For the Appearance of Safety and for Liquidity

Dear Reader,

Let’s take a short diversion from the breakdown of civil society and limited government in Australia to look at the move in gold and silver. But rather than talking about the price action — impressive as it has been lately, with the gold price reaching an intraday high of $2,870 last week — let’s talk about one of the main drivers of higher gold prices: lower (and negative) real yields on government bonds.

There’s probably no more important question in the world of finance and economics today. The fate of multiple asset classes hinges on real yields — stocks, bonds and gold. But there’s even more at stake. I’m talking about more than just sound money. I’m talking about a stable society, a healthy economy and limited government that’s accountable to the people.

First though, heavily indebted governments all around the world require low interest rates to finance their huge borrowing and spending plans in a pandemic world (and to refinance the trillions they’ve already borrowed). Over 90% of government bonds trade at a yield lower than 1%, according That number was under 40% in 2019.

This is a long-term trend going back 700 years, according to research published last year by the Bank of England. The ‘risk-free’ rate of borrowing, usually ascribed to the most credit-worthy government of the day, has been going down since the 14th century. But what does it mean for investors when ‘real yields’ — the actual return on an investment after you adjust for inflation — are below zero?

I’ll cut to the chase and then backfill with more data: it means even higher valuations in the equity market, the acceptance of negative real returns by investors in government bonds and a rush into any alternative asset that promises safety (hello gold, silver and bitcoin). It also means a crash in equity prices becomes more likely as investors and portfolio managers are forced to seek risk. Let me explain.

On the one hand, the existence of about $15 trillion worth of negative yielding government bonds makes some sense in a COVID, risk-averse world. It’s widely thought that — with the exception of Argentina every 20 years or so — most governments don’t have to (or won’t) default on their debt. They can always raise taxes to pay interest or get their central banks to support the bond market. It’s as close as you get to ‘risk-free’, allegedly, hence the ‘risk-free rate’.

But in a low interest rate world, where even official inflation (which tends to understate what’s really going on with prices) is running hotter than interest rates, the real yield on government debt is negative. It means rather than expecting even a modest return on your capital, you accept that if you hold a government bond to maturity, you won’t even get all your capital back!

Why would anyone do that?

Government debt markets are generally highly liquid

For the appearance of safety and for liquidity, that’s why. Government debt markets are generally highly liquid. You can buy and sell easily. Which means during times of crisis and uncertainty — like now — you can park your money ‘safely’ in negative yielding government bonds while you decide whether to buy Apple or gold.

There IS a problem though. If you’re an institution that invests in government bonds to offset predictable liabilities — pensions, expenses for an institution with a large endowment, that sort of thing — then a negative real yield means you have to generate your returns somewhere else, or else you begin drawing down your capital.

Instead of making enough in government bonds to offset your liabilities, you have to take a risk on some other asset. Which brings me back to Apple. It’s set to become the first stock with a $2 trillion market capitalisation. It will probably happen sometime this month if the trend continues.

Apple’s market capitalisation grew by about $206 million PER MINUTE on Thursday, according to Charlie Biello of Compound Capital Advisors.

With a price-to-sales ratio at an all-time of 7.37 and a market cap just under $2 trillion, the value of Apple’s stock was worth more than the entire GDP of the following countries: Italy, Brazil, Canada, Russia, South Korea, Spain, Australia, Mexico, Indonesia, Netherlands, Saudi Arabia, Turkey, Switzerland, Taiwan, Poland, Thailand, Sweden, Belgium, Iran, Austria, Nigeria, Argentina, Norway, UAE, Israel and Ireland.

And the combined market cap of Apple, Amazon, Microsoft, and Google — which was just $382 billion on 6 March 2009 — is now $6.2 trillion. That’s greater than the GDP of any other country on Earth except China (if those statistics can be taken at face value). These numbers tell me two things.

First, the best time to buy a stock is not when its price-to-sales ratio is at 7.37. You want to buy common stocks when the fear in the air is palpable — and AFTER the mean-reverting crash in valuations. That was the case in March 2009. It will be the case again in the future. But it is definitely not the case now.

Second, you have an epic mania in tech stocks which becomes even easier to understand in the context of negative real yields. Portfolio managers with a conventional mix of 60% stocks and 40% bonds are not going to make much money, in real terms, on bonds. They have to buy riskier bonds (investment grade corporate bonds, junk bonds, or something like a Collateralised Loan Obligation…made up of a hodgepodge of risk corporate debt but wrapped up with nice credit rating to appear ‘safe’).

Or, the other option is to ditch the allocation to bonds and increase the allocation to equities. If you can’t beat ‘em, buy ‘em! And that appears to be what’s at least partially driving the huge run-up in the tech stocks.

If you’re going to pursue more risk, you might as well get some bang for your buck. The returns on the tech stocks now seem like a never-ending, self-fulfilling feedback look where liquidity and the appetite for growth drive higher share prices.

But if lower real yields are partly driving the blow-off in growth and momentum stocks, they’re also contributing to the rise in gold, silver and bitcoin as alternative assets. These ‘fringe assets’ are under-owned by professional investors and punters. That’s why the recent crash to the upside has been so notable — a small fraction of the liquidity from traditionally ‘safe’ assets now appears to be going into precious metals and cryptocurrencies.

Like all breakout moves up, the gold and silver moves will correct. You should prepare for that. Try to buy on those corrections. Not at all-time highs. And consult your local mining stock expert for the precious metals and mining stocks that should follow the move in underlying metals prices. Please note: not all mining stocks are created equal and the stocks can lag the underlying for longer than you think.

In the meantime, the rise in gold and silver is also related to perceptions of safety in other assets (like bonds and stocks). But it’s also related to the creeping feeling (a matter of psychology) that our elected political leaders have taken leave of their senses and of the accountability they’re supposed to have to the people they serve.

Yes, I’m talking to the conga line of health officers, police officers, uniformed military and professional politicians who are now urging Australians to ‘do the right thing’ and accept huge infringements on basic civil liberties. Curfews, breaking windows to remove people from their cars, suggestions that you might need a permit to travel or even to prove you have a ‘valid’ reason to be outside. It’s madness.

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Since we began publishing alternative investment ideas in Australia in 2005, a core tenet of our business and our philosophy is that sound money, limited government, and the Rule of Law are all related ­— three different but coequal pillars of a civil society where voluntary trade and commerce between free people promotes the general welfare of all.

All of that is under attack right now in Australia — under the guise that the government knows best and has the authority to close businesses, regulate commerce, limit your physical movement and throw you in jail for daring to violate the emergency orders of the Chief Medical Officer. The history books will view it as a giant black mark on Australian politics and the media that covers them that it happened with such widespread support.

Until the history is written, keep an eye on alternative assets like gold, silver and bitcoin. The era of real negative rates on government bonds may be here for a while. Governments require low rates to pay for the unprecedented expansion of the state into private life and commerce, as a result of COVID. Inflation will be their ultimate way out of this huge debt. More on that next week.


Dan Denning Signature

Dan Denning,
Editor, The Rum Rebellion

Dan Denning is the co-author of The Bonner-Denning Letter.

Dan was a founder of Port Phillip Publishing back in 2005, which quickly became the leading publisher of its kind for independent financial research and insights. In 2014 he left to head up Southbank Investment Research in the UK. Dan is also the author of the 2005 book, The Bull Hunter. Today, he’s based in his home state of Colorado. Each Monday in The Rum Rebellion you’ll get Dan’s unique contrarian thinking to provide insights you won’t find anywhere else.

Dan Denning’s belief in free markets, sound money, personal liberty, and small government have underpinned everything he’s done during his 23 years in the financial publishing industry.

The Rum Rebellion