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Luis Arenzana

What’s going on?

«Even if property rights and legal security have been under constant threat in Spain for centuries, some people naively believed that joining the European institutions would fix that problem. Nothing could be further from the truth so far»

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What’s going on?
zipi|EFE

As we slowly but surely approach the summer doldrums, there is an appearance of a return to normalcy. Vaccination rates for those in the highest risk categories are very high in the developed countries. This is the case today even in the EU. Most of you are probably busy making plans for the summer holidays. Even though many of us dread going back to airports, not so much because of CoVid, but because airports and air travel, especially in Europe, are undoubtedly the nadir of the human peacetime experience so far into the 21st century, we will still travel. The apps that show airplanes’ location report increasingly more crowded skies overhead. Little by little, we are overcoming the Pandemic and, more importantly, our own fears.  

The usual pundits depict a rosy scenario where a combination of fiscal spending and monetary easing will turbo charge a multi-year economic recovery and expansion. Consequently, financial markets reach new highs for stocks and new lows for bonds nearly on daily basis. The bonds that are cratering are the same bonds that only a few months ago these same pundits insisted could not go down in price because of central banks’ intervention and because sovereign issuers could not afford higher financing costs. Future generations of philosophy students may use these propositions as examples of circular reasoning. 

The Bloomberg Barclays US Treasury Total return Index is down 3.22% year to date. It will take two years of carry on US 10-year notes at current yields to maturity just to recover that loss. The S&P Eurozone sovereign bond Total Return Index is down just over 3% year to date, but in this case, it will take a much longer time to recover this loss because of the tiny carry, if any.  As an extreme case, take the Republic of Austria 0.85% bond of 2120. This 100-year bond is down 31 points year to date.  It is a good thing this is such a long dated debenture, because it will take nearly thirty-eight years’ worth of coupons just to make up that loss. For the holders of the myriad 0% coupon bonds issued at negative yields to maturity by Germany and other AAA euro zone countries, all we can say is that we may be sympathetic but in any case, their jobs suck. If one is compelled to buy such toxic crap to match duration risk, it is probably best to look for a different occupation. Only in the hyper-theoretical world of EU insurance and pension regulation would anybody hedge a liability by voluntarily entering a financial contract that will return nothing or even cost you money over 30 even 50 years. You may as well just hold the cash in a bank vault.

While the press reports gleefully on the excesses in equities and other ebullient markets, very little ink has been used to report on the blood bath in fixed income markets, and yet even if the beginning of the massacre in bond-land has become a taboo topic, it remains the biggest financial risk out there, as we expected. It is interesting to note that as longer dated yields rise from their lows, policy rates remain unchanged. Thus, investors subscribing to the thesis that banks in the euro area are a good investment because they are poised to make money when rates go up remain indifferent to the losses on these banks Government Bond portfolios year to date, while there remains no indication that policy rates may go up in the near future. Ditto for insurance companies. These stocks are reaching new highs even as their shareholder’s equity suffers losses stemming from the marking to market of their fixed income portfolios. 

In the US, the outstanding volume of reverse repos is growing to new records. This reflects the appetite that US banks have for funding Treasurys held by the Federal Reserve Bank of New York at a small but positive rate of interest. The US Treasury is reversing the issuance policy of the Trump administration by extending maturities, while secretary Mnuchin’s strategy was to shorten them. Surely, anybody who is vaguely familiar with President Biden’s fiscal plans would do the same. Consequently, and in spite of QE, yields on Treasurys have backed up just a tad, yet enough to spook some tourists in longer dated bonds. Also because of smaller T-bill issuance, rates on the safest assets known to banks are sometimes slightly negative. Funding the Fed at a positive rate of interest is therefore a much better alternative. Some observers see nefarious signs in this activity, they could be right.

Never mind these developments in fixed income markets, investors are much more interested in the wild swings of crypto currencies, social media “pounder stocks” such as Game Stop or AMC, or big trends such as ESG investments, which for the time being are neither E, S, nor G proof. The cryptocurrency debate is draining millions of person-hours that could best be used for other faith-based activities such as praying that the next pandemic comes at a time when we have better political leadership.  We are not asking here for Churchills of FDRs, just average competence. 

Over in Spain, or at least in Madrid, daily life has been close to normal for most of the past 12 months. Conversely, political and economic developments are as close to a Twilight Zone episode as was the case with the March 2020 lockdown. While the Government is busy implementing the conditionality enacted by the Brussels bureaucracy to be eligible for the EU New Generation funds, the domestic and external message is dumbfounding. Sanchez, like so many other of his fellow heads of government, has discovered the near limitless power that comes from the State running the economy and the financial system, and he likes it. We are witnesses to the demise of civil society and the market economy as a result. All private activity is to be replaced by an all-powerful Government sector led by politicians who naturally know best. If this sounds familiar to some of you, it is because this is what we ended up with in the inflationary 1960s and 70s. It took two decades of market-orientated reforms to sort out that mess and return to low inflation and full employment. 

The economic policy mistakes of the 1970s were too numerous to enumerate. Wharton Professor Jeremy Siegel called it “the greatest failure of American macroeconomic policy in the post-war period.” One of the key actors was John Connally, the Nixon administration’s Secretary of the Treasury. He did not have formal economics training yet he took on a big gamble when he closed the gold window for the US dollar. Generous spending on the Great Society and the Vietnam War led to a large fiscal expansion partly financed by the Fed’s very accommodating monetary policy. The real Fed Funds rate hit a low of -4.42% in the mid-1970s. The 1973 Oil embargo did not help tame the inflationary spiral. Consumer confidence and business investments declined and unemployment ballooned.  The experiment of enlarging the Government sector by debasing the currency failed miserably.  Surpringly, many people today believe that this time is different and politicians will succeed in eating their cake and having it too.  This is, once again, the triumph of hope over experience.

In this confusing time, there are dinner table topics of conversations that have become banal in Spain, which would raise the hair in the back of the neck of fellow diners elsewhere. It is not uncommon to discuss such pointed topics as what is the best way to keep squatters from occupying one’s home while refurbishing it, or what are the pros and cons of financial exile in a number of foreign jurisdictions. Even if property rights and legal security have been under constant threat in Spain for centuries, some people naively believed that joining the European institutions would fix that problem. Nothing could be further from the truth so far.  

The current government aims to raise taxes on earned income and investment income to fund its progressive agenda. It will also expropriate savers with a wealth tax, which according to their economic spokesperson has not been a problem in France. It is surprising he does not know that the wealth tax was largely rescinded in 2018 to stem the steady brain drain and the capital outflows. The Spanish government will try as well to avert the probable insolvency of the public pension system down the road by increasing payroll taxes on the highest earners, who of course will see nothing in return, and eliminating the tax advantages of private pension plans whose only beneficiaries admittedly are the plans’ managers. Yet they seem to be blind to the inconvenient truth that most private pension plans in the euro zone are underfunded even when they are allowed to use accounting fictions such as the Ultimate Forward Rate to reduce the present value of future liabilities. Yet nothing this government says or does should surprise anybody. They operate in a parallel universe where the current political instability arising from a complex and fragile coalition with very little voter support is not an issue.  How do they reach this conclusion? The argument is that the Dutch Government has some coalition stability issues as well. They may not even be aware that The Netherlands is AAA rated and has a debt to GDP ratio under 50%, or they may know this, but they speculate that their audience cannot tell the difference, even if they knew the facts.

Banks and insurance companies are eager to assist in this plunder when it suits their interests. This is the case with specialized investment funds (SIFs) or professional investment funds (PIFs), which in Spain are called Sicavs, the generic term that applies to most collective investment schemes in the EU. This is the case perhaps for the same reason that Internet broadband access is called Wi-Fi or a conference call “una call”. Affluent individuals use these structures to manage their financial assets efficiently and with reasonably low expense ratios. These funds have the tax benefits of collective investment schemes while avoiding the onerous fees that management companies and private banks charge their customers with no visible performance benefits.  

These “professional” Sicavs have been a target of populist rhetoric for as long as we can remember.  Why this is the case remains elusive. They provide no tax advantage over any other collective investment scheme.  Yet, new legislation will soon make the requirements for these vehicles harder to meet for many people because the new law will require, not just a minimum of 100 investors, but in addition a minimum investment of €2,500 each. Who benefits from these changes? Certainly not taxpayers as the event of dissolution will not be a tax event as long as the proceeds are re-invested in collective investment schemes!  Financial intermediaries are receiving one more subsidy from the Spanish Government to get over CoVid.

There might be some ways around this.  The first solution is cost free but complex and requires information and co-operation. All Sicavs could invest €2,500 in each of 99 other SICAVs. We surmise that most bankers are dead set against providing this solution from conversations with a number of them.  The push back is an incredibly cynical argument “How could my client possibly find 99 other SICAvs with the same investment strategy?” Some larger SICAV sponsors will realize that they are better off gifting or lending €2,500 to each of the 99 minority to meet the new requirements.  As with most new government schemes this reform is a regressive form of expropriation. In this case, for the least affluent among the affluent. While €247,000 may be a small price to pay for some compared to delivering their life’s savings to the fee carnage that banks have in store for these “new” clients, it may be too much of a burden for smaller schemes.   This is just the latest example of how “regulatory capture” works in the financial services industry in Spain. 

Traditionally Spanish governments tried to ease the strains on public pensions by encouraging private pension schemes with tax breaks. What ensued was a private pension industry, which charges such onerous fees that the government eventually was forced to set ceilings on the total expense ratios. Notwithstanding these noble efforts, the bulk of private pension plans have returned very little, if anything at all, in spite of the recent 13-year-old bull market in equities and fixed income. God only knows what will happen to these suffering savers if the collapse of the fixed income market continues apace. 

The conditionality that comes with the EU funds will require other tax and benefits changes. CO2 credits is the most regressive of all new taxes.  Domestic electricity prices are soaring because of the steep rise in CO2 credit prices to the point where the Government has imposed a windfall tax on clean sources of energy to lower domestic electricity rates.  What some analyst saw as a bonanza to utilities has become a problem for their shareholders.  Their analysis did not take into account the “Gilets jaunes” effect.   All these central bankers rooting for a resumption of inflation and the politicians that egg them on forget at their own peril that if successful they will be driven out of town tarred and feathered. 

The “silent majority” stood behind Nixon and supported the War in Vietnam until inflation got out of control.   When Nixon signed Executive Order 11615 closing the gold widow, imposing a 90-day freeze in wages and prices, and a 10% surcharge on imports, he opened a Pandora’s Box. Speaking on Television, he said:

The third indispensable element in building the new prosperity is closely related to creating new jobs and halting inflation. We must protect the position of the American dollar as a pillar of monetary stability around the world.

In the past 7 years, there has been an average of one international monetary crisis every year …

I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.

Now, what is this action—which is very technical—what does it mean for you?

Let me lay to rest the bugaboo of what is called devaluation. 

If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today.

The effect of this action, in other words, will be to stabilize the dollar

 

It was a remarkable exercise in cynical mendacity, which backfired. Marvin Gaye caught the mood of the time in Inner City Blues:

“Inflation, no chance 

To increase finance

Bills pile up in sky high

Send the boy to die 

Oh, make me wanna holler 

The way they do my life (He-ey-ey)”

We do not expect that the numerous tax increases coming to Spain, both progressive and regressive, will lead to widespread violent protests as was the case in France or is the case today in Colombia, but we do not see how an already tense political backdrop may improve if the much promised V-shaped recovery does not materialize.  When all Spaniards realize that, they have joined a small group of impoverished and indebted countries which have lost significant ground in their development and are absent from the technology revolution that is sweeping advanced economies, it might be too late to look for a solution. In the interim, those who can will move abroad to avoid expropriation. Young people will stay to face a dire future as most of them do not have the education nor the training for the jobs offered in the 2021 marketplace. Finally, senior citizens face some uncertainty regarding the buying power of their pensions in the future. Some people call us overtly pessimistic; we hope they turn out to be right.

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