December 22, 2020
My Dear Reader,
With all of the insane election and political turmoil over the past few months, it’s easy to miss the reality of our current economic situation and what it means to you going forward. Even in the face of a multitude of viable vaccines, numerous governors have refused to lift their lockdown restrictions. While we may be insulated from this under Bill Lee’s watch, the United States economic situation cannot be carried by just a few brave governors. Instead the majority have forced the fed to take actions that it had not foreseen in order to keep some economic sectors alive.
Writing for Fox Business, Jonathan Gruber makes note that:
“The dollar is trading at/near multi-year lows against major currencies including the euro, Japanese yen, Australian dollar and Chinese yuan. A weaker dollar makes American-made products cheaper for overseas buyers, but also makes imports more expensive for U.S. consumers.
The central bank on March 15 slashed its federal funds rate to near zero in order to help combat what would become the sharpest economic slowdown of the post-World War II era amid stay-at-home orders aimed at slowing the spread of COVID-19.”
This continues the trend that has been occurring in Europe for quite some time. In order to keep interest rates artificially low to stimulate the European economy and encourage the modern economic practices that utilize leverage, European central banks have been steadily cutting bond rates to the point that even junk bond rates are negative. But, as I’m sure we often ask ourselves when looking at the news, why does that matter and how does it affect you? For starters, it could mean that there will be trouble down the road for those who have a slightly safer portfolio position, and for those who use junk bonds to act as little “morganizers” The incentive to purchase the debt of an underperforming company becomes less and less attractive. We can see this trend play out among the larger portfolios that many Americans rely on.
According to the Financial Times, The Ball Corporation, makers of aluminum cans, recently secured the lowest ever borrowing costs:
“Aluminium can maker Ball Corporation secured the lowest-ever borrowing costs for a US junk-rated company on Monday, as income-starved investors shrugged off lingering concerns over Covid-19 in their pursuit of higher yields. Ball raised $1.3bn through a 10-year bond, paying an annual coupon of 2.875 per cent, according to people familiar with the terms. It was the lowest borrowing cost clinched in the junk debt market for a 10-year bond, according to financial data provider Refinitiv.”
This article proves what most experts have been saying for a while, in that there is a search for a higher yield, well so remaining in a safe position, yet due to government spending and rate cuts, this seems untenable. In fact, in a recently published working paper by Neng Wang and Jinqiang Yang titled “The endowment model and Modern Portfolio Theory” Illustrated Trend in public pensions towards riskier, alternative assets.
However, one of the greater fallacies when taking on any risk is that greater risk equals greater reward. In fact, I hate losing money MORE than I like earning a rate of return, and remember that a greater risk does not equal a greater rate of return. According to the IBF;
“If investors did get an extra return (a risk premium) for bearing unsystematic risk, it would turn out diversified portfolios made up of stocks with large amounts of unsystematic risk would give larger returns than equally risk portfolios with less unsystematic risk. Investors would snap at the chance to have these higher returns, bidding up the prices of stocks with large unsystematic risk and selling stocks with equivalent betas but lower unsystematic risk. This process would continue until the prospective returns of stocks with the same betas were equalized and no risk premium could be obtained for bearing unsystematic risk. Any other result would be inconsistent with the existence of an efficient market.”
So while the general consensus might be to increase risk, to account for the lower yields of bonds, it may not guarantee a greater rate of return. It may in fact simply expose more people to great losses from which they may not recover. This is due to the principal known as opportunity cost. Opportunity cost is seldom explained by the financial community. If your financial advisor has already explained this to you, or you know what it means, thank him or yourself; not understanding it can cost you hundreds of thousands of dollars over your lifetime. The basic premise is that every dollar you spend today could have been invested to yield increasingly more money over time. This is a sobering fact: every dollar spent today will never again be able to work in your favor. For instance, $100 invested today at the market average rate of return of 7.91 percent will be worth about $1,000 in thirty years. So, every payment made today with your own dollars hurts you in the future. This is why excessive taxation, especially personal income tax, is so harmful to all levels of society. USA Today estimates that the average American pays roughly $10,000 in personal taxes per year. If we use this number and apply the current market average rate of return of 7.91 percent, that one year’s payment of $10,000 costs $96,463 thirty years later. Albert Einstein once called compound interest the 8th wonder of the world. Yet it is surprising how few people are able to take advantage of it. The idea of a compound interest is that over time, starting slowly, the interest gained from an investment will compound exponentially if left untouched. But an investment that is interrupted will reset the compounding effect, and will forever damage the earning potential of that investment. Opportunity cost and compound interest are the two most basic wealth-building fundamentals, and I believe in every purchase we make, we are contributing to opportunity cost and stopping our compound interest.
For example, when we buy a car, traditionally we have two choices, either paying cash or financing. When we pay cash for a car, we do so in the hopes that we will avoid paying interest to the bank or financial institution. However, in doing so, we greatly exacerbate the opportunity cost of losing cash as a leveraging tool. If we take a 25-year-old who has $100,000 in an account that compounds at 7.91% annually, and compounds that number for 30 years until he retires, he will have earned $981,410. However, if we make just one payment for a car, even if we use the average price of $20,000, this man will only earn $785,128 over the same time. This number is if we only purchased one car for this man’s entire life. But what if he gets married? What if he needs to purchase a car for his son? Maybe like the average American, he’ll have two kids and need a car for his daughter as well. What about college for both his kids?
I believe that the current situation will eventually cause more people to turn to alternative strategies such as the private reserve strategy or tried and true strategies in real assets such as precious metals and Real Estate. But with the current political turmoil and outlook, the general financial situation doesn’t appear to be improving anytime soon.
To Your Creation and Potential,