Is your retirement plan ready for a 50% drop?

Monday, 11 March 2019
Melbourne, Australia
By Selva Freigedo

Editor’s note: Bernd Struben and the staff at Port Phillip Publishing are off today for the Labour Day holiday in Victoria. You may also be enjoying a day off for Canberra Day in Canberra, Adelaide Cup Day in South Australia, or Eight Hours Day in Tasmania.

We’ll be back at our posts tomorrow, 12 March 2019. Today, we hope you’ll enjoy a complimentary back-issue of Global Investor.

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The following article was originally published on 21 February 2019.


Imagine this.

A severe financial crisis hits the country.

The central bank, who has been keeping interest rates low, lowers rates even further to stimulate the economy.

They are now at a negative 4%.

A negative interest rate works kind of like a tax. Keeping your money in the bank means that you lose 4% a year. The idea is to get people spending, instead of saving.

But people have an alternative: cash.

They are stashing and using it instead of depositing it in the bank. You see, no negative interest rate applies to cash.

So, the government comes up with a ‘solution’.

To make cash less appealing, they create two different currencies. One is cash. The other is e-money.

In practice, there are now two currencies.

E-money is only used electronically, and pays a negative 4% interest.

You can still use cash, but it has an exchange rate against e-money.

Every time you want to deposit cash into your bank account, you have to exchange it to e-money. The conversion is 1 to 0.96…that is for every $100 in cash you deposit you get 96 e-money…so you lose 4% of it.

Stores also have two different prices. One is for payments in e-money, the other is for payments in cash.

Paying in e-money means a 4% discount.

So, effectively, there are no benefits on holding cash.

This isn’t my idea…but one that’s coming from the International Monetary Fund (IMF). They published it in a recent study on how to make negative interest rates work.

It’s been interesting times since the 2008 financial crisis.

We have seen unusual policies like zero or negative interest rates to boost growth.

Interest rates have been now low for a long time. And major banks around the world are struggling to get back to normal. Even the RBA has had rates stuck at a record low for years now.

Low interest rates are the new normal.

What will happen in the next crisis? Not many countries have room in monetary policy to respond. As the IMF noted, In the OECD countries, only Turkey, Mexico and Iceland could cut rates by between 3­–6% points.

The scenario the IMF depicts could be quite a plausible one when the next crisis hits. 

Interest rates could be set to go even lower than now. But, there is one big problem with this.

As this week’s expert, Charlie Morris tells us there is only so much growth you can get from stimulus at zero rates.

Charlie is our chief strategist in London and editor of The Fleet Street Letter.

As Charlie told readers, 2019 has been quite different from 2018:

It is no coincidence that 2019 has seen a divergence in equity returns. 2018 was a transitional year that has likely seen the end of this decade-long bull market. But it can be dangerous to be wedded to a view and I believe it pays dividends to be looking over your shoulder to see what is changing.

The rally so far in 2019 has been driven by talk of continued easy money. This may do wonders in China and may even drag other markets along with it. But for the weaker economies, the evidence grows that it is the end of the road.

The recent rally has benefited the likes of the US, Canada, the UK, Asia, Australia and other emerging markets. The notable exceptions are Europe and Japan; both zero interest rate policy (ZIRP) countries, that are plagued by the threat of deflation. Despite these countries being the serial money printers, fresh stimulus seems to be pushing on a string.

We have seen quite a lot of stimulus in recent years, and continue to see it.  

As Charlie continued:

China now has the largest [central bank balance sheet] in the world, closely followed by Europe and Japan. In contrast, the mighty US has dropped into fourth place and is declining.

chart image

Source: Bloomberg
Click to enlarge

‘[…]This stimulus is supposed to make up for the lack of demand that exists after a banking crisis. The banks in China do what they are told to do. In the US and the UK, they are fixed and lend on a commercial basis. However, in Europe and Japan, they are broken, and lending occurs at a snail’s pace. That is not only down to the bank’s health, but also a lack of demand.[…]

Low inflation and low rates are a troublesome combination.

The thing is, zero interest rate policies affect the economy…and banking health. As Charlie continued:

While it seems that all major markets are experiencing falling inflation and bond yields, this is exacerbated within the ZIRP countries. At the heart of the problem is that the ZIRP bond markets have nothing left to give. […]

Above all, this means the economy is cool, and is the worst environment not just for industry in general, but for the banks. […]

As stocks have got off to a good start this year, one group stands out for making new lows, and that is the European banks. […] It is my thesis that central banks can only keep the wolves at the door for the ZIRP countries. For the rest, that stimulus is much more likely to be effective.’

And as Charlie explained, this could be dividing the world into two different groups: functioning and zombie economies.

The UK, China and the US have bonds plus inflation above 4%. The ZIRP countries have it below 2% and falling. For Japan, it is close to zero despite the might of its arrows approach back in 2013.

There is no academically backed logic for adding bond yields to inflation, but it makes for an interesting and stable observation, nevertheless. And it is logical as it clearly separates functioning economies from zombie economies, which is largely a function of the health of their banking system.

Notice how Germany joined Japan in the low inflation camp from the time of the euro crisis back in 2011. Prior to that, it had traded alongside the leading developed economies. You can also see how Japan fell from 2% and into negative territory in 2008.The vast stimulus package worked for a while, but it has tended back towards zero, despite continued money printing by the bank of Japan. And above all, there is China that now sits neatly alongside the US and the UK.

chart image

Source: Bloomberg
Click to enlarge

Yet as Charlie continued, while the 2019 rally has rewarded some countries, we haven’t seen the same results in their banking system.  

Although it’s still early days, the 2019 rally has rewarded markets in line with the health of their banking system. The market takes the view that additional stimulus will have the most impact in healthy countries and the least where the outlook is the dire. The US, Canada, Australia, Brazil and the UK have all done noticeably better than the eurozone and Japan.

But when you look at the banks, the breadth (percentage of stocks rising versus falling) is alarming. Not only do Japan and Europe score zero, but so does the UK, Canada and Australia. And the almighty US scores a paltry 10%.

But according to Charlie, not everything is lost.

The balance of power has been shifting eastward for many years, and the Chinese have more firepower than many people think. Their debts are home owned, and their banking system is an obedient servant of the state. That means stimulus can get through to the economy and quickly, but by order of government policy. […]

In the case of China, the economy is clearly slowing down, yet there is still structural demand within the economy and the country is moving forwards; albeit at a more moderate pace. And of course, the banking system still functions. This can be illustrated by looking at the banks around the world. […]

Of the top 60 banks around the world, China accounts for 31% of their value, the US 28%, the UK 5.9% and 5.2% for the entire eurozone, which is only slightly higher than for Japan. This link between a healthy banking system and economic growth is inescapable, with the proof being comparative growth rates over the past decade or so. On this basis, it comes as no surprise that the eurozone has slumped, as there is no banking system to support it.

As you heard from Charlie, there are two different groups in the world right now, functioning economies and zombie economies.  

Stimulus may do very little for the ZIRP countries while it could do quite a bit for China…even if it is entering a bubble.

As Charlie continued:

China may well be going into a bubble. Fuel is being thrown on to the fire, the stock-market is cheap and the nation is motivated and ambitious. When George Soros was asked what to do if you spot a bubble, he said you should buy it. That’s because they are fantastic while the party lasts.

The West keeps struggling with low interest rates and low growth…and we could see interest rates hit below zero and a tax in cash if another crisis were to hit soon.

That’s why we still see opportunity coming out from the East.



PS: I hope you got as much from the above article as I did. I’ll be back with you tomorrow with the latest investment insights from our Australian team.

In the meantime, be sure to check out what’s on offer over at Global Investor.