Here Be Dragons!

It is said that ancient mariners’ maps bore legends that warned of mythical dragons beyond the horizon that would destroy any vessel venturing into their waters.

dragon-map

Many economists today feel the same trepidation that sailors of generations long past must have felt as their ships sailed beyond the known limits.  Our own Federal Reserve has minted oceans of money, trillions of dollars, out of thin air.  Our national debt stands at levels unimaginable just a handful of years ago.  Some say that our national debt is the dragon that will devour us.  By most measures, it appears that could be the case.  However our national debt is not a democrat or republican issue.  It’s a government issue – a government on a decades-long spending bender:

fed-debt-by-president

Source: truthfulpolitics.com

Yes, debt could be a dragon.

Critics of reduced government spending often say that our absolute level of debt is not a concern because our GDP and income have increased greatly over the years however when we look at our national debt as a percent of GDP, the picture is not much prettier.  Notice how it is now the highest it has been since the Great Depression?  Could be a dragon!

percent-gdp

Source: https://deutscheam.com/en-us/thought-leadership/cio-view/article/debt-curse-or-blessing?kid=disp.CIOView201610.outbrain_us.ad.focus

The real dragon in the room is deflation.  After nearly a decade of printing mountains of money, the US Federal Reserve and Central Banks the world over are not only out of bullets, they have barely kept the deflation wolf from at bay.  As we have written about in previous posts, the velocity of US money has slowed as all of the fiscal stimulus has become lodged in corporate balance sheets in the form of debt used to fund enormous stock buy-backs.  Very little investment has found its way into new property, plants, equipment or employees.

Think about it: doubling the national debt in eight years has produced a gasping patient.  With the Fed starting to soak up liquidity, the edge of the horizon is in sight.  When GDI and GDP (gross domestic income and gross domestic product) slip into negative territory, THERE BE DRAGONS!  The deflation dragon – the worst of them all!

gdi-in-us

Source: Author & unknown artist & http://www.telegraph.co.uk/business/2016/10/19/fed-risks-repeating-lehman-blunder-as-us-recession-storm-gathers/

The point?  Gather up all of the liquidity you can muster.  You probably have between a month and six months to gird your loins before the deflation dragon appears and when it does, it will likely thrash the markets for two, three or even four years – or more.  Who really knows?  We aren’t getting into this downturn on the well-worn path of the 60’s, 70’s, 80’s, 90’s and even early 2000’s.  This time we have invented a whole new breed of beast.  At the nadir, you will be able to acquire quality income-producing assets at once in a lifetime prices.  But don’t buy too early.  Channel Rothschild, JP Morgan and Joe Kennedy – buy at the bottom, after all of the liquidity that rushes into the market after the first wave is wiped out by the second and third waves.  Patience will be rewarded.

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ABOUT VERTICAL

Vertical Capital Advisors is a firm built on creating tangible value for our clients.  We work with clients in just about every industry.  And we work with both capital growers and capital allocators.

Joe Briner
Managing Director
Vertical Capital Advisors LLC
briner@verticalcapitaladvisors.com
866-912-9543 ext 108

 

 

Would you be willing to risk a 60% loss in order to get 2.85% interest from your bank?

Would you be willing to risk a 60% loss in order to get 2.85% interest from your bank?

Italy’s 50-Year 2.85% Bonds are 300% Oversubscribed – So what?

This week Italy began selling 50-year bonds paying 2.85% and they had three times more orders than they had bonds to sell[1].

“So what?” you ask.  “That means nothing to me”.

Or does it?

Bond buyers are generally a very bright lot.  They are probably the sharpest people in the business world.  They analyze every scrap of economic data continuously, day and night.  These hyper-analytical people are willing to commit money to an investment that has a very low yield for a very long time and whose host is in dangerous financial territory.  The Italian banking system is technically bankrupt as we wrote about in earlier posts and unemployment is over 20%.  We pegged Italy as one of the likely triggers for the next recession.

The country risks are readily apparent.  The interest rate risk is even greater. interest-rate-risk

You probably know that the price of bonds is inversely related to the rate.  As rates go down, prices generally go up.  As rates go up, prices fall.  The relative price to rate movement is determined by a bond’s duration which is a function of the rate and the time to maturity.  With a low rate, there is not much room to fall but a lot of room to rise.  And 50 years is an eternity in the world of bonds.  So if rates rise just 1%, these bonds are expected to lose 22% of their value.  Now the average rate for 10-year Italian bonds since 1991[2] has been a shade under 6%, let’s call it 3% higher than the 2.85% rate on the 50-year bonds.  Investors are willing to risk losing over 60% of the value of their bond investment in order to get a paltry 2.85% return and are in fact betting that interest rates do not return to normal, because if they do, and if they need liquidity, they will lose over 60% as sure as the sun will rise tomorrow.

italy-govt-bond

Forget Brexit.  It will be conditions like this that set off the next round of creative destruction.

So, would you be willing to risk a 60+% loss in order to get 2.85% interest from your bank?  Of course not.  Why are billions of dollars flowing into these bonds, then?  Because there is no alternative.  Investors are starved for yield.  They would rather risk the devil they know over the devil they don’t.

Fortunately, we have found a few brave capital allocators who are willing to seek higher returns from unknown enterprises like yours because they have the intellectual capital to analyze your business plan and make a rational determination that the expected return is higher and the risk is lower than Italy’s 50-year 2.85% bonds.

 

________________________________

ABOUT VERTICAL CAPITAL ADVISORS

Based in Atlanta, GA and created to help businesses survive the devastation of the Great Recession, Vertical Capital Advisors is a firm built on creating tangible value for our clients.  We work with clients in just about every industry and we work with capital consumers and capital providers.

 

Joe Briner
Managing Director
Vertical Capital Advisors LLC
briner@verticalcapitaladvisors.com
866-912-9543 ext 108

[1] Reference: http://www.wsj.com/articles/italian-treasury-sounding-out-investors-on-50-year-bond-1473260474

[2] Reference: http://www.tradingeconomics.com/italy/government-bond-yield