How worried should we be about debt?
All of the long-term bleak market forecasts have something to do with the debt piling up on government balance sheets. Seth Klarman, who is the founder and portfolio manager of the Baupost Group, a hedge fund with over $25 billion in assets, and who is compared to Warren Buffett, and is nicknamed the Oracle of Boston released a letter this week that gave a bleak warning on global division and debt. The full story of the letter can be found here.
Klarman’s warning is very similar to that of Jeffrey Gundlach, CEO of Doubleline Capital. Gundlach said in a recent Barron’s interview, “One of the reasons the economy picked up was the tax package and increase in government spending. Those are one-off things—unless if you keep doing it. If you keep having a delta of incremental spending and deficit, you’re going to end up with trillions and trillions and trillions of dollars of debt—precisely when the Fed has raised interest rates. I’ve been calling it a suicide mission: You’re issuing increasingly more debt and the cost of that debt is being voluntarily raised.”
The investment implication is likely to be diminishing growth expectations. This is the message coming out of the World Economic Forum that was held in Davos this week. This is not a short-term dire warning, but one that will take time to play out. Seth Klarman also wrote that since the worst does not frequently happen, you cannot let the fear of a monster storm completely paralyze you. I expect that governments around the world can just keep printing new money as long as interest rates remain low.
The biggest risk to most financial plans is above average inflation. A CD or short-term bond that pays 2% is not much of a return if inflation jumps to 3%. The real rate of return, which is inflation adjusted, is the true goal of all investors. Over the long-term, the best hedge against inflation is a diversified stock and bond portfolio. Fixed annuities and low rate CD’s will reduce market risk but do increase inflation risk.
Political risk and inflation risk will become more intertwined in the coming years. We are seeing signs of politicians trying to address higher deficits with unrealistic solutions. This week Alexandria Ocasio-Cortez proposed a 70% tax rate. Elizabeth Warren proposed a new “wealth tax” on very rich Americans with $50 million in assets. As I’ve written before, I’m less worried about a China trade deal or government shutdowns. If these new tax proposals were to gain in popularity, the stock market would fall even faster than December’s “correction” and there would be no “V” recovery this time. Liquidity would just disappear and it would not reappear until market levels were much lower. Investors will eventually turn their attention to government deficits but the timing is unknown. This is a long-term concern but it does shape how I’m constructing portfolio allocations to hedge against some of this potential risk.
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