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Buy Your Winter Coat in the Summer – When it’s on Sale!

By:

Chief Investment Officer at Capital Wealth Advisors

CHIEF CONCLUSION: Investments that could be considered “safe” have changed over time. One key driver of this change is how our financial authorities, in particular the world’s central bankers, have chosen to react to developments. When confronted with unexpected economic weakness, these central bankers cut interest rates. Falling interest rates are good for the prices of the highest quality, longer duration bonds. This has historically made them especially appealing to own in an equity rich portfolio. With U.S. equity markets at new all-time highs, we believe that now is an excellent time to begin rebuilding such hedges in the fixed income markets. We are trying to buy our winter coat in the summer! When it’s on sale.

Walter Bagehot was the London-based Editor of “The Economist,” the leading global financial publication of his day in the 1860s and 1870s. Of course, Britain was the financial capital of the world back then. To its credit, this worthy publication is still available today in both magazine and online form and is an excellent summary of globally impactful political, economic, and financial news and analysis. Understandably, Bagehot’s vantage point gave him unique insights into the financial markets. This proved especially fruitful as he had a ring-side seat for the Lehman Crisis of his day, the collapse of Overend, Gurney and Company. When this bank failed in London in 1866, it sparked the largest financial crisis in decades in Britain and impacted the global financial markets in ways that persisted for years.

Bagehot drew upon his observations of this crisis to publish what would be his landmark work, “Lombard Street: A Description of the Money Market.” In particular, this work would come to be the bible of risk management for central bankers in their role as “lenders of last resort,” meaning they were a source of liquidity for market participants during a panic when liquidity was unavailable. From that day and for the next 140 years this thinking would guide the behavior of central bankers – until the collapse of Lehman threatened to take down the highly interconnected global financial system and panicked modern central bankers into changing strategies. Before we talk about what changed, lets first take a minute to understand how things operated for more than a hundred years.

Bagehot’s conclusion was that the best way for a central bank to deal with a crisis of confidence was to lend freely and early against the best collateral – at high rates of interest. The goal of this strategy was to provide liquidity but also facilitate the needed economic adjustment that the unfolding crisis had revealed, hopefully in an orderly manner. This incremental liquidity would buy time for the needed readjustment.   Implied in his counsel of lending at high rates was to discourage what would come to be known as moral hazard, namely that a central bank “rescue” would reward bad behavior that led to the crisis in the first place. Bagehot’s counsel signified that he believed that high interest rates had an important role in discouraging moral hazard because the central bank’s high rate would incent market actors to find lower cost sources of liquidity from the private market if it could be found. Nonetheless, the central bank should stand ready to provide the necessary liquidity at this higher rate against the collateral of the highest quality securities, in the event that insufficient liquidity was available from private sources. So, even though Bagehot clearly endorsed the need for “activist” central banking during a crisis, his suggested strategy was structured to minimize the risk of moral hazard. His focus on managing moral hazard was a key part of central bank thinking – until the failure of the Lehman overwhelmed it and marked a sea change in 140 years of central banking policy.

LEHMAN’S COLLAPSE THREATENS THE SYSTEM: CENTRAL BANKERS ABANDON ALL PRETEXT OF FIGHTING MORAL HAZARD

I am often asked what insights made it possible for us to dramatically outperform in the unfolding carnage of the Global Financial Crisis sparked by the failure of Lehman Brothers. Our early focus on the leveraged real estate market and the problems that would flow from its decline was one key insight. Another, which is more germane to this discussion of moral hazard, was that we knew something that our central bankers did not. We knew that the vast web of global overindebtedness and these interconnected liabilities made the system shockingly fragile and prone to collapse. This discovery, sadly, was late in coming to our central bankers and played the key role in explaining why they were so late to acknowledge and respond to the crisis.

Furthermore, the memoirs of crisis actors such as Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke – which I re-read this weekend – both reveal how obsessed they were leading up to Lehman’s failure with avoiding one form of moral hazard, bailouts. In the end, however, their worry about the system’s collapse clearly overcame their fear of moral hazard, as the subsequent bailouts illustrated. The crisis sparked by Lehman’s failure got their full attention, very late in the downcycle. And they threw out the rulebook that had worked for 140 years. Then a new era began, which is still in its early stage, but we think marks a profound change – with implications for our asset allocation and how we can best manage risk over the course of the cycle.

Moral hazard has ceased to stand in the way of intervention. Rescuing the overindebted financial system, a development that the US Federal Reserve had overseen and in fact encouraged, came to be all that mattered. This trend became global when in 2012, the Fed’s brother central bank, the European Central Bank, dropped its emphasis on moral hazard with the promise of its Chairman Mario Draghi to “do whatever it takes” to stop the debt crisis that was threatening to bring down Europe’s financial system. So died 140 years of central banking policy. Welcome to the new world of central banking.

This change upended 140 years of central bank crisis management that Bagehot had so well described. Certainly, the Global Financial Crisis marked an important escalation in government in many aspects of the global economy and had many unintended consequences that accompanied this greater activism. One such change was that the health of our fragile financial system became more important than moral hazard. This meant ever more proactive efforts by central bankers to try to keep debts from going bad, such as their recent and powerful global response to the COVID-19 crisis. Our regulators made it clear that they did not want system-wide debt levels to fall, but rather did whatever it took so that debts would keep growing. This has many important and poorly understood repercussions that will impact financial markets for many years, not all of them good. However, we believe one thing is clear, that we can use the knowledge of how central bank behavior has changed to manage risks more thoughtfully over the course of the cycle.

BONDS: WE BELIEVE THE TREND IS (STILL) YOUR FRIEND

The chart below shows that the total return (yield + price appreciation) of the longest dated U.S. government Treasury bonds have been 7.7% per year for the past thirty years!

longer dates us gov bonds return 7.7% annualized return

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Originally Posted on September 2, 2021 – Buy Your Winter Coat in the Summer – When it’s on Sale!

CWA Asset Management Group, LLC is an SEC-registered investment adviser, doing business as Capital Wealth Advisors and as blueharbor wealth advisors. CWA’s ADV 2A can be accessed via https://adviserinfo.sec.gov/. This material is as of the date indicated, is not complete, and is subject to change. Any opinions expressed herein represent current opinions only and no representation is made with respect to the accuracy, completeness or timeliness of information and CWA assumes no obligation to update or revise such information. Additional information is available upon request. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified and CWA is not responsible for third-party errors. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Nothing herein should be interpreted as investment advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Specific companies or securities described in this report are meant to be illustrative of investment style. Such case studies are not meant to be, and may not be, representative of any portfolio or holdings of CWA Asset Management Group, LLC. CWA does not guarantee the accuracy of information of any third-party website denoted in this article. Third-party website is provided for informational purposes only.

Please note that past performance is not indicative of future results.

This material is solely for informational purposes and is intended only for the named recipient. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

Disclosure: Capital Wealth Advisors

CWA Asset Management Group, LLC is an SEC-registered investment adviser, doing business as Capital Wealth Advisors (“CWA”) and as blueharbor wealth advisors. CWA’s ADV 2A can be accessed via https://adviserinfo.sec.gov/. This material is as of the date indicated, is not complete, and is subject to change. Any opinions expressed herein represent current opinions only and no representation is made with respect to the accuracy, completeness or timeliness of information and CWA assumes no obligation to update or revise such information. Additional information is available upon request. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified and CWA is not responsible for third-party errors. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Nothing herein should be interpreted as investment advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Specific companies or securities described in this report are meant to be illustrative of investment style. Such case studies are not meant to be, and may not be, representative of any portfolio or holdings of CWA Asset Management Group, LLC. Please note that past performance is not indicative of future results. This material is solely for informational purposes. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

CWA does not guarantee the accuracy of information of any third-party website denoted in this article. Third-party website is provided for informational purposes only. CWA is not implying an affiliation, sponsorship, endorsement with/of the third party or that any monitoring is being done by CWA of any information contained within the website.  CWA is not responsible for the information contained on a third-party website or the use of or inability to use such site.  Nor do we guarantee their accuracy or completeness.

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