Brexit, is fragmenting what was effectively a single global pool of capital.

Countries are moving to rebuild defence, secure energy independence and bring industry back onshore. But these initiatives are costly, and the burden falls hardest on governments that are already heavily indebted. Because the funding must come from a finite pool of savings, we believe that a fight for capital is unavoidable.

Financial repression is one solution to controlling capital and one that we believe is, and will, become increasingly important in this new world order. It is a term and a practice that is coming back into fashion after several decades and describes the practice whereby government policies, regulations, and laws deliberately channel domestic savings into public sector debt at artificially low interest rates.

Financial repression has not been in the economic lexicon for some time, as highlighted by the lack of Google searches up until very recently.

Stanford University economists Ronald McKinnon and Edward Shaw first introducedthe term in a 1973 paper on financial markets and economic development when they labelled South Korea's financial situation as "financial repression."

They were describing South Korea's interest rate ceilings and government-directedinvestment programs, which were all designed to keep capital at home. The ceilings meant that savers had to take rates below the rate of inflation so the government andcompanies would not have such a hefty interest rate on their debt.

Other examples of financial repression include governments encouraging or compelling domestic savers to hold government bonds at low real or sometimes even negative, yields. To do so, savers may be required to sell assets, including offshore assets, which leads to the repatriation of capital.

This practice, although not known by such a term then, helped Britian and the US clear the debts of the Second World War. Long dated bonds of that era, which were offeredat yields below inflation, became known as certificates of confiscation.

The consequences

We are now observing more governments of developed countries taking steps to retain domestic savings and direct them towards national priorities. This has impacts beyond improving individual nation's debt positions, it also means capital becomes less free to move around the world in search of the best return.

This is important for investors to note because it means political priorities are increasingly influencing where capital is allocated.

This goes against the grain of traditional assumptions that investors are free to decide where to allocate capital based on risk and return, value, liquidity, preference etc.

If controls, regulation or political direction intervene between the investor and the asset, an accurate assessment of cashflows and fair valuation, for example, may be rendered effectively meaningless.

Looking at individual countries, the US is stretched when it comes to its government debt burden, paying more and more to service it at the same time as it grows. While its private sector is in a much better position, it does rely significantly on foreign savings, thanks to the enduring popularity of US assets.

This is where the US is most vulnerable. If other countries decide to bring their capital home, it is the highly liquid US securities they are very likely to divest first, and any sell-off might hit America hard.

Financial repression and the resulting capital repatriation can hit investors in two ways. Firstly, the assets they are directed to own at home are likely to have unattractive real yields, and secondly because the liquidation of assets abroad may drive prices lower.

A new game plan

So, what should an investor do under this changing world order? We would argue it is prudent to invest with the four following tenants in mind: short duration, strong balance sheets, real assets, and diversification.

Short duration

Investing in short duration securities is as much a liquidity choice under an uncertain monetary regime as anything else. It gives investors the ability to have capital returnedsooner, allowing them to retain a degree of control they would not have with longer-term investments.

Given the move towards lower yields on sovereign bonds by governments, we also suggest investors should hold as little as they dare and at the shortest duration they can justify. Long duration government bonds are the sort of nominal assets that are hit hardest by financial repression.

Strong balance sheets

A company in a strong financial position with little debt offers investors some insurance in the current environment. A company that can fund its own ambitions does not have to compete with governments or other businesses for scarce finance and it can invest when others are constrained.

Real assets

Real assets are also attractive because their value relies on productive capacity rather than nominal or market values. Replacement values and cashflows of real assets have a better chance of keeping pace with inflation and are more likely to survive post financial repression.

The risk is that as many of them are fixed in place - think power lines and roads - which leaves them vulnerable to government policies around taxation, regulation andpotentially confiscation.

Diversification 

Diversification is key for any investor, but it is hard to find in a global market which is highly correlated to anything AI.

We believe diversification increasingly resides in areas such as alternative risk premia, including volatility strategies, trend following, merger arbitrage and catastrophe bonds.

The era in which capital flowed freely towards its highest expected return is giving way to one in which governments increasingly influence where savings are invested. The consequences may take time to become apparent, but they could be profound for asset prices and portfolio construction. In a world in a world increasingly shaped by the fight for capital, investors need to be appropriately prepared.